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The first step in the capital budgeting process is the evaluation of cash flows. Recall there are three types of cash flows that are considered during capital budgeting.
There are other considerations to take into account during the cash flow analysis.
The first special consideration that needs to be given to 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 an existing investment with a new identical one or replacing 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 second cash flow consideration concerns sunk costs. Sunk costs are costs from the past that have already been booked and cannot be recovered. These are different from future costs, which can be avoided if action is taken.
EXAMPLE
Research and development costs are sunk costs that a business may incur. If R&D spends a year researching the viability of a 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. This brings the effective average task rate to a little over 25%.
Also, 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 is earned by them.
EXAMPLE
A machine that lasts five years would not have its 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.
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