CAPITAL BUDGETING

FURTHER CONSIDERATION
 FURTHER TOPICS
 CAPITAL RATIONING
 DETERMINING CASHFLOW
 CAPITAL BUDGETING AND TAXATION
 CAPITAL BUDGETING AND INFLATION
 EVALUATING MUTUALLY EXCLUSIVE

INVESTMENT WITH UNEQUAL LIVES

 CAPITAL BUDGETING UNDER CONDITION OF

RISK AND UNCERTAINTY

 REPLACEMENT DECISION
 LEASE OR BUY DECISIONS
DETERMINING
CASHFLOW
COMPONENTS OF CASHFLOWS

Initial
Investment
Annual net Cash flows
Terminal Cash flows
 INITIAL INVESTMENT

Is the net cash outlay

in the period in which
an asset is purchased
ELEMENTS OF INITIAL INVESTMENT
 Gross Outlay or Original Value.
- Also includes accessories
- Also includes Freight and installation
charges.

 Increase in net working capital.

 Salvage value/Scrap(net) for the old machine

 EXAMPLE
New Investment:

Year: 0 1 2 3
Initial Capital:
-Plant Cost…… xx
-Accessories….. xx
-Freight & Inst…xx xx
Change in NWC xx
Initial Capital xx
Replacement Investment:
Year: 0 1 2 3
Initial Capital:
-Plant Cost…… xx
-Accessories….. xx
-Freight & Inst…xx xx
Change in NWC xx
Scrap value of old Machine xx
Initial Capital xx
ANNUAL CASH FLOWS

Annual cash flows should

always be after tax cash
flows.
ANNUAL CASH FLOWS……..
APPROACHES:
BOTTOM –UP APPORACH
UP – BOTTOM APPROACH
DEPRECIATION TAX SHIELD

APPROACH
 EXAMPLE

Sales xx
Less: Cost of sales (xx)
Gross Profit xx
Less: Expenses (xx)
EBIT xx
Less: Tax (xx)
Net Profit XX
 BOTTOM UP APPROACH
CASH FLOW = NET INCOME(PROFIT) + DEPRECIATION.

Examples:
Sales $1500
Cost $700
Depreciation $600
Tax 34%
 EXAMPLE

Sales 1500
Less: Cost of sales (700)
Gross Profit 800
Less: Expenses (600)
EBIT 200
Less: Tax 68
Net Profit 132
BOTTOM UP APPROACH
CASH FLOW = NET INCOME(PROFIT) + DEPRECIATION

Operating Cash Flow = 132 + 600

OCF =732
UP-BOTTOM APPROACHES
Operating Cash Flows = Sales – cost – tax

OCF = 1500 – 700 – 68

OCF = 732
DEPRECIATION TAX SHIELD
 TaxShield : Is the savings that
results from depreciation deduction.

 Tax shield = Depreciation x Tax rate.

DEPRECIATION TAX SHIELD
OCF = (Sales – Cost)(1-t)+Depreciation tax Shield.

OCF = (1500 -700)(1-0.34)+(600X0.34)

OCF = 732
ANNUAL CASH FLOWS……..

Remember to include
any change in working
capital.
 TERMINAL CASH FLOWS
It includes the following:
The net annual cash flow of the last

year

Release of working capital

The salvage value

TERMINAL CASH FLOWS………

Salvage value: Is the

market price of an
investment at the time of its
sale.
Treatment of salvage value
 If Salvage Value (SV) < Book Value(BV) = Loss on Sale.

Net Proceeds = SV – T(SV-BV)

Net Proceeds = SV + Tax credit on loss.

Treatment of salvage value……..

 If Salvage Value (SV) > Book Value(BV) but SV < OV=

Ordinary Profit
Net Proceeds = Salvage Value - Tax on ordinary
Profit.

Net Proceeds = SV – T(SV-BV)

Treatment of salvage value……..
 If
Salvage Value (SV) > Original Value(OV) =
Ordinary Profit + Capital gain.

Net Proceeds = Salvage Value - Tax on ordinary - Tax on capital gain

Net Proceeds = SV – T(SV-BV)-Tc(SV-OV).

 KEY ISSUES:
 Always use incremental cash flows
 Do not include Sunk Cost
 Do not include allocated overheads. i.e general

overheads.
 Include opportunity cost
 Incidental effect must be included
 Includes contingent cost
 Includes tax liability and tax benefit
 Do not include interest on loan .
TAXATION AND INVESTMENT

APPRAISAL
TAXATION AND INVESTMENT APPRAISAL

Taxation has following effects on

capital budgeting:

Corporatetaxes on project profit and losses.

Investment Incentives(Capital allowances).
Corporate Taxes on Project Profit and Losses

Where the project generates profit

this is taxed at the appropriate
ruling rate of corporate tax.
Corporate Taxes on Project Profit and Losses.

When a project produces losses:

a) Where the firm has sufficient profit
from other operations, the loss on the
project will reduce the overall taxation
liability of the firm. This reduction of
tax is equivalent to cash inflows to the
project.
= Loss x Corporate tax
Corporate Taxes on Project Profit and Losses.

b) Where the project loss causes an overall

loss ,the resulting cash inflow from the loss
can be either:

i. Carried back to previous profit making year

in this case the equivalent cash inflows
should be shown against the project in the
year in which the reduction of tax liability
was possible.
Corporate Taxes on Project Profit and Losses.

ii. Carried forward to a future profit

making year, similarly the
equivalent cash inflow would be
shown against the project in the
future year when sufficient profit
become available.
INVESTMENT INCENTIVES
(CAPITAL ALLOWANCES)

Also know as Writing-down allowances or depreciation

tax shield.

It is a system of depreciation used in the

determination of taxable income. Capital
allowances rate tend to be more generous
than the depreciation that accountants will
charge for the financial accounting
purposes.
 CAPITAL ALLOWANCES
Reasons for existence of capital allowances:
a) Subjective nature of the depreciation is there by
removed from tax system.

b) Generous capital allowances can be used as an

investment incentives, this accelerated depreciation
for tax purposes lowers the tax bill quickly and thus
is a cash incentive