Capital Budgeting

PPT 2
• Capital Budgeting is the allocation of funds to
different long term projects.
• It is denotes a decision situation where a the lump
sum funds are invested in the initial stages of the
projects and returns are expected over a long
period i.e a period beyond one year.
• It may be to buy land, building, plant etc. or on a
program of R&D, promotional campaign.
• The objective is to select those long term
investment projects which will make the maximum
contribution to the shareholders wealth.
Why capital budgeting decisions are important
Problems related to Capital Budgeting Decisions
• Types of Capital Budgeting Decisions
 5
Capital Budgeting - A Three Step Process

Estimation of costs and benefits or cash flows

Estimation of the required rate of return

Application of the capital budgeting decision

criterion/technique
• The challenge is how to measure costs and benefits.

• Accounting profit vs Cash Flows: Which is the

correct way to move ahead?
• Problems with Accounting Profit as a measure of
costs and benefits
• It can be easily affected by discretionary
accounting policies followed by the firm such as
depreciation, inventory valuation etc.
• It includes various non-cash items such as
depreciation, writing off certain losses or
expenses.
• It is based on accrual concept which leads to
comparing cash flows occurring in different time
periods.
• Incase of mutually exclusive projects with
different life time, accounting profits of different
time periods are not comparable
 Calculation of cash flows
• It has been assumed that there is only equity financing and there are no taxes.
• Profit = Rev – Exp – Dep
• Cash Flows = Rev – Exp – Capex
⇒ Cash Flows = (Rev – Exp – Dep) + Dep – Capex
⇒ Cash Flows = Profit + Dep – Capex

• Relaxing the assumption about the absence of taxes

Revenues XXXX
(-) Expenses XXXX
EBDIT XXXX
(-) Depreciation XXXX
EBIT XXXX
(-) Taxes at rates applicable XXXX
PAT XXXX
+ Depreciation XXXX
Cash flows XXXX

⇒ EBIT – taxes + Dep

⇒ EBIT – tax rate (EBIT) + Dep
⇒ EBIT (1- tax rate) + Dep
 Cash flows = REV – Exp – Taxes
⇒ REV – Exp – Tax rate (EBIT)
⇒ REV – Exp – Tax rate (Rev – Exp – Dep)
⇒ REV – Exp – Tax rate (Rev – Exp) + Tax rate (Dep)
⇒ Taking Rev – Exp as common we get
⇒ (Rev – Exp) (1 – tax rate) + Tax rate (Dep)
⇒ EBDIT (1 – tax rate) + Tax
Taxrate
Rate(Dep)
(Dep)

Depreciation
⇒ Long-term effects Tax Shield
⇒ N L=obbkjnnjterm effects
After introducing net working capital changes (NWC)
and capital expenditure we get:

Cash Flows = EBIT (1- tax rate) + Dep – NWC – Capex

or

EBDIT (1 – tax rate) + Tax rate (Dep) - NWC – Capex

• Terminal Cash Flows (TCF)
• TCF = Sale price of the asset + tax effect of sale of
asset + Working capital released 12000-15000=
3000 x 0.3=900 20000-3000=17000 (5100) 100000
83000
• Treatment of depreciation and profit/loss on sale/
scrapping of asset:
✔ accounting treatment
✔ treatment under the Income Tax Act, 1961 – Block of assets
• We can see the difference in the two treatments by
solving the following question but lets first learn
how to apply the block of assets concept.

• Q) A firm buys an asset for Rs.1 lakh and expected

operating profits (before depreciation @ 20% W.D.
V and tax @ 30%) of Rs.30,000/year for the next 4
years after which the asset would be disposed off
for Rs.45000. Calculate the cash flows for 4 years.
Conditions for claiming depreciation-
1. Asset must be owned by the assessee. Assessee
should be a beneficial owner and not necessarily a
registered owner
2. It must be used for the purpose of business or
profession that is it should be actually put to use and
not merely ready for use.
3. Revaluation of assets is ignored for income tax
purposes
4. Incase of the assessee being the part owner,
depreciation shall be allowed to him to the extent of
his share.
5. End use of the asset is relevant for determining the
rate of depreciation applicable.
Basic concepts for computation of
depreciation allowance-
1. Block of assets
2. Written down value
3. Actual cost
4. Method of depreciation
 Block of Assets
It means a group of assets falling within a
class of assets in respect of which the same
percentage of depreciation is prescribed.
A taxpayer may have 17 different blocks (out
of which 16 blocks are of tangible assets and
1 block of intangible assets).
Number Nature of asset Rate of
Depreciation

Buildings:
Block 1 1. Residential building other than hotels and boarding 5%
houses
Block 2 2, General- Office, factory or buildings which are not 10%
mainly used for residential purpose
3. Temporary Structures
Block3 100%

Block 4 Furniture and fittings 10%

Plant and Machinery:
Block 4 1. General 15%
Block 5 2. Renewable energy devices being windmills or pumps 15%
and generators running on windmills installed before
1.4.12
3. Other renewable energy devices irrespective of date
Block 6 of installation or devices stated in (2) installed after 80%
31.3.12
Number Nature of asset Rate of
Depreciation

Block 7 Motor Cars 15%

Block 8 Motor cars, motor vans, motor buses and motor lorries 30%
used in a business of running them on hire

Books owned by assessee carrying on a profession-

Block 9 1. Books being annual publications 100%
Block 10 2. Other books 60%
Block 11 Books owned by assessee carrying on business in 100%
running lending libraries
Block 13 Aero planes 40%

Block 14 Air and water pollution control equipments 100%

Block 15 Computers including computer software 60%

Block 16 Ships 20%

Block 17 Intangible assets 25%

• Calculation of Written Down Value (W.D.V)
WDV of the block on the 1st day of the PY XXXXX

Add Actual cost of the asset acquired during the PY falling in the XXXX
same block.

Less Money received/ receivable in respect of that asset which is XXX

sold, discarded, demolished or destroyed during the PY and
the amount of scrap value.

Less Actual cost of assets falling within that block transferred by XX

way of slump sale u/s 50B as reduced by:
1. Depreciation actually allowed upto AY 1987-88 in
respect of the asset transferred
2. Depreciation that would have been allowable for AY
1988-89 and future years as if the asset was the only
asset in the block of assets
W.D.V of the block for the assessment year XXXX
 Points
• The reduction of the moneys payable shall be to the extent that W.
D.V becomes nil
• Moneys payable means the sale price of the asset and includes any
insurance, salvage or compensation payable in respect of the asset
• Where sec 50 is not attracted then expenditure incurred wholly
and exclusively in connection with the transfer of the asset shall
not be adjusted from the W.D.V of the asset and the gross sale
value shall be deducted from the W.D.V of the block of the assets.
Such expenditure is allowable as revenue expenditure u/s 37(1)
 Capital Gains incase of Depreciable Assets u/s 50
• Notwithstanding anything contained in clause (42A) of section 2, where
the capital asset is an asset forming part of a block of assets in respect of
which depreciation has been allowed under this Act or under the Indian
Income-tax Act, 1922 (11 of 1922), the provisions of sections
48 and 49 shall be subject to the following modifications :—
(1) where the full value of the consideration received or accruing as a result
of
the transfer of the asset together with the full value of such consideration
received or accruing as a result of the transfer of any other capital asset
falling within the block of the assets during the previous year, exceeds the
aggregate of the following amounts, namely :—
(i) expenditure incurred wholly and exclusively in connection with such
transfer or transfers;
(ii) the written down value of the block of assets at the beginning of the
previous year; and
(iii) the actual cost of any asset falling within the block of assets acquired
during the previous year,
such excess shall be deemed to be the capital gains arising from
the transfer of short-term capital assets;
 Capital Gains incase of Depreciable Assets u/s 50
• (2) where any block of assets ceases to exist as such, for the reason
that all the assets in that block are transferred during the previous
year, then following shall be deemed to be the STCG:

Net Sales Consideration XXXX

Less
1. W.D.V of the block at the beginning of the year XXXX
2. Actual cost of the assets acquired during the year XXXX
STCG XXXX
Points
1. If the asset is stolen or damaged from the block of assets and no
insurance compensation is received and there are other assets in
the block, then no separate tax treatment is required. Loss due to
theft or destruction of the asset will be contained in the W.D.V of
the block and shall be allowed as depreciation over a no. of years

2. If the asset is stolen or damaged from the block of assets and no

insurance compensation is received and the asset stolen /
damaged was the only asset in the block then W.D.V of the block
will become nil since the block ceases to exist and will be a dead
loss and will have no tax treatment. Related tax planning tip is to
purchase an asset in this block in this year.
 Actual Cost
• It means actual cost to the assessee as reduced
by the proportion of the cost thereof, if any, as
has been met, directly or indirectly, by any other
person or authority.
• It includes all expenses directly relatable to
acquisition of the asset.
• Interest pertaining to the period till the asset is
put to use should be added to the actual cost of
the asset.
• Expenditure incurred on travelling for acquiring
the depreciable assets is part of actual cost.
 Method of depreciation
• The method is “Written down value”.
• However, in case of tangible assets of an
undertaking engaged in generation or
generation and distribution of power in some
cases, is available according to “Straight line
method”.
No depreciation will be charged in the
following cases
• If written down value of the block of asset is
reduced to zero, though the block is not empty.

• If the block of asset is empty or ceases to exist on

the last of the PY (though the written down value
is not zero).
.
• If nothing is mentioned about the date of
use of an asset, then assume that the asset
is put to use on the same day the asset is
acquired.
• Residential quarters provided to the
assessee’s employees is considered to be
used for business or profession.
Depreciation is allowable on such buildings.
Similarly, if furniture, air-conditioners,
refrigerators, fans etc. are provided than
depreciation is admissible.
When WDV becomes nil and block of continues to exist
Q) WDV of the block of assets on 1.4.12 ( assets A,B,C,D,E) 2 lakhs
Cost of Asset F acquired on 1.4.12 3 lakhs
Asset A sold on 31.3.13 9 lakhs
Rate of depreciation is 15% and tax rate is 30%
Ans.
WDV as on 1.4.12 2,00,000
Add: Actual cost of assets acquired during the PY 2012-13 3,00,000
Less: Moneys payable in respect of assets sold during the
PY 2012-13 (Restricted to 5 lakhs) 5,00,000
WDV for AY 2013-14 NIL

STCG under Sec 50

Sale Price 9,00,000
Less WDV as on 1.4.12 2,00,000
Less Cost of assets acquired during the Year 3,00,000
STCG 4,00,000
Tax effect of sale = 400000 (STCG )x 30% (tax rate)= Rs. 120000
Tax effect of sale= Rs. 120000 is increase in tax or cash outflow and hence
will be reduced as a terminal cash outflow.
When WDV becomes nil since block of ceases to exist
Q) WDV of the block of assets on 1.4.12 ( assets A,B,C,D,E) 5 lakhs
Cost of Asset F acquired on 1.4.12 1 lakhs
All Assets sold on 31.3.13 2 lakhs
Rate of depreciation is 15% and tax rate is 50%

Ans.
WDV as on 1.4.12 5,00,000
Add: Actual cost of assets acquired during the PY 2012-13 1,00,000
Less: Moneys payable in respect of assets sold during the
PY 2012-13 (Restricted to 6 lakhs) 2,00,000
WDV for AY 2013-14 (Since block ceases to exist) NIL

STCG under Sec 50

Sale Price 2,00,000
Less WDV as on 1.4.12 5,00,000
Less Cost of assets acquired during the Year 1,00,000
STCG - 4,00,000
Tax effect of sale = 400000 (STCL )x 50% (tax rate)= Rs. 200000
Tax effect of sale= Rs. 200000 is decrease in tax or cash outflow and hence
will be added as a terminal cash inflow.
 • Financial Cash Flows
• Interest charges are not taken into account as it
will lead to double counting while discounting the
cash flows.

• Cash flows= EBIT – tax + Dep

• Substituting tax = EBIT x Tax rate we get
⇒ EBIT (1- Tax rate) + Dep
⇒ EBIT – interest - tax + Dep + interest(1-tax rate)
=> PAT + Dep + interest(1-tax rate)
PBT x tax
rate
Q) Following is the income statement of the project :
• Sales revenue Rs.4,75,000
• Less:
Cost of goods sold Rs.2,00,000
General expenses Rs.1,00,000
Depreciation Rs.50,000 Rs.3,50,000
EBIT Rs.1,25,000
Less: interest Rs. 25,000
PBT Rs.1,00,000
Less tax @ 40% Rs.40,000
PAT Rs.60,000

• Apply the formulas to get the relevant cash flows from the
above statement and see whether you get the same answer
with the different formulas
• Ans. Rs.1,25,000
• Go to Capital Budgeting PPT 1 from
slide 25