Capital Budgeting

Capital Budgeting Decisions

• Related to allocation of funds to different long term assets.
• Lumpsum funds are invested in the initial stages of the project and
returns are expected over a long period.
• Examples of capital budgeting decisions;
• Buying land and building
• Undertaking a program on research and development
• Diversifying into a new product line
• Replacing an existing machine
Significance of Capital Budgeting decisions
• Has long term effects
• Involves substantial commitments
• Irreversible decisions
• Affects capacity and strength to compete
Difficulties in Capital Budgeting decisions
• Future uncertainty
• Time element
• Measurement problem
Types of Capital Budgeting decisions
• From the point of view of firm’s existence;
• New firm
• Existing firm
• Replacement and Modernization decision
• Expansion
• Diversification
• From the point of view of decision situation;
• Mutually exclusive decisions
• Accept-Reject decisions
• Contingent decision
Capital Budgeting Decision process
• Estimation of cost and benefits of a proposal
• Estimation of required rate of return
• Evaluation of different proposals in order to select one
Estimation of cost and benefits (cash flows)
of a proposal
• 2 alternatives for measuring the cost and benefit of the proposal;
• Accounting Profits
• Cash Flows
• We consider cash flows for capital budgeting processes
• Eg; ABC Ltd. is evaluating a capital budgeting proposal. Estimate the annual accounting profit and the cash flow
based on the following information:

Cost of the plant 11,00,000

Installation cost 3,400
Economic life 7 years
Scrap value 30,000
PBITDA 2,00,000
Tax rate 50%

• PAT = 23,328; CF = 1,76,671

• Cash flows can be divided into the following;
• Initial
• Cost of purchase and Installation Cost (Outflow)
• Sunk Cost (Ignored)
• Salvage value of existing asset (in case of replacement) (Inflow)
• Opportunity Cost (Considered)
• Additional working capital requirement (Outflow)
• Subsequent
• Terminal
• Sale price of the asset
• Working capital released
In capital budgeting decisions, we only consider incremental cash
flows (cash flows that differ as result of accepting a particular
proposal).
Incremental Cash Flows
• Standalone Principle
• Co-existence with the proposal
• Allocated overhead costs: If the existing overhead cost is allocated to
the new proposal, then it is not to be taken as a cost of the project.
However, if the overhead cost is expected to increase after the project
is implemented, then only incremental overhead cost should be
considered.
• Product cannibalization
Treatment of depreciation
• 2 ways;
• Accounting treatment
• Treatment under Income Tax Act, 1961
• Cash flows will be different under these 2 methods
• Question: A firm buys an asset costing 1,00,000 and expects operating
profits (before depreciation @20% WDV and tax @30%) of 30,000 P.A.
for the next 4 years after which the asset would be disposed off for
45,000. Find out the cash flows for different years.
Year PBD Depreciation PBT Tax PAT CF
1 30,000 (20,000) 10,000 (3,000) 7,000 27,000
2 30,000 (16,000) 14,000 (4,200) 9,800 25,800
3 30,000 (12,800) 17,200 (5,160) 12,040 24,840
4 30,000 (10,240) 19,760 (5,928) 13,832 24,072

Initial Cash flow = -1,00,000

Terminal cash flow;
Scrap value: 45,000
WDV: 40,960 (51,200-10,240)
Profit: 45,000 – 40,960 = 4,040
Tax on profit: 30% * 4040 = 1212
Net cash inflow = 45,000 -1,212 = 43,788
Financial Cash flows
• Any new project being considered for implementation may require the firm to raise additional funds. This may also entail further cash flows like interest and dividend.
• Interest exclusion principle;
• Cost of raising funds is not counted in capital budgeting cash flows
• They are considered in the calculation of discount rate
• If these costs are counted in capital budgeting cash flows, it will lead to double counting
• Investment decision and Financing decision should be considered separately

• Question: Compute the annual cash inflows for a project on the basis of its income statement given below:

Net Sales 4,75,000

COGS (2,00,000)
General Expenses (1,00,000)
Depreciation (50,000)
PBIT 1,25,000
Interest (25,000)
PBT 1,00,000
Tax (@30%) (30,000)
PAT 70,000
The annual cash inflow can be ascertained using the following 2 methods:

Net sales 4,75,000 PAT 70,000

(COGS) (2,00,000) Depreciation 50,000
(General Exp) (1,00,000) Interest 25,000
(Depreciation) (50,000) (Tax Effect of Interest (7,500)
25000*0.3)
PBIT 1,25,000
Annual Cash Inflow 1,37,500
(Tax) (37,500)
Depreciation 50,000
Annual Cash Inflow 1,37,500

Cash Inflow = EBIT (1-t)+ Depreciation – Increase in Net Working Capital

OR
Cash Inflow = PAT + Non-cash expenses + Financial charge (1-t) – Increase in Net Working Capital
Summarizing Cash Flow Estimation
• Initial Cash Outflow:
• Cost of new plant + Installation expenses + Other CAPEX + Additional Working
Capital – Salvage value of Old Plant + Tax liability on account of capital gain on
sale of old plant (if any) – Tax benefit on capital loss on sale of old plant (if
any) .
• Subsequent cash Inflow:
• PAT + Depreciation + Financial charge (1-t) – Increase in Net Working Capital –
Repairs (if any) – CAPEX (if any)
• Terminal Cash Inflow:
• Annual cash inflow + Working Capital released + Scrap value of the proposal
(if any) – Tax liability on capital gain (if any)+ Tax savings on capital loss (if any)
Summarizing Cash Flow Estimation
• All relevant cash flows are considered
• Cash flows are considered on after tax basis
• Cash flows are considered on incremental basis
• Tax savings is treated as an inflow
• Sunk costs are ignored
• Opportunity costs are considered
• Additional Working capital required is treated as an outflow
• Unless stated otherwise, all inflows/outflows are assumed to occur at the end of the
period
• Savings in costs are considered as an inflow on after-tax basis
• Allocated overheads are not outflows as they are not incremental
Question 1: X Ltd. is planning to purchase a machine for ₹ 1,50,000
which is likely to bring following earnings in the next 5 years:
•Years 1 2 3 4 5
•Earnings(₹) 50,000 55,000 60,000 62,000 65,000

The purchase of the machine will result in increase in working capital

by ₹ 15,000. The machine will be depreciated on SLM basis and has a
salvage value of ₹ 25,000. The company is subject to tax at the rate of
30%. Find out the initial, subsequent and terminal cash flows from the
machine.
Question 2: ABC Ltd. is considering a proposal to replace one of its
plants costing Rs. 60,000 and having WDV of Rs. 24,000. The remaining
economic life of the plant is 4 years after which it will have no salvage
value. However, if sold today, it has a salvage value of Rs. 20,000. The
new machine costing Rs. 1,30,000 is also expected to have a life of 4
years with a scrap value of Rs. 18,000. The new machine due to its
technical superiority, is expected to contribute additional annual
benefit (before depreciation and tax) of Rs. 60,000. Find out the cash
flows associated with this decision given that the tax rate applicable to
the firm is 30%. (The capital gain or loss may be taken as not subject to
tax).
Question 3: ABC Ltd. is planning to install a new machine costing ₹
15,00,000 with a salvage value of ₹ 1,00,000 after 5 years of life.
Following information is available in respect of the machine:
• Annual production: 1,00,000 units for year 1 which increases by 10,000 units
P.A. for the next 4 years
• S.P.: ₹ 16 P.U.
• V.C.: ₹ 10 P.U.
• F.C.: ₹ 2,00,000 P.A.
• Tax rate: 30%
• Depreciation: 20% on WDV
Find out the initial, subsequent and terminal cash flows from the machine