Capital Budgeting and Long Term Financing

Lecture 2
Date: 23 Sep 2017

Presented by : Muhammad Mahfuzur Rahman FCA

Capital is the stock of assets that will generate a flow of income in the future.

Capital budgeting - is the planning process for allocating all expenditures that will have
an expected benefit to the organization for more than one year.

Capital budgeting is a process Capital budgeting usually Capital

used by companies for involves the calculation of budgeting is
evaluating and ranking potential each project's future tool for
expenditures or investments that accounting profit by period, maximizing a
are significant in amount. The the cash flow by period, the company's future
large expenditures could include present value of the cash flows profits since most
the purchase of new equipment, after considering the time companies are
rebuilding existing equipment, value of money, the number of able to manage
purchasing delivery vehicles, years it takes for a project's only a limited
constructing additions to cash flow to pay back the number of large
buildings, etc. The large amounts initial cash investment, an projects at any
spent for these types of projects assessment of risk, and other one time.
are known as capital factors.
expenditures.
Capital Budgeting-An Investment Concept
Investment refers to an outlay of funds on which management expects a return.
An investment creates value for shareholders when expected returns from
investment exceed its cost.

Why investment is made?

Expansion Plants, Growth Strategies, Capacity Increase

Increase of the efficiency of the manufacturing facilities
Deploying of Fixed Assets, Copy Rights, Franchises, licenses, Patents
Establishing new brands, new lines of business, new products
Opening new offices, new factories, overseas branches
Capital Budgeting Decisions
Cost reduction decisions - (Should a new equipment be purchase in order to reduce
costs?)
Plant expansion decisions -(Should a new plant, warehouse, or other facility be
acquired in order to increase capacity and sales?)
Equipment selection decisions -(Would machine A, machine B, or machine C be the
most cost-effective?)
Lease or buy decisions - (Should new plant facility be leased or purchased?)
Equipment replacement decisions - (Should old equipment be replaced now or later?)
 Capital Budgeting Process:
1. Generating ideasthe most important part
of the process.
2. Analyzing individual proposalsincluding
forecasting cash flows and evaluating the
project.
3. Planning the capital budgetthis will take
into account a firms financial and real
resource constraints; it will decide which
projects fit into the firms strategies.
4. Monitoring and post-auditingcomparing
actual results with predicted results and
explaining the differences. This is very
important; it helps improve the forecasting
process and focuses attention on costs or
revenues that are not meeting expectations.
Basic principles of Capital Budgeting

Decisions are based on cash flows.

The timing of cash flows is crucial.
Cash flows are incremental.
Cash flows are on an after-tax basis.
Financing costs are ignored.

During the capital budgeting process answers to the following questions are
sought:
What projects are good investment opportunities to the firm?
From this group which assets are the most desirable to acquire?
How much should the firm invest in each of these assets?
Example:
A company is studying the feasibility of acquiring a new machine. This machine will cost
$350,000 and have a useful life of 3 years after which it will have no salvage value. It is
estimated that the machine will generate operating revenues of $300,000 and incur
$75,000 in annual operating expenses over the useful life of 3 years. The project requires
an initial investment of $15,000 in working capital which will be recovered at the end of
the 3 years. The firms cost of capital is 16%. The firms tax rate is 25%. Depreciation is not
considered.
Solution:
Initial Investment is $350,000. Initial Net Working Capital is $15,000
Present Value of the annual operating cash flow after tax
= ($300,000-$75,000) x (1-0.25) x PVIFA (16%,3years)
= $225,000 x 0.75 x 2.2459
= $378,996

Note: The number 2.2459 can be obtained by using an ordinary calculator.

Procedure to be followed:
For Year 1, divide 1 by 1.16 = 0.8621
For Year 2, the calculator screen shows 0.8621, press the = key, you will get 0.7432
For Year 3, the calculator screen shows 0.7432, press the = key, you will get 0.6406
Add up all the three to get 2.2459

Since the asset will not have any salvage value at the end of the third year we need not
calculate the Present Value.

Present Value of the net working capital at the end of the project
= $15,000 x PVIFA (16%, 3rd year)
= $15,000 x 0.6406
= $9,609

Net Present Value = ($ 350,000) + ($ 15,000) + $ 378,996 + $ 9,609 = $ 23,605

Since the NPV is positive it is feasible to purchase the equipment.
Home Work: 23 Sep 2017

Under a special licensing arrangement, S Corporation has an opportunity to market a new

product for a five-year period. The product would be purchased from the manufacturer, with S
Corporation responsible for promotion and distribution costs. The licensing arrangement could
be renewed at the end of the five-year period. After careful study, S Corporation estimated the
following costs and revenues for the new product:

At the end of the five-year period, if S Corporation decides not to renew the licensing
arrangement the working capital would be released for investment elsewhere. S uses a 14%
discount rate. Would you recommend that the new product be introduced?