Estimation of Costs and Benefits of a Proposal

The selection or rejection of a proposal is based on the careful evaluation of costs and
benefits related to the proposal. In the capital budgeting procedure, the estimation of cost and
benefits of different proposals being considered for decision making is the first step. The
estimation of cost and benefits may be made on the basis of input data being provided by
production, marketing, accounting or any other department. What is required is the
synchronization of this data and to make an attempt to forecast the costs and benefits of a
proposal. But the question at this stage is how to measure the cost and benefits of a proposal ?

Two alternatives are suggested for measuring the cost and benefits of a proposal i.e., the
accounting profits and the cash flows.

1. Accounting Profit : The benefits of a proposal may be measured in terms of the profit
generated by it or in terms of a measure based on accounting profits. However, the
accounting profit, which otherwise is a good, estimate of judging the efficiency of any firm,
may not be a good measure to estimate the value/benefit created by a proposal. The
accounting profit as a measure of benefits of a proposal is discarded on the following grounds
:

(a) The accounting profit is, to a large extent, affected by the discretionary accounting
policies being followed by the firm. These policies, which usually differ from one firm to
another or from one period to another, may be depreciation policy, inventory valuation
policy, capital expenditure and revenue expense policy, etc. Thus, the accounting profit is not
an objective figure.

(b) The accounting profit is affected by so many non-cash items such as depreciation, writing
off the accumulated losses, etc. The balancing profit figure after these items is not a true
measure of benefits contributed by a proposal.

(c) The accounting profit measures the profit of any particular year in terms of the money of
that year. However, the cost and benefits of a proposal may occur over a period of number of
years. The benefits if measured in terms of accounting profit, are expressed in monies of
different time period and are not comparable. Similarly, if two mutually exclusive proposals
have different economic lives, then the accounting profits emerging over different periods are
not comparable.

(d) The accounting profit is based on the accrual concepts. For example, the sales revenue
and the expenses, both are recorded for the period in which they occur instead of the period in
which they are actually received or paid.

Thus, in view of these flaws, the accounting profit as a measures of benefits of a proposal is
outrightly rejected. Instead, the cost and benefits are measured in terms of cash flows.

2. Cash Flows : In capital budgeting, the cost and benefits of a proposal are measured in
terms of cash flows. The term cash flow is used to describe the cash movement arising
because of a proposal. Though it may not be possible to obtain exact cash-effect
measurement, it is possible to generate useful approximations based on available accounting
data. The costs are denoted as cash outflows whereas the benefit are denoted as cash inflows.
It may be noted that the cash outflows represent outflows of purchasing power and cash
inflow is an inflow of purchasing power. The cash outflows and inflows are used to denote
the cost and benefit of a proposal.

It may be noted that the accounting profit figure is the resultant figure on the basis of several
accounting concepts and policies. Some of the costs which are deducted from the sales
revenue to arrive at the profit figure do not involve any cash flow. These charges against
profit are simply book entries. For example, depreciation, provision for bad and doubtful
debts, writing off the goodwill, etc., do not involve any cash flow. Similarly, a capital
expenditure though involving a cash payment is not considered as the cost for the period and
hence is not deducted from the sales revenue. Therefore, there is a difference between
accounting profit and cash flow. This difference arises because of non-cash transactions.

The following is the income statement of a firm :

Amount  

Sales Revenue

– Cost of Production ` 60,000

– Depreciation 15,000

Profit before Tax

– Tax @ 40%

Profit after Tax

Now, presuming that all the sales, expenses and taxes have been effected in cash, the cash
flow position of the firm can be expressed as follows :

Amount  

Cash realized from sales

– Cost of Production ` 60,000

 – Taxes paid 10,000

Cash increase

(i.e., cash inflow)

The difference between the Profit after tax (i.e., ` 15,000) and cash inflow (i.e., ` 30,000) is
due to the existence of non-cash expense of depreciation of ` 15,000. On the basis of this
example, the cash flow may be stated as follows :

Cash flow    =   Profit after Tax (PAT) + Non-cash Expenses (N/C Exp.)

Further, if the firm has spent ` 5,000 on capital expenditure, then this will not affect the profit
figure but the cash flow will be reduced by ` 5,000 as follows :

Cashflow = PAT + N/C Exp. – Capital Expenditures

(6.1)

= ` 15,000 +` 15,000 – ` 5,000

= ` 25,000

Equation 6.1 depicts that even if sales and operating expenses are effected in cash, the profit
of the firm and the cash flows may be different. The reason for this difference may be the
non-cash expenses and the existence of capital expenditure.

Example 1

The cost of a plant is ` 5,00,000. It has an estimated life of 5 years after which it would be
disposed of (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is
estimated to be ` 1,75,000 p.a. Find out the yearly cash flow from the plant, (given the tax
rate @ 30%).

Solution :

Annual depreciation charge (` 5,00,000/5)

Profit before depreciation, interest and taxes

 – Depreciation

Profit before Tax

Tax @ 30%

Profit after Tax

+ Depreciation (added back)

Therefore, cash flow

Example 2

ABC Ltd. is evaluating a capital budgeting proposal for which relevant figures are as
follows :

Cost of the Plant

Installation cost

Economic life

Scrap value

Profit before depreciation and tax

Tax rate

Solution :

Annual depreciation charge

 (` 11,03,400 – ` 30,000)/7

Profit before depreciation and taxes

– Depreciation

Profit before Tax

– Tax @ 50%

Profit after Tax

+ Depreciation (added back)

Cash inflow (yearly)

The plant has an initial cash outflow of ` 11,03,400 (` 11,00,000+` 3,400), and its annual cash
inflows for 7 years will be ` 1,76,671 p.a. However, in the 7th year, there will be an
additional cash inflow of ` 30,000 i.e., the scrap value. Therefore, in the 7th year, the total
cash inflow will be ` 2,06,671.

Examples 6.1 and 6.2 make an assumption that all the sales and expenses have been effected
in cash. However, in practice there is a time gap between the occurrence of sales and
expenses and their incidence on cash flow. Thus, pattern of receipts from receivables (debtors
and bill) and the pattern of payments to payable (creditors and bills) should also be analyzed
to assess the effect on cash flow.

Cash Flows versus Accounting Profit : The accounting profits are calculated for

stewardship purposes and are period-oriented. Moreover, the accounting policies relating to
depreciation, inventory valuation, and allocation of indirect costs may cause wide
discrepancies in accounting profit in identical situation. These problems may all be overcome
by focusing on the cash flows which will be identical irrespective of the person making
estimation thereof. The concept of cash flows as a measure of evaluating the cost and benefits
of a proposal is better than the concept of accounting profit in more than one ways as
follows :

(a)   The accounting profit ignores the concept of time value of money, whereas the cash flow
incorporates the time value of money also.
(b)   In capital budgeting, a finance manager is concerned with measuring the economic value
created by a decision rather than book entry value. In cash flow analysis, the cost and benefits
are measured in terms of actual cash inflows and outflows rather than profit figure.

(c)   The accounting profit may be influenced and affected by adopting one or the other
accounting policy, however the cash flow are the actual flows and are not affected by any
such discretionary policy of the firm.

Thus, the cash flows as a measure of cost and benefits of a proposal is a better technique to
evaluate a proposal. The cash flows associated with a proposal may be classified into :

(i) Original or Initial cash outflow,

(ii) Subsequent cash inflows and outflows, and

(iii) Terminal cash flow

1. Original or Initial Cash Outflow : All the capital projects require a sizeable initial cash
outflow before any future inflow is realized. This initial cash outflow is needed to get a
project operational. In most of the capital budgeting proposals, the initial cost of the
project i.e., the initial investment cost is the cash outflow occurring in the initial stages of the
projects. Since the investment cost occurs in the beginning of the project, it is relatively easy
to identify the initial cash outflows. It reflects the cash spent to acquire the asset. There are
several points worth noting here as follows:

(a) Installation cost : The initial cash outflow includes the total cost of the project in order to
bring it in workable condition. Thus, the initial cash outflow includes not only the cost of
plant, but also the transportation cost, installation cost and any other incidental cost.

(b) Sunk cost : Sunk cost is that cost which the firm has already incurred and thus has no
effect on the present or future decisions. If a firm which owns a plot of land which is lying
idle for the time being, is now considering to construct a factory at this plot, then the cost of
the plot is a sunk cost for the factory proposal, and is irrelevant. However, if the plot of land
is to be purchased now, then the cost of the land will be included in the initial cost of the
project.

Suppose, the firm had spent ` 50,000 to erect a fence on this plot of land, when it was lying
idle. This cost of fence is also a sunk cost even if the fence is required for the factory project.
However, if the fence is not required and is to be removed before the new factory building is
constructed, then the cost of removal would be a relevant cost and is to be added to the initial
cost of the project.

Similarly, expenses incurred on conducting a market survey to assess the potential market, or
associated with research and development activities occurring well before the product is
considered for introduction are sunk costs for a product now under full investment analysis.
The sunk costs are neither re-covered if the proposal is rejected nor incremental if the project
is accepted, and therefore, should not be considered in the capital budgeting decision process.

The sunk cost is an irrelevant cost for the investment proposal and is to be ignored. If the
sunk cost is included in the initial cash outflow then the finance manager may commit the
sunk cost fallacy. It may be noted however that although the sunk costs are irrelevant for
capital budgeting proposals yet the firm does need to recover these costs over time otherwise
the firm will cease to exists.

(c) Salvage value of existing asset : In case of replacement decisions, the salvage value of
the existing asset is an inflow. If the firm decides to replace the existing asset then the
outflow would occur on the new asset and simultaneously, an inflow would occur from the
sale of the old. This salvage value is deducted from the outflow to find out the net initial
outflow. Further, that the sale of old asset may result in some profit or loss on sale of asset.
For example, if the book value of the asset, being scrapped, is ` 1,00,000 and it is sold for `
1,80,000. This would be result in a capital loss of ` 20,000. Or, if the asset is sold for `
1,25,000, there would be a capital gain of ` 25,000. This profit or loss would affect the
taxable income and the tax liability. The profit on sale would involve additional tax payment
and loss on sale would result in tax saving, while finding out the initial outflows of a capital
budgeting decision situation. The salvage value of the existing asset, as well as the tax effect
of profit or loss on sale, both are considered.

(d) Opportunity Cost : In some cases the finance manager may overlook some of the costs of
proposal. Such costs may be the opportunity costs of some resources which are already
available or being procured in the firm. Using of some resources, such as office space, for a
new proposal by divesting them from some other existing use, causes the opportunity costs.
When a firm uses such resources, by divesting, there is a potential for opportunity
cost i.e., the cost created for the rest of the business as a consequence of the proposal. This
opportunity cost may be a significant portion of the total cost of the proposal.

The general framework for analyzing the opportunity costs begins by asking the question, “Is
there any other use for this resource right now?” For many resources, there will be an
alternative use if the project being analyzed is not undertaken. The opportunity cost may
occur as follows :

(i) The resource might be rented out, in which case the rental revenue is the opportunity lost
by taking this project.

(ii) The resource could be sold, in which case the sales price (net of tax liability and lost
depreciation tax benefits) would be the opportunity cost of taking this project.

(iii) The resource might be used elsewhere in the firm, in which case the cost of replacing the
resource is considered as the opportunity cost.

Thus, the transfer of experienced employees from established divisions to a new project
creates a cost to these divisions and has to be considered for decisions making. Similarly, if
the office building is to be constructed on an idle plot of land, then the cost of land is a sunk
cost for the building project and be ignored therefore. But, if the firm did not use the plot for
building purpose, it could sell it or use it for some other project and thus the plot of land has
an opportunity cost. So, the firm should include the market value of the land as the part of the
initial cost of the project. The amount originally paid for acquiring the plot is a sunk cost and
is irrelevant.

(e) Additional Working Capital Requirement : Another item that needs consideration to

ascertain the initial cash outflow is the working capital required for the proposal or more
precisely, the change in working capital due to the proposal. Since the change in working
capital affects the cash flows, it is important that the working capital requirement of every
alternative proposal be analyzed and considered for the capital budgeting decision.

An investment proposal if accepted, would require increase in minimum cash balance to be

maintained, higher inventory level and more receivables. The new project may require the
firm:

(i) to extend additional credit to its customers

(ii) to carry additional inventory to serve customer orders

(iii) to enlarge its cash balance to meet its enlarged transactions

This additional working capital is the additional investment to be made in the project, and is
therefore, also included in the initial cash outflows of the project. However, the additional
working capital is required only for the period equal to the life of the proposal. At the end of
the proposal, this additional working capital being invested now will be released and
recaptured by the firm. Thus, the cash inflow for the last year of the life of the project would
also include the working capital released by the project.

Failure to consider the working capital needs in the capital budgeting decision may have two
consequences i.e.

(i) the cash flows will be over-estimated

(ii) even if, working capital is salvaged fully at the end of the project life, the net present
value of the cash flows created by change of working capital will be negative and hence the
capital budgeting decision may be taken wrongly.

2. Subsequent Annual Inflows and Outflows : The original investment cost or the initial
cash outflow of the proposal is expected to generate a series of cash inflows in the form of
cash profits contributed by the project. These cash inflows may be same every year
throughout the life of the project or may vary from one year to another. The timings of the
inflows may also be different. The cash inflows mostly occur annually, but in some cases
may occur half-yearly or biannually also. These cash inflows generated during the life of the
project may also be called operating cash flows. There are different ways of finding out the
operating cash inflows. These can be explained as follows :

Sales

– Costs

– Depreciation

Profit before tax

 Tax @ 34%

Profit After Tax

Operating cash inflows (OCF) may be found as under :

(i)    OCF    =   PBT + Dep. – Tax

=   ` 20,000 + 60,000 – 6,800 = ` 73,200

(ii)   OCF    =   PAT + Dep.

=   ` 13,200 + 60,000 = ` 73,200

(iii)  OCF    =   Sales – Costs – Taxes

=   ` 1,50,000 – 70,000 – 6,800 = ` 73,200

(iv)  OCF    =   (Sales – Costs) (1 – t) + Dep. (t)

=   (` 1,50,000 – 70,000) (1 – .34) + ` 60,000 (.34) = ` 73,200

The Operating cash flows are positive cash flows for most of the conventional revenue
generating proposals, however, in case of cost reduction proposals these cash flows may be
negative.

Following points are worth noting here :

a. Sometimes, the project may require some subsequent cash outflows also in the form of
periodic intensive repair, periodic shunting cost, etc. All these cash inflows and outflows are
to be considered for the capital budgeting decision.

b. If additional working capital is required by the proposal in any of the subsequent years
then it should be considered as outflow for that year. However, if the working capital is
released in any of the subsequent years, then it should be considered as cash inflow for that
year.

c. It is important to recognize the timing of these subsequent cash inflows and outflows, as
these are to be adjusted for the time value of money. The more quickly and earlier, the cash
inflows occur, the more valuable these are.

So, subsequent annual cashflow can be described as :

 Annual PAT + Non-cash expenses – Capital expenditure ± Change in
=
Inflow working capital

3. Terminal Cash Inflows : The cash inflows for the last year will also include the terminal
cash flows in addition to annual cash inflows. Two common terminal cash inflows may occur
in the last year. First, as already noted, the estimated salvage or scrap value of the project
realizable at the end of the economic life of the project or at the time of its termination is the
cash inflow for the last year. At the time of disbanding or termination of the project, the
market value of the land etc. also become cash inflows from the project. Second, as already
noted, the working capital which was invested (tied up) in the beginning will no longer be
required as the project is being terminated. This working capital released will be available
back to the firm and is considered as a terminal cash inflow. So,

Sale Price of asset ± Tax effect of sale of asset + Working

Terminal CF =
capital released.

Incremental Approach to Cash Flows

In capital budgeting, the cash flows are measured in the incremental terms i.e., only those
cash flows are considered, that differ or occur as a result of undertaking/accepting the
particular proposal. These incremental cash flows are also known as relevant cash flows.
These refer to those cash flows which can be associated and attributed to adoption of a
particular proposal.

So, what is a relevant cash flow? In general, a relevant cash flow for a project is a change (in
the firm’s future cash flows) that occurs as a direct consequence of the decision to accept that
project. As the relevant cash flows are defined in terms of changes in a increments to the
existing cash flows, these are called incremental cash flows. The concept of incremental cash
flows is central to the process of capital budgeting.

Any cash flows that exists or is expected to occur regardless of whether a project is taken up
or not, is not a relevant cash flow and is ignored in capital budgeting. Following points are
worth nothing about incremental cash flows :

(i) Stand Alone Principle : If an existing firm is taking up a new project, then it would be
very tedious and cumbersome to actually calculate the total future cash flows of the firm with
or without that project. In order to avoid this situation, the stand alone principle is applied and
only the effect of project’s cash flows on the firm’s otherwise cash flows is identified.

‘Stand Alone Principle’ implies that each project is a ‘minifirm’ within the larger firm. Each
‘minifirm’ has its costs, revenues and cash flows. So, the ‘minifirm’ be evaluated on the basis
of its own cash flows, rather than the total cash flows of the firm. Thus, a project is evaluated
purely on its own merits, in isolation from other activities of the firm.
(ii) Co-existence with the proposal : The incremental cash flows are those which co-exist
with a proposal i.e., the particular cash flows may appear only if the project is undertaken.
For example, ABC & Co. is evaluating project X and project Y. The project X requires an
intensive repairs costing ` 1,00,000 at the end of 5th year, while the project Y necessitates an
annual service contract for ` 25,000 p.a. In this case, the repair cost of ` 1,00,000 is relevant
for project X only, while the annual cash outflow of ` 25,000 is relevant for project Y only.
The repair cost is not required if project Y is implemented and the service contract is not
required if the project X is installed.

(iii) Allocated Overhead costs : The overhead costs are those which are not directly related
to a product. These are allocated to a product on some rational basis such as machine-hour
rate etc. These overhead costs which are already being incurred by the firm and perhaps also
being charged from the goods produced presently, are irrelevant from the point of view of
new project. If therefore, some existing overhead cost is allocated to the new proposal, then
this is not to be considered for finding out relevant cash flows of the proposal. Moreover, it is
not incremental. However, if the overhead costs is expected to increase after the new project
is implemented, then only this incremental overhead cost will be considered as costs and the
cash outflow for the proposal.

For example, any increase in administrative or staff cost that can be traced to the project is an
incremental cost and should be considered. One way to estimate the incremental component
of these costs is to break them down on the basis of whether they are fixed or variable, and, if
they are variable, what they are a function of.

(iv) Product Cannibalization : This refer to the phenomenon whereby a new product

introduced by a firm competes with and reduces sales of some other existing product of the
same firm. The product cannibalization refers to the sales generated by one product, which
come at the expense of other products being sold by the same firm. On one level, it can be
argued that this is a negative incremental effect of the new product, and the lost cash flows or
profit from the existing products should be treated as costs in analyzing whether or not to
introduce the product.

The decision whether or not to include the cost of lost sales created by product
cannibalization will depend on the potential for a competitor to introduce a close substitute to
the new product being considered. Two extreme possibilities exist :

(i) If the business in which the firm operates is extremely competitive and there are no
barriers to entry, it can be assumed that the product cannibalization will occur any way, and
the costs associated with it have no place in an incremental cash flows analysis.

(ii) If a competitor cannot introduce a substitute, because of legal restrictions such as patents,
the cash flows lost as a consequence of product cannibalization should be included in the
capital budgeting analysis, at least for the period of the patent protection.

In most cases, there will be some barriers to entry, ensuring that a competitor will either
introduce an imperfect substitute, leading to much smaller erosion in existing product sales,
or that a competitor will not introduce a substitute for some period.

In this case, an intermediate solution whereby some of the product cannibalization costs are
considered, may be appropriate. Firms with stronger brand name loyalty should include into
their capital budgeting analysis, most of the cost of lost sales resulting as a consequence of
new product.

The principle of incremental cash flows in capital budgeting analysis is critical. A finance
manager while evaluating a proposal should note whether a particular cash flow is
incremental or not. Only the incremental cash flows should be considered for capital
budgeting. Any cash inflow or outflow that can be directly or indirectly traced to a project
must be considered. Obviously, the incremental cash flows analysis also implies that any
reduction in cash inflow or outflow that occurs as a consequence of a project should also be
considered.

Taxation and Cash Flows

The cash flows that are related to capital budgeting decisions are the after-tax cash flows
only. The after-tax cash flows resulting from a project are in fact the relevant incremental
cash flows. These after-tax cash flows would not occur if the project is not undertaken.

The annual cash inflow from a project will result in increase in the taxable profit. So, the cash
flow from a project would also affect the tax liability of the firm. The increase in tax liability
will be equal to the cash inflow multiplied by the tax rate. Or, the net cash inflow will be
equal to cash inflow (before tax) multiplied by (1-tax rate). Therefore, the relevant cash flow
for a capital budgeting decision is the cash flow net of incremental tax liability. It may be
noted that in Chapter 1, one of the axioms of financial management has been given as “All
financial decisions are subservient to tax laws”.

So, the capital budgeting analysis should be done in after-tax terms. This implies that all
items that affect taxes, even non-cash item such as depreciation, should be considered in the
analysis.