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Capital Budgeting

Capital Budgeting is the process of identifying, analyzing and selecting investment projects whose returns are expected to extend beyond one year.

Capital Budgeting involves Generating investment projects consistent with the firms strategic objectives Estimating after tax incremental operating cash flow Evaluating incremental operating cash flow Selecting projects based on value maximizing criterion Reevaluating implemented projects continually and performing postaudits for completed projects

Types of Projects
New product or expansion of existing products Replacement of equipment or building Research and Development Exploration Other9safety related or pollution control devices)

Characteristics of project flows


Cash flow (not accounting flow) Operating cash flow (not financing) After tax flow Incremental flow

Basic principles in estimating project flow


Ignore sunk cost Include opportunity cost Include project driven changes in NWC Include effects of inflation

Calculating incremental CF
Initial Cash Outflow Interim incremental cash flow Terminal cash flow

Basic format for estimating ICO


Cost of new asset + Capitalized exp. (installation/shipping cost) +(-) Increase (decrease) in NWC - Proceed from the sale of old asset (Replacement) + (-) Tax (tax advantage) due to sale of old asset (Replacement) = ICO

Basic format for estimating Interim Incremental CF


Inc. (dec.) in operating revenue less (plus) inc. (dec.) in operating exp. - (+) Inc. (dec.) in depreciation charges = Net change in income before tax - (+) Inc. (dec.) in tax = Net change in income after tax +(-) Increase (decrease) in depreciation charges = Interim Incremental CF

Basic format for estimating Terminal CF


Inc. (dec.) in operating revenue less (plus) inc. (dec.) in operating exp. - (+) Inc. (dec.) in depreciation charges = Net change in income before tax - (+) Inc. (dec.) in tax = Net change in income after tax +(-) Increase (decrease) in depreciation charges = terminal CF before wind up consideration + Final salvage value -(+) tax (tax advantage) due to sale of asset = Terminal CF

Asset expansion
New asset price= Tk. 100000 Useful life= 4 years 3 year property class Installation cost= Tk. 15000 Salvage= Tk. 15000 Tax rate= 35% Depreciation basis= Tk.100000 Net operating revenue yr. 1- Tk. 34267 yr. 2- Tk. 38260 yr. 3- Tk. 57372 yr. 4- Tk. 32358

Asset Replacement
New asset price= Tk. 18000 Useful life= 4 years 3 year property class Installation cost= Tk. 2000 Salvage of new equipment= Tk. 2500 Old equip wont have any salvage Old equip remaining life = 2 yr. Old equip original life 4yrs. 3 year property class Old equip depreciation basis= Tk. 8000 Tax rate= 35% Net operating revenue Tk. 7100