Financial Management


Topics to be covered
• Capital Budgeting
– Concepts
– Capital Budgeting Techniques

– Problem Solving

Financial Management


Capital Budgeting Financial Management 3 .

• It therefore involves current outflows in return for series of anticipated flows of future benefits. • While an opportune investment decision can yield spectacular returns. • 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. an ill-advised/incorrect decision can endanger the very survival of the firm. Financial Management 4 .Capital Budgeting • Capital Budgeting decisions relate to long-term assets which are in operation and yield a return over a period of time. • A few wrong decisions and the firm may be forced into bankruptcy.

2) It is not often possible to calculate in strict quantitative terms all the benefits or costs relating to a specific investment decision. an element of risk is involved in forecasting future sales revenue as well as the associated costs of production and sales. Therefore.• Capital decisions are faced with a number of difficulties. Financial Management 5 . The two major difficulties are: 1) The benefits from long-term investments are received in some future periods which are uncertain.

2) Cost reducing investment decisions – subject to less risk as potential savings can be estimated better from past production and cost data Financial Management 6 . namely: 1) Revenue expanding investment decisions – subject to more risk as it is difficult to estimate revenues and costs of a new product line.• Capital decisions are of two types.

Accounting Profit v/s Cash Flow Approach • The capital outflows and revenue benefits associated with such decisions are measured in terms of cash outflows after taxes. • The major difference between the cash flow and the accounting profit approach relates to the treatment of depreciation. Financial Management 7 . • The cash flow approach for measuring benefits is theoretically superior to the accounting profit approach as it: – Avoids the ambiguities of the accounting profits concepts – Measures the total benefits and – Takes into account the time value of money.

Depreciation is charged on the year end balance of the block which is equal to the opening balance plus purchases made during the year minus the sale proceeds of the assets during the year. In case the entire block of assets is sold during the year. it is recognised. A block of assets is a group of assets (Say of plant & machinery) in respect of which the same rate of depreciation is prescribed by the Income Tax Act. depreciation is charged on a block of assets and not on an individual asset. Financial Management 8 • • . no depreciation is charged at the year end. as a source of cash to the extent of tax advantage in the cash flow approach. Profit as per Cash Flow Approach = Accounting Profit + Depreciation • For taxation purposes.• While the accounting approach considers depreciation in cost computation. on the contrary.

the difference is a short-term capital gain which is subject to tax.• If the sales proceeds of the block sold is higher than the opening balance. • Any such adjustment related to the payment of tax/tax shield us made in terminal cash inflows of the projects. there is a short-term capital loss and the firm is entitled to tax shield on short-term capital loss. (Terminal cash inflows relate to cash flows in the final year of the asset) Financial Management 9 . • In case vice versa.

What to consider & what to ingnore • The data required for capital budgeting are after tax cash outflows and cash inflows. Financial Management 10 . • The existing fixed costs are therefore ignored for capital budgeting decisions. • Incremental after-tax cash flows are the only relevant cash flows in the analysis of new investment projects. • These cash flows should be incremental in the sense that they are directly attributable to the proposed investment project.

Categories of Capital Projects • The investments in new capital projects can be categorised into: (i) A single proposal (ii) A replacement proposal (iii) Mutually exclusive proposals Financial Management 11 .

net of removal costs). cash outflows primarily consist of: (i) Purchase cost of the new plant & machinery (ii) Its installation costs (iii) Working capital requirement to support production & sales • The cash inflows after taxes (CFAT) are computed by adding depreciation (D) to the projected earnings after taxes (EAT) from the proposal. the project. • In the terminal year. the cash inflows include salvage value (if any. apart from operating CFAT. recovery of working capital and tax advantage/tax paid.Single/Independent Proposals • In case of single/independent investment proposal. Financial Management 12 .

• The relevant CFAT are incremental after-tax cash inflows. the sale proceeds from the existing machine reduce the cash outflows required to purchase the new machine.Replacement Proposals • In the case of replacement situations. Financial Management 13 .

• The computation of the cash outflows and cash inflows are on lines similar to the replacement situation.Mutually Exclusive Proposals • In the case of mutually exclusive proposals. Financial Management 14 . the selection of one proposal precludes the selection of the other(s).

Capital Budgeting Techinques • The capital budgeting evaluation techniques are as under: 1) Traditional methods (a) Average/Accounting Rate of Return (ARR) (b) Pay Back (PB) period 2) Discounted Cash Flow (DCF) methods (a) Net Present Value (NPV) method (b) Internal Rate of Return (IRR) (c) Profitability / Present Value Index (PI) Financial Management 15 .

ARR method is unsatisfactory method as it is based on accounting profits and ignores time value of money Financial Management 16 • • • • .Traditional Methods ARR Method • The ARR is obtained by dividing annual average profits after taxes by average investments. ARR = Annual Average profits after taxes Average investments Average Investments = ½ (Intial cost of machine – Scrap/Salvage Value) + Salvage Value + Net Working Capital Annual average profits after taxes = Total expected after tax profits Number of years.

Problem Solving • ARR Method Financial Management 17 .

Financial Management 18 . ignoring interest payment. It is determined as follows: – In case of annuity CFAT: Initial Investment Annual CFAT – In case of mixed CFAT: Calculated by obtaining the cumulating CFAT till the cumulative CFAT equals the initial investment. • • Although the pay back period method is superior to the ARR method in that sense that it is based on cash flows.Traditional Methods Pay Back (PB) period Method • This method measures the number of years required for the CFAT to pay back the initial capital investment outflow. it also ignores time value of money and disregards the total benefits associated with the investment proposal.

Problem Solving • Pay Back period method Financial Management 19 .

Discounted Cash Flow (DCF) method • The DCF methods satisfy all the attributes of a good measure of appraisal as they consider the total benefits (CFAT) as well as the timing of benefits. Financial Management 20 . • Rs. • Time value of money refers to ascertaining the value of money to be received in future in context of the present value. 100 to be received after one year will not be treated at the same value today. 100 received after one year. • Rs 100 received today is more valuable than the same Rs. • The concept of time value of money comes in use in the DCF methods. It may be equivalent to only Rs. 90 received today.

Discounted Cash Flow (DCF) method Net Present Value (NPV) Method • The NPV may be described as the summation of the present values of: (i) operating CFAT (CF) in each year. and (ii) salvage values (S) and working capital (W) in the terminal years (n) minus the summation of present values of the cash outflows (C O) in each year. Financial Management 21 . MINUS the present value of Capital Investment done today NPV = PV of Cash Inflows (-) PV of Capital Investment • The NPV is computed using the cost of capital (k) as a discount rate for calculating the present values of future cash flows.

Discounted Cash Flow (DCF) method • Internal Rate of Return (IRR) Method • The IRR is defined as the discount rate (R) which equates the aggregate present value of the operating CFAT received each year and terminal cash flows (working capital recovery and salvage value) with aggregate present value of cash outflows of an investment proposal. • Financial Management 22 . The project will be accepted when IRR exceeds the required rate of return.

• • PI = PV of Future Cash inflows PV of Capital Investment • The proposal will be worth accepting if the PI exceeds one. Financial Management 23 .Discounted Cash Flow (DCF) method • Profitability Index (PI) Method • The profitability index / present value index measures the present value of returns per rupee invested. It is obtained dividing the present value of future cash inflows (both operating CFAT & terminal) by the present value of capital cash outflows.

Problem Solving Financial Management 24 .

THANK YOU Financial Management 25 .