[MUSIC PLAYING] This is Dr. Bob Nolley, continuing our discussion on capital budgeting. We noted that the first step in the capital budgeting process is evaluation of cash flows. This lesson will cover some additional points to be made about this process.
You will recall that there are three types of cash flows that we could consider during capital budgeting. Operational cash flows are those that originate from the core internal business of an organization. Financing cash flows originate from the issuance of debt or equity. And investment cash flows are those originating from assets other than capital expenditures that earned dollar returns.
But there are other considerations to take into account during this process. The first special consideration that needs to be given to a cash flow is that of replacement projects. A replacement project is an undertaking in which the company eliminates a project that is at the end of its life and substitutes another investment. This replacement project could serve the purpose of replacing existing investment with a new identical one, or placing an existing one that is producing unfavorable results with one that management believes will perform better.
When considering a replacement project, two things need to be considered. The first of these is the cash flows from the original project. An analysis needs to be done to decide the optimal time to exchange these projects.
This leads to the second replacement project issue, and that is salvage value. This could be from the sale of existing equipment. And that cash flow needs to be considered for the new project.
The second cash flow consideration concerns sunk costs. Sunk cost are costs from the past that have already been booked and cannot be recovered. These are different from future costs which could be avoided if action was taken.
An example of a sunk cost is the research and development cost that a business may incur. If R&D spends a year researching the viability of our product line, the cost of research should not be considered when pricing the new product. That cost is already sunk.
A third cash flow consideration is taxes. There are different ways to look at the tax impact as it pertains to cash flows. There is the statutory tax rate that is mandated by law. And in the United States, the corporate tax rate is 21%, recently lowered from 35%.
However, 44 of the 50 United States also levy a state corporate income tax. So this brings the effective average tax rate to a little over 25%. And since for many of the states there are income tax brackets for corporations, they need to consider the marginal tax rate, which is the tax rate that will be paid on the next dollar of income.
The fourth and final cash flow factor that needs to be considered is depreciation. Depreciation is the implementation of the accounting matching principle where the cost of assets is matched to the period in which the revenue was earned by them.
For example, a machine that last five years would not have this total expense recognized in the year of purchase, but rather would be divided over the course of its five year life. Financial statements recognize depreciation as an expense, but it is not a cash flow in that period. Cash flow analysis during capital budgeting needs to recognize the difference between the accounting impact and the cash flow impact of equipment acquisition.
Let's review the aspects of cash flow analysis that businesses need to be sure to consider. Replacement projects concerning the acquisition of new assets that will replace assets already in service. Determination of cash flows from the first project need to be considered, as well as any potential salvage value of the older equipment.
Sunk costs need to be recognized but not included in the project decisions. Sunk cost are unrecoverable.
Tax rates need to be considered at both the federal and the state level. While the statutory regular corporate tax rate is 25%, the marginal tax rate may be different depending on the tax brackets for corporations in the states in which they are chartered.
Finally, depreciation needs to be considered. It is the impact on allocating the cost of a capital acquisition over the life of an asset rather than recognizing it in the year of purchase. It shows as an expense on financial statements, but it is a non-cash item.
This is Dr. Bob Nolley. And I'll see you in the next lesson.
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