Capital Budgeting

25-03-2010
 Answer the following
 What are the finance decisions?
 What is the finance decision that takes care
of the assets of the firm?
 What is the expenditure which acquires
long term benefits for the firm?
 What are the steps in capital budgeting?
 What are the motives of making capital
expenditure?
 Name a few types of project


 What is capital budgeting?
 The process of evaluating and
selecting long term investments that
are consistent with the firm’s goal of
maximising owners’ wealth
 Expenditures
 Capital expenditure: (CAPEX)
 An outlay of funds by the firm that is
expected to produce benefits over a
period of time greater than one year.
 Operating Expenditure: (OPEX)
 An outlay of funds by the firm resulting
in benefits received within a year
Difficulties in Capital Budgeting
 Future uncertainty
 Incomparable periods of cost and
benefits
 Non quantifiable costs and benefits
 Rationale for capital budgeting
decisions
 Efficiency
 Expand revenues – Less certain
 Reduce cost – More certain
 Other Names
 OPEX:
 Operating expense, Operational
expense, Operational
expenditure
 CAPEX:
Distinguish between the capital expenditure
and operating expenditure
 Purchase of a photocopier
 Purchase of paper, toner
 Cost of power and maintenance
 Establishment of a new plant
 Wages to workers in the new plant
 Acquisition of a firm
 Training of a workers
 Training of sales force
 Some new items on capital
budgeting
 AT & T buys 8 per cent stake in Tech
Mahindra for $ 197 million
 Maruti Suzuki lines up for Rs. 1260
crore investment to double its
capacity in k-series petrol engine
Steps in Capital Budgeting Process
 Proposal Generation
 Review Analysis
 Decision Making
 Implementation
 Follow-up
 Key Motives for making capital
expenditure

 Expansion
 Replacement
 Renewal
 Other Purposes – Inorganic growth,
Competition, Survival strategy
 Basic Terminology
 Independent vs. Mutually Exclusive
Projects
 Unlimited Funds vs. Capital Rationing
 Accept-Reject vs. Ranking
Approaches
 Conventional vs. Non-conventional
cash flow patterns
 Independent vs. Mutually Exclusive Projects
 Independent Projects:
 Projects whose cash flows are unrelated
or independent of one another; the
acceptance of one does not eliminate the
others from further consideration
 Mutually Exclusive Projects:
 Projects that compete with one another,
so that the acceptance of one eliminates
from further consideration all other
projects that serve a similar function
 Unlimited Funds vs. Capital
Rationing
 Unlimited Funds:
 The financial situation in which a firm is able
to accept all independent projects that
provide an acceptable return
 Capital Rationing:
 The financial situation in which a firm has
only a fixed amount of funds available for
capital expenditures, and numerous projects
compete for this fund
 Accept-Reject vs. Ranking Approaches

 Accept-Reject Approach:
 The evaluation of capital expenditure
proposals to determine whether they meet
the firm’s minimum acceptance criterion.
 Ranking Approach:
 The ranking of capital expenditure projects
on the basis of some pre-determined
measure, such as the rate of return.
Conventional vs. Non-conventional
cash flow patterns
 Conventional cash Flow Patterns:
 A conventional cash flow pattern
consists of an initial outflow followed
only by a series of inflows
 Non-conventional cash flow patterns:
 An initial outflow followed by a series
of inflows and outflows
 Relevant Cash Flows
 The incremental cash outflow
(investment) and resulting
subsequent inflows associated with a
proposed capital expenditure
 Incremental cash Flows
 The additional cash outflows or
inflows which are expected to result
from a proposed capital expenditure
 Major cash flow components
 Initial investment
 Operating cash inflows
 Terminal cash inflows
 Major cash flow components
 Initial Investment:
 The relevant cash outflow for a proposed
project at time zero
 Operational Cash Inflows:
 The incremental after-tax cash inflows
resulting from implementation of a
project during its life
 Major cash flow components
 Terminal Cash flow:
 The after-tax non-operating cash
flow occurring in the final year of a
project. It is usually attributable to
liquidation of the project
 Expansion vs. Replacement Cash
flows
 Cash Flows for Expansion decisions:
 Initial Investment
 Operating cash inflow
 Terminal cash inflow
 Cash Flows for Replacement decisions:
 Complicated
 Incremental outflows and inflows of cash
need to be identified
 Replacement Cash flows
 Initial Investment:
 Initial investment required to acquire
new asset – After tax cash inflows
from liquidation of old asset
 Operating Cash Inflows:
 Operating cash inflows from new
asset – Operating cash inflows from
the old asset
 Replacement Cash flows
 Terminal cash flow:
 After tax cash flow from termination
of new asset – After tax cash flow
from the termination of old asset
 Cash Flow estimates
 Tax effect
 Effect on other projects
 Effect of indirect expenses
 Effect of depreciation
Sunk Cost vs. Opportunity Cost
 Sunk cost:
 What is spent and cannot be taken
back
 Opportunity cost:
 Alternative benefits missed on
account of a choice/ decision