Ab22eCapital Budgeting- I (1)

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Amity Business School

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BY:

Shamsher jang




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The Position of Capital Budgeting

Capital Budgeting

Long TermAssets Short TermAssets

Investment Decison

Debt/Equity Mix

Financing Decision

Dividend Payout Ratio

Dividend Decision

Financial Goal of the Firm:

Wealth Maximisation

Position of Capital Budgeting




Capital Budgeting- Meaning

Capital Budgeting refers to the expenditure on the

capital assets.

Spending money on capital assets is a very important

decision that a finance manager is required to take.

Capital investment expenditure may be on Plant,

Machinery Equipment, Land, Building etc.




Capital RationingCapital rationing is the financial situation in which a

firm has only fixed amount to allocate among

competing capital expenditures.

This refers to a situation in which a firm has more

acceptable investments than it can finance. This

involves ranking of the acceptable investment

projects.




Significance of Capital

Budgeting




It involves substantially higher amounts than for

other routine expenses.

The decision is irreversible, i.e. it is not possible to

withdraw your steps easily, once you have taken few

steps in this regard.

It has long term impact on the affairs of a company

and it, hence determines the future of a company.




An expenditure made on a capital asset has a long term

perspective.

We spend today, to gain some advantages in future.

This expenditure involves a big cash outflow of funds

initially, compensated by small but recurring doses of

inflow of funds in future for some time.




Cash Flow Pattern

Conventional: Conventional cash flow pattern is aninitial outflow followed by only a series of inflows

Non-conventional: Alternating inflows and outflows

and an inflow followed by outflows are examples of

non-conventional cash flow patterns.




Cash Flows in a Conventional Project

+

0

í 1 2 3 4 5 6

Y

+ shows Cash inflows

&

- shows Cash outflows




The essence of the capital budgeting decision making

is to determine, whether the initial expenditure of

funds is duly compensated by the inflow of funds

occurring in future.

If greater values can be assigned to the inflow of

funds than the present expenditure, then that capitalinvestment proposal must be accepted because that

will add up to the wealth of the company.




Nature of Capital Budgeting

The Capital Budgeting decision is a decision on an expenditure

of capital nature which is intended to create physical assets.

The assets in return are expected to reap benefits to the

company for the years to come.




The expenditure on monetary assets like purchase of Bonds,

Shares, Treasury bills, Debentures etc.) is NOT to be treated as

a capital budgeting expenditure.

Only investment in physical assets is appraised in capital

budgeting while investment in monetary and financial assets is

appraised under portfolio analysis.




Types of Capital Budgeting Decisions

From the point of view of firm¶s existence

From the point of view of Decision Situation



Amity Business SchoolFrom the point of view of firm¶s existence

(a) New Firm

(b) Existing Firm

Replacement & Modernization Decision

Expansion

Diversification




Mutually Exclusive Decisions

Mutually exclusive projects (decisions) are projects that compete with oneanother; the acceptance of one eliminates the others from further consideration.

Contingent Decisions

TheyThey areare dependentdependent projectsprojects;; thethe choicechoice of of oneone investmentinvestment necessitatesnecessitatesundertakingundertaking oneone or or moremore other other investmentsinvestments

Independent Projects / Accept-Reject Decisions

TheyThey areare projectsprojects whosewhose cashcash flowsflows areare unrelatedunrelated / / independentindependent of of oneoneanother another;; thethe acceptanceacceptance of of oneone doesdoes notnot eliminateeliminate thethe othersothers fromfrom further further considerationconsideration..

From the point of view of Decision Situation




Capital Budgeting Process

Generati n of Investment Ideas

Estimating Cash Flows

Eval ating Cash Flows

Selecting Projects

Execution and Monitor ing




Cash Flow ± Concept & Estimation

Every investment proposal involves cash f lows- large initial cash

outf low followed by small but recurr ing inf lows.

The crux of the whole process is, to assess whether the value of

inf lows is greater than the outf lows or not.

If greater value can be assigned to the inf lows/ returns than the

outf lows/ expenditure, the proposal may be treated as prof itable and

therefore, acceptable.




Principles of Cash-flow Estimation




Capital Budgeting should be based on cash flows. The reason is that

cash f lows are very certain amounts and are not subject to different

interpretation by different people.




Accrual pr inciple is considered better for the purpose of accounting

(Probably because it calculates prof it or loss for a given per iod), butfor a long term investment decision making, cash pr inciple will be

better.




Every payment of cash, for whatever purpose is an outflow,

While every receipt of cash, for whatever reason is an inflow.

Any Non cash expenditure (like depreciation) will not be

accounted for because it does not involve any cash f lows.




Cash f low should be taken on µ After±Tax¶ basis. One should

calculate Cash Flow After Tax (CF ATs)

Sunk Costs should be ignored. The cost which have already been

incurred should not be taken in to account while calculating cash

outf lows for a per iod.




A very important aspect of each cash f low calculation is that cash

flow on account of interest payments are NOT to be considered,

while making the calculation of cash f low, because the discounting of

cash f low for their time value of money automatically takes in to

account the interest cost of any investments.




Treatment of Working Capital in

Project Evaluation




Almost every Investment proposal requires an additional investment

in Working Capital (in some form or the other).

The proposal, if accepted would require increase in minimum Cash

Balance , higher inventory levels or more receivables.

Any additional investment in working capital cannot be used

elsewhere and is similar to an investment made in building, plant.

Machinery etc. It has to be viewed as a cash outf low, when it is

made.

At the end of the proposal , this additional working capital being

invested now will be released . Thus, any decrease in working

capital can be treated as a release of working capital or cash inf low.




Hence, Cash needs for working capital should be treated as a cash

outf low at the time of commencement of a project and should be

treated as inf low when that cash is released at the time of closure or

termination of projects.




Requirements of Good Method of P

rojectEvaluation It should be based on cash f lows rather than on prof its or

expenditures.

Cash f lows to be recovered over the entire expected life of the assetrather than few years only.

It should give absolute value of gain or loss.

It should consider the time value of money.

It should indicate relative prof itability between different alternatives,

so that a ranking can be made between different proposals.

It should indicate the degree of r isk and the chances of getting prof it

or loss in a given situation.




General Rules for Calculation of Cash Flow inCapital Budgeting Proposals

1. Only ³Cash Flows´ are relevant : Cash Flow should be

differentiated from accounting prof its.

2. Cash f lows should be recorded only when they occur and not

when the work is undertaken or liability incurred.

3. Estimate cash f lows on an incremental basis that follow from the

project.

4. Estimate Cash f lows before interest.




5. Include effect of Cannibalization .

6. Include Working Capital equirements.

7. Forget Sunk Costs

8. Include Opportunity Cost

9. Beware of Allocated Overhead Cost : If the amount of overhead

changes as a result of the investment decision, then they are

relevant and should be included.

10. Effect of Depreciation




Relevant Cash Outf lows Irrelevant Cash Outf low

1. Var iable Labour expenses 1. Fixed Overhead expenses(existing) / Allocated Overheads

2. Var iable mater ial expenses 2. Sunk Cost

3. Additional f ixed overhead

expenses

4. Cost of the investment

5. Marginal Taxes

Relevant and Irrelevant Outflows




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CAPITAL BUDGETING DECISION INVOLVESTHREE STEPS:

1. Estimation of costs and benef its of a proposal or of each

alternative ( determination of Cash Flows)

2. Estimation of the required rate of return, i.e., the cost of

capital

3. Selection and applying the decision cr iter ion.




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1.ESTIMATION OF CASH FLOWS

The costs and benefits for a capital budgeting

decision situation are measured in terms of cash

flows.

An important point is that all cash flows are

considered on after tax basis.

The cash flow from the project are compared with the

cost of acquiring the project.




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Calculation of different cash flows

INITIAL CASH OUTFLOW:

Cost of new plant

+ Installation expenses

+ Other Capital expenditure

+ Additional working capital

- { }Salvage value ( Scrap Value)

of old plant -Tax liability on account

of capital gain on sale of old

plant (if any).




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SUBSEQUENT ANNUAL INFLOWS:Profit after tax (PAT)

+ Depreciation

± Repairs (if any)

± Capital Expenditure (if any).

TERMINAL CASH INFLOW:

Annual cash inflow

+ Working capital released

+ { }Salvage value ( Scrap Value)

of new asset -Tax liability on account

of capital gain on sale of

new asset (if any).




Capital Gain = Salvage Value of Asset

- Book Value of Asset

( or Wr itten Down Value of

asset)

If the value is negative, then it is Capital Loss




Question




A

company desires to make an investment of R

s. 1,00,000 in a newmachinery. Additional installation and transportation cost is Rs. 20,000.

The Machine has a life of 5 years after which it is expected to fetch Rs.

10,000 as scrap value.

The machine is expected to generate an output of 2000 units p.a. in thef irst 2 years and 3000 units p.a. for the last 3 years.

The Product is expected to fetch Rs. 15 in the f irst 3 years and Rs. 18 in

the last 2 years.

The additional cost of operating a machine is expected to be Rs.5,000

p.a. for the f irst 3 years and Rs. 8,000 p.a. thereafter.

Calculate Cash Flow After Tax (CF ATs) for the above proposal on the

assumption of Straight line depreciation and tax rate 30%.




Solution




INITIAL CASH OUTFLOW:

Cost of new machinery 1,00,000

Add : Installation expenses 20,000

1,20,000




Calculation

of

Depreciation

Cost of Machinery 1,00,000

Add: Transportation &

Installation Cost 20,000

1,20,000

Less: Scrap Value 10,000

Total Amount to be depreciated 1,10,000

Annual Depreciation =

1,10,000/5

22,000




Year 1 2 3 4 5a. Output (Units) 2,000 2,000 3,000 3,000 3,000

b. Price (Rs.) 15 15 15 18 18

c. Revenue [ a x b] 30,000 30,000 45,000 54,000 54,000

Less :Operating Exp.

5,000 5,000 5,000 8,000 8,000

Less: Depreciation 22,000 22,000 22,000 22,000 22,000

d. Profit Before Tax (PBT) 3,000 3,000 18,000 24,000 24,000

Less : Tax @ 30% 900 900 5,400 7,200 7,200

e. Profit After Tax (PAT) 2,100 2,100 12,600 16,800 16,800

Add Back : Depreciation 22,000 22,000 22,000 22,000 22,000

CFAT (PAT + Dep.) 24,100 24,100 34,600 38,800 38,800

SUBSEQUENT ANNUAL INFLOWS




Annual cash inflow 38,800

Scrap Value 10,000

(in Rs.) 48,800

TERMINAL CASH INFLOW:

Ab22eCapital Budgeting- I (1)

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