CAPITAL BUDGETING DECISIONS

Accepting projects that yields a return higher than the hurdle rate
narain@fms.edu

Capital Budgeting Decisions Capital budgeting decisions relate to selection of a longterm asset or investment proposal or course of action that generally involves use of funds today but generate regular and recurring benefits in future.  Benefit may be in the form of increased revenue or reduced cost  Capital budgeting decision involves: – – – – Additions Modifications Replacements Disposals narain@fms.edu .

rate or time period 3. Compare this against a predetermined amount. Make a choice narain@fms.edu . an attempt is made to:1. Reduce costs and benefits to a single figure 2.Capital Budgeting Decision Process While evaluating projects.

5. 4.e. 7.edu . All cash flows take place at the end of the time period 2. are known with certainty Perfect capital markets Projects are infinitely divisible but exhibit decreasing return to scale Cash flows are in independent of each other overtime and other investment decisions Rational decision parties It is a well-behaved project or conventional cash flow projects narain@fms.Assumptions in Capital Budgeting 1. size and timing of cash flow 3. 6. No change in the risk i.

and operating Forecasting of benefits Determination of cost of capital or required rate of return Treatment of time element – economic life of project Treatment of risk element narain@fms. Forecasting of future costs – both initial 2.Problems involved in Capital Budgeting 1. 3.edu . 4. 5.

Cost – Benefit measurement  Profit is not a theoretical superior basis of measurement  Cash Flow is considered to be the superior basis of measurement – Is not affected by the Accounting conventions – Objective and verifiable  Cash Flow models can also be taken at different levels of analysis – – Operating Free Cash Flow – Free Cash Flow to Equity narain@fms.edu .

Cash Flows of the Project  After – tax incremental operating cash flows  Only the cash flows which are incremental in nature and directly attributable to the project are relevant  Net of tax effect – tax liability or tax shield  Depreciation & Amortisation – non cash items but affects taxes  Indirect overheads – ignore if not affected by the project  Effect on other projects – consider with the projects flows  Opportunity costs – consider with the project flows narain@fms.edu .

edu .Cash Flows of the Project  Financial charges – ignore in the project flows – Investment & Financing decisions are considered separately – Avoids double counting as these charges are reflected in the hurdle rate  Changes in working capital – consider with the project flows – Only changes are considered – Need arise because account books are kept on accrual basis narain@fms.

Proforma Cash Flow Statement 1. Cash flow from financing Interest/Dividend paid Capital funds raised narain@fms.Increase in Working Capital 2.Income tax paid .edu . Cash flow from investing Cash paid to acquire Fixed Asset Cash received for disposing Fixed Asset 3. Cash flow from operations Profit before tax + Depreciation & other non-cash items + Interest & other non-operating items .

edu 100000 30000 70000 . calculate the cash inflow: Net Sales Revenue 475000 Cost of goods sold General expenses Depreciation Profit before interest and taxes Interest 200000 100000 50000 350000 125000 25000 Profit before tax Tax @30% Profit after tax narain@fms.Cash flow computation With the help of following projected Income Statement.

Cash flow computations The cost of a new plant is Rs. if tax rate is assumed to be 30% and depreciation is provided on straight line basis. interest and taxes (PBIT) is estimated to be Rs.edu . 5. Profit before depreciation.00.000. It has an estimated life of 5 years after which it would be disposed off (scrap value is nil).75. Find out the yearly cash flow from the plant. 1. narain@fms.000 p.a.

Cash flow computations ABC Ltd.000 Rs. 30.000 30% Compute cash flows for the relevant period assuming written down method of providing depreciation. 11.400 7 years Rs. is evaluating a capital budgeting proposal for which relevant figures are as follows: Cost of Plant Installation cost Economic life Scrap value Rs. narain@fms.000 Profit before depreciation and tax Tax rate Rs.00. 3.edu . 5.00.

The annual maintenance cost shall be Rs. After 5 years the system will be phased out.edu .000 compute the cash flows for the project if tax rate is 30% and depreciation is provided at 60%. narain@fms.000 80.000 80.000.000 1.00. 20.000. The expected scrap value is Rs.Illustration 1 A company has created computer facility at a cost of Rs. 2 lac. 40.000 60. The project gross cash inflows are expected to be: 1st yr 2nd yr 3rd yr 4th yr 5th yr 50.

000 which would be used for 5 years.000 (d) 20. The increase in the working capital requirement will be Rs.000.000. 10. The installation charges will be Rs.edu .Illustration 2 A firm is using a two year old machine that was purchased for Rs.000. 20. 1. narain@fms. Depreciation rate is 40%.000 (b) 60. Firm is considering its replacement with a new machine costing Rs. Determine the initial cash flow if salvage value of existing machine is (a) 80.000 (c) 50. The firm is subject to income tax rate of 35% and capital gains tax rate of 30%.000 as a result of using the new machine.40. The remaining life is 5 years. 70.

000.000 p. narain@fms.a. Its present salvage value is its book value but nil after 5 years. Determine the post tax incremental cash flow. 1.000 after 5 years.00. It will have a salvage value of Rs. It is depreciable @ 20%. It can be replaced with a new machine worth Rs.00. 2. 90.33%. It will depreciate @ 33.000.edu . 4. and remaining life of 5 years.50. The tax rate is 35%.Illustration 3 A machine has a book value of Rs. The new machine will save Rs. in manufacturing costs.

Determine the post tax incremental cash flow.30.Exercise A machine purchased for Rs.000 and remaining life of 4 years. It is depreciable @ 50%. It will depreciate @ 40%. The new machine will save Rs. The tax rate is 35%. narain@fms.000 after 4 years. It can be replaced with a new machine worth Rs.000 but nil after 4 years. 1. 96.000. 24. It will have a salvage value of Rs. Its present salvage value is Rs.000 has a book value of Rs. 8. 60.edu .000 in manufacturing costs. 20.

000 5.000 11.00.000 2.50.000 21.000 Planning period Depreciation on new asset Depreciation on old asset Tax rate narain@fms.000 3.000 4.25.50.50.000 Annual cash expenses on new asset Current book value of old asset Present scrap value of old asset Annual revenue from old asset Annual cash expenses on old asset 9.50.000 19.00.00.000 2.00.edu 4 years 20% 25% 30% .25.Illustration Find incremental CFAT from the following information: Purchase price of the new asset Installation costs Increase in working capital in year zero Scrap value of the new asset after 4 years Annual revenues from new asset 10.

50. The salvage value at the end of year 10 is estimated at Rs.edu .000 for its installation. 20. narain@fms.000 with an additional investment of Rs.00. 5. The machine is estimated to generate a sales revenue of Rs. 1.Exercise A company is considering to install a machine costing Rs. The profit after tax is expected at 10% of the sales while the working capital requirement are expected to be 5% of the sales. for the remaining life of the machine.50.000 in the first year and the sales are expected to grow at 5% p.000. Compute the cash flows assuming SLM depreciation and additional working capital is required at the beginning of each year and is fully salvageable.00.a. 2.

Solution  Initial investment outlay – Rs. 2. 3. 2.385  Ninth Year CFAT – Rs.319  Eighth Year CFAT – Rs.875  Seventh Year CFAT – Rs.396 .737  Fifth Year CFAT – Rs. 3.104 narain@fms.55.14. 7.000  Second Year CFAT – Rs.750  Third Year CFAT – Rs. 2. 3.77.28.987  Fourth Year CFAT – Rs.35. 2.01.65. 2.edu  Tenth Year CFAT – Rs.50.000  First Year CFAT – Rs.88.44.54. 2.024  Sixth Year CFAT – Rs. 7.

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