USA Capital Budget
Annual cash flows can be used to analyze potential investments by companies, known as capital budgeting. Projected cash flows are generated, and then analysis is performed to determine whether a project meets required criteria for approval, and to make a comparison decision between multiple possible projects.
USA Capital Budgeting
There are 5 critical steps to Capital Budgeting in the US.
1) Determine the initial net cost of the project. Calculate all costs and revenues involved in the capital investment.
2) Determine the amount of working capital required for the duration of this project. This working capital could be due to increased levels of inventory, or increased accounts receivables due to higher levels of sales.
3) Determine the incremental changes in revenues and costs for each year of the Capital Budgeting Project. Input the costs and revenues as positive values in the appropriate column for each year of the project. Determine the amortization deduction for each year of the Capital Budgeting Project, as this will change the taxes payable each year, even though it is a non cash deduction.
4) Determine the net salvage value of the capital assets at the end of the Capital Budgeting Project. Include all costs and revenue involved in decommissioning the project.
5) Recover the working capital that was originally committed for use in this project.
USA Capital Budget Instructions
Required Rate of Return
Input the required rate of return that the company uses to evaluate its capital investments.
Number of Periods
Input the number of years over which the capital budget will be assessed.
Initial Net Cost
Input the total net initial cost, including the cost of the asset, and all related initial costs.
Net Salvage Value
Input the salvage value at the end of the project, net of any additional related costs.
Input the working capital requirements of this project. The working capital will be a negative cash flow at the beginning of the project, and will be recouped at the end of the project.
Input the tax rate. The tax rate will be applied to revenues less costs, less amortization deduction.
Input the total annual revenue each year of the project as a positive value.
Input the total annual cost each year as a positive value.
Input the annual amortization deduction related to this project. The amortization deduction will reduce the taxes paid, as amortization is a tax deductible expense, but is not included in cash flow projections as it is a non cash expense.
Descriptions & Formulas
Net Present Value (NPV) is the present value of all projected cash flows, discounted by the required rate of return of a company. If the NPV is positive, then the potential project is expected to generate a return higher than the cost of implementation. NPV is used to compare the expected return of multiple projects, but care must be taken to understand the effect different time horizons may have on the NPV of different projects.
Internal Rate of Return (IRR) is used to compare the rates of return generated by cash flows over a period of time. IRR sets the NPV to 0, and then solves for k, the rate of return. IRR is used to compare multiple projects, but has some limitations. It assumes that all positive cash flows can be re-invested at the same rate of return. This might not be a reasonable assumption if the rate differs from available rates of return available from other projects. IRR will also produce a false result if there are positive cash flows followed by negative cash flows.
Profitability Index is a variation of NPV, comparing discounted future cash flows against the initial outlay in the form of a ratio. This ratio compares the magnitude of the future cash flows against the initial investment required to initiate the project. This is useful for comparing the profitability of projects of different sizes, where NPV might favor a larger project, but the smaller one might be more profitable.
Equivalent Annual Annuity (EAA) is used to compare projects with different time horizons. A longer project might produce a higher NPV than a shorter one, simply due to the greater amount of positive cash flow, but not be as profitable as the shorter one. EAA is used to compare projects with different time horizons on an annual basis, by taking the individual NPV of the project, and determining the equivalent annual annuity payment the project would return over the life of the project.
NPV=Net Present Value of a project
K=Required Rate of Return
N=Number of years of project
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