Capital Budgeting

Decisions
Introduction
 Capital Budgeting is the process of evaluating and selecting long-
term investments that are consistent with the goal of shareholders
(owners) wealth maximisation.
 Capital Expenditure is an outlay of funds that is expected to produce
benefits over a period of time exceeding one year.
 Such decisions are of paramount importance as they affect the
profitability of a firm, and are the major determinants of its
efficiency and competing power. While an opportune investment
decision can yield spectacular returns, an ill-advised/incorrect
decision can endanger the very survival of a firm.
Contd.
 Capital expenditure decisions are beset with a number of difficulties. The major difficulties are:
 The benefits from long-term investments are received in some future period which is
uncertain. Therefore, an element of risk is involved in forecasting future sales revenues as
well as the associated costs of production and sales.
 Costs incurred and Benefits received from CB decisions occur in different time period.
 It is not often possible to calculate in strict quantitative terms all the benefits or the costs
relating to a specific investment decision.
Types
 Capital budgeting decisions are of two types:
 Investment Decisions Affecting Revenues: It is more difficult to estimate revenues and costs
of a new product line.
 Investment Decisions Reducing Costs: Such types of decisions are subject to less risk as the
potential cash saving can be estimated better from the past production and cost data.
 Capital Budgeting Process includes four distinct but interrelated steps used to
evaluate and select long-term proposals: proposal generation, evaluation, selection
and follow up.
 Three types of decisions:
 Accept-reject Decision
Accept reject decision/approval is the evaluation of capital expenditure proposal to
determine whether they meet the minimum acceptance criterion.
All independent projects are accepted.
 Mutually Exclusive Project Decisions
Mutually exclusive projects (decisions) are projects that compete with one another; the
acceptance of one eliminates the others from further consideration.
 Capital Rationing Decision
Capital rationing is the financial situation in which a firm has only fixed amount to
allocate among competing capital expenditures.
Cash Flow vs Accounting Approach
 The capital outlays and revenue benefits associated with such
decisions are measured in terms of cash flows after taxes. The cash
flow approach for measuring benefits is theoretically superior to the
accounting profit approach as it: avoids the ambiguities of the
accounting profits concept, measures the total benefits and takes
into account the time value of money.
 The major difference between the cash flow and the accounting
profit approaches relates to the treatment of depreciation. While the
accounting approach considers depreciation in cost computation, it is
recognised, on the contrary, as a source of cash to the extent of tax
advantage in the cash flow approach.
Incremental Cash Flows
 The data requirement for capital budgeting are after tax cash outflows and cash inflows. Besides, they should be
incremental in that they are directly attributable to the proposed investment project. The existing fixed costs,
therefore, are ignored. In brief, incremental after-tax cash flows are the only relevant cashflows in the analysis of
new investment projects.
 Incremental Cash Flows are the additional cash flows (outflows as well as inflows) expected to result from a
proposed capital expenditure.
 Relevant Cash Flow is the incremental after-tax cash outflow (investment) and resulting subsequent inflows
associated with a proposed capital expenditure.
Table 1: Relevant and Irrelevant Outflows
Relevant Cash Outflows Irrelevant Cash Outflows
1. Variable labour expenses 1.Fixed overhead expense
(existing)
2.Variable material expenses
2. Sunk costs
3. Additional fixed overhead
expenses
4. Cost of the investment
5. Marginal taxes
Cash Flow Pattern
 Conventional Cash Flow Pattern
 Conventional cash flow pattern is an initial outflow followed by a series of inflows.

 Non-Conventional Cash Flow Pattern

 Non-conventional cash flow pattern is a pattern in which an initial outflow is not followed by a series of
inflows.
 Eg: alternating inflows and outflows
 Eg: A machine purchased for Rs. 1000 L generates a cash flow of Rs 250L each for next five years. In sixth
year, an outlay of Rs. 400L is required to overhaul the machine, after which it generates cash flows of Rs.
250 for next four years.
 Cash Flow Estimates: There are certain ingredients of cash flow streams.
 Tax Effect
 Effect on Other Projects
 Effect of Indirect Expenses
 Effect of Depreciation
 Working Capital Effect
 Salvage Value
 The data requirement for capital budgeting are cash flows, that is, outflows and inflows. Their computation
depends on the nature of the proposal. The investment in new capital projects can be categorised into:
 Single proposal
 Re-placement proposal
 Mutually exclusive proposals
Single Proposal
 In the case of single/independent investment proposal, cash outflows primarily consist of
 Purchase cost of the new plant and machinery
 Its installation costs
 Working capital requirement to support production and sales (in the case of revenue
expanding proposals/release of working capital in cost reduction proposals.
 The cash inflows after taxes (CFAT) are computed by adding depreciation (D) to the projected
earnings after taxes (EAT) from the proposal.
 In the terminal year of the project, apart from operating CFAT, the cash inflows include
salvage value (if any, net of removal costs), recovery of working capital and tax
advantage\taxes paid on short-term capital loss/gain on sale of machine (if the block ceases
to exist).
Format 1: Cash Outflows of New Project [Beginning of the Period at Zero Time (t = 0)]

1. Cost of new project

2. + Installation cost of plant and equipment
3. ± Working capital requirements

Format 2: Determination of Cash Inflows: Single Investment Proposal (t = 1 – N)

Particulars Years
1 2 3 4 .... N
Cash sales revenues
Less: Cash operating cost
Cash inflows before taxes (CFBT)
Less: Depreciation
Taxable income
Less: Tax
Earning after taxes
Plus: Depreciation
Cash inflows after tax (CFAT)
Plus: Salvage value (in nth year)
Plus: Recovery of working capital (in nth year)
Example 1
An iron ore company is considering investing in a new processing facility. The
company extracts ore from an open pit mine. During a year, 1,00,000 tonnes of
ore is extracted. If the output from the extraction process is sold immediately upon
removal of dirt, rocks and other impurities, a price of Rs 1,000 per ton of ore can
be obtained. The company has estimated that its extraction costs amount to 70
per cent of the net realisable value of the ore.
As an alternative to selling all the ore at Rs 1,000 per tonne, it is possible to
process further 25 per cent of the output. The additional cash cost of further
processing would be Rs 100 per ton. The proposed ore would yield 80 per cent
final output, and can be sold at Rs 1,600 per ton.
For additional processing, the company would have to install equipment costing
Rs.100 lakh. The equipment is subject to 20 per cent depreciation per annum on
reducing balance (WDV) basis/method. It is expected to have useful life of 5
years. Assume that the depreciation in the last year is not charged in accordance
with Gross Block of Assets concept.
Additional working capital requirement is estimated at Rs.10 lakh. The company’s
cut-off rate for such investments is 15 per cent. Corporate tax rate is 35 per cent.
Assuming the the expected salvage is Rs 10 lakh, compute the cash inflows and
outflows.
Solution
Financial Evaluation Whether to Instal Equipment for Further Processing of Iron Ore
(A) Cash Outflows
Cost of equipment Rs 1,00,00,000
Plus: Additional working capital 10,00,000
1,10,00,000
(B) Cash Inflows (CFAT)
Particulars Year
1 2 3 4 5
Revenue from processing
[(Rs 1,600 × 20,000) –
Rs 1,000 × 25,000)] Rs 70,00,000 Rs 70,00,00 Rs 70,00,000 Rs 70,00,00 Rs 70,00,00
Less: Processing costs: 0 0 0
Cash costs (Rs 100
× 25,000 tons) 25,00,000 25,00,000 25,00,000 25,00,000 25,00,000
Depreciation
(working note 1) 20,00,000 16,00,000 12,80,000 10,24,000 —
Earnings before taxes 25,00,000 29,00,000 32,20,000 34,76,000 45,00,000
Less: Taxes (0.35) 8,75,000 10,15,000 11,27,000 12,16.600 15,75,000
Earnings after taxes (EAT) 16,25,000 18,85,000 20,93,000 22,59,400 29,25,000
Add: Depreciation 20,00,000 16,00,000 12,80,000 10,24,000
CFAT 36,25,000 34,85,000 33,73,000 32,83,400 29,25,000

Also, Salvage value and release of WC

In terminal year
Working Notes
1 Depreciation Schedule
Year Depreciation base of equipment Depreciation @ 20% on WDV
1 Rs 1,00,00,000 Rs 20,00,000
2 80,00,000 16,00,000
3 64,00,000 12,80,000
4 51,20,000 10,24,000
5 40,96,000 Nil@
@Given
Replacement Situation
 In the case of replacement situation, the sale proceeds from the existing machine reduce the cash
outflows required to purchase the new machine. The relevant CFAT are incremental after-tax cash
inflows.
Format 3: Cash Outflows in a Replacement Situation.

1. Cost of the new machine

2. + Installation Cost
3. ± Working Capital
4. – Sale proceeds of existing machine

Format 4: Depreciation Base of New Machine in a Replacement Situation.

1. WDV of the existing machine

2. + Cost of the acquisition of new machine (including installation costs)
3. – Sale proceeds of existing machine
Example 3
Royal Industries Ltd is considering the replacement of one of its moulding
machines. The existing machine is in good operating condition, but is smaller than
required if the firm is to expand its operations. It is 4 years old, has a current
salvage value of Rs 2,00,000 and a remaining life of 6 years. The machine was
initially purchased for Rs 10 lakh and is being depreciated at 20 per cent on the
basis of written down value method.
The new machine will cost Rs 15 lakh and will be subject to the same method as
well as the same rate of depreciation. It is expected to have a useful life of 6 years,
salvage value of Rs 1,50,000 at the sixth year end. The management anticipates
that with the expanded operations, there will be a need of an additional net working
capital of Rs 1 lakh. The new machine will allow the firm to expand current
operations and thereby increase annual revenues by Rs 5,00,000; variable cost to
volume ratio is 30 per cent. Fixed costs (excluding depreciation) are likely to
remain unchanged.
The corporate tax rate is 35 per cent. Its cost of capital is 10 per cent. The
company has several machines in the block of 20 per cent depreciation.
Should the company replace its existing machine? What course of action would
you suggest, if there is no salvage value?
Solution
Financial Evaluation Whether to Replace Existing Machine
(A) Cash Outflows (Incremental)
Cost of the new machine Rs 15,00,000
Add: Additional working capital 1,00,000
Less: Sale value of existing machine 2,00,000
14,00,000
(B) Determination of Incremental CFAT (Operating)
Year Incremental Incremental Taxable Taxes EAT CFAT
contribution(a) depreciation(b) income (0.35) [Col. 4-Col.5] [Col.6 + Col.3]

1 2 3 4 5 6 7
1 Rs 3,50,000 Rs 2,60,000 Rs 90,000 Rs 31,500 Rs 58,500 Rs 3,18,500
2 3,50,000 2,08,000 1,42,000 49,700 92,300 3,00,000
3 3,50,000 1,66,400 1,83,600 64,260 1,19,340 2,85,740
4 3,50,000 1,33,120 2,16,800 75,908 1,40,972 2,74,092
5 3,50,000 1,06,496 2,43,504 85,226 1,58,278 2,64,774
6 3,50,000 55,197 2,94,803 1,03,181 1,91,622 2,46,819
aRs 5,00,000 – [Rs 5,00,000 × 0.30, variable cost to value (V/V) ratio] = Rs 3,50,000
b(given)

Also, Salvage value and release of WC

In terminal year
Given:
1.Incremental Depreciation (t = 1 – 6)
Year Depreciation (20% on WDV)
1 Rs 2,80,000
2 2,08,000
3 1,66,400
4 1,33,120
5 1,06,496
6 55,197c
Mutually Exclusive Proposals

 In the case of mutually exclusive proposals, the selection of one proposal precludes the
selection of the other(s). The computation of the cash outflows and cash inflows are on lines
similar to the replacement situation.
Thankyou!