Amity Business School

BY:
Shamsher jang

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Position of Capital Budgeting

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Capital Budgeting- Meaning

• Capital Budgeting refers to the expenditure on the

capital assets.

• Spending money on capital assets is a very important

decision that a finance manager is required to take.

• Capital investment expenditure may be on Plant,

Machinery Equipment, Land, Building etc.
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Capital Rationing
Capital rationing is the financial situation in which a
firm has only fixed amount to allocate among
competing capital expenditures.

This refers to a situation in which a firm has more

acceptable investments than it can finance. This
involves ranking of the acceptable investment
projects.
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Significance of Capital
Budgeting
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• It involves substantially higher amounts than for

other routine expenses.

• The decision is irreversible, i.e. it is not possible to

withdraw your steps easily, once you have taken few
steps in this regard.

• It has long term impact on the affairs of a company

and it, hence determines the future of a company.
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An expenditure made on a capital asset has a long term

perspective.

We spend today, to gain some advantages in future.

This expenditure involves a big cash outflow of funds
initially, compensated by small but recurring doses of
inflow of funds in future for some time.
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Cash Flow Pattern

• Conventional: Conventional cash flow pattern is an

initial outflow followed by only a series of inflows

• Non-conventional: Alternating inflows and outflows

and an inflow followed by outflows are examples of
non-conventional cash flow patterns.
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Cash Flows in a Conventional Project

+
0
− 1 2 3 4 5 6
Years

+ shows Cash inflows

&
- shows Cash outflows
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The essence of the capital budgeting decision making

is to determine, whether the initial expenditure of
funds is duly compensated by the inflow of funds
occurring in future.

If greater values can be assigned to the inflow of

funds than the present expenditure, then that capital
investment proposal must be accepted because that
will add up to the wealth of the company.
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Nature of Capital Budgeting

• The Capital Budgeting decision is a decision on an expenditure

of capital nature which is intended to create physical assets.

• The assets in return are expected to reap benefits to the

company for the years to come.
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• The expenditure on monetary assets like purchase of Bonds,

Shares, Treasury bills, Debentures etc.) is NOT to be treated as
a capital budgeting expenditure.

• Only investment in physical assets is appraised in capital

budgeting while investment in monetary and financial assets is
appraised under portfolio analysis.
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Types of Capital Budgeting Decisions

• From the point of view of firm’s existence

• From the point of view of Decision Situation

 From the point of view of firm’sAmity
existence
Business School

(a) New Firm

(b) Existing Firm

• Replacement & Modernization Decision

• Expansion

• Diversification
From the point of view of Decision Situation
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Mutually Exclusive Decisions

Mutually exclusive projects (decisions) are projects that compete with one
another; the acceptance of one eliminates the others from further
consideration.

Independent Projects / Accept-Reject Decisions

They are projects whose cash flows are unrelated / independent of one
another; the acceptance of one does not eliminate the others from further
consideration.

Contingent Decisions

They are dependent projects; the choice of one investment necessitates

undertaking one or more other investments
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Capital Budgeting Process

• Generation of Investment Ideas

• Estimating Cash Flows

• Evaluating Cash Flows

• Selecting Projects

• Execution and Monitoring

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Cash Flow – Concept & Estimation

• Every investment proposal involves cash flows- large initial cash

outflow followed by small but recurring inflows.

• The crux of the whole process is, to assess whether the value of
inflows is greater than the outflows or not.

• If greater value can be assigned to the inflows/ returns than the

outflows/ expenditure, the proposal may be treated as profitable and
therefore, acceptable.
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Principles of Cash-flow Estimation

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Capital Budgeting should be based on cash flows. The reason is that

cash flows are very certain amounts and are not subject to
different interpretation by different people.
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Accrual principle is considered better for the purpose of accounting

(Probably because it calculates profit or loss for a given period), but
for a long term investment decision making, cash principle will be
better.
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• Every payment of cash, for whatever purpose is an outflow,

• While every receipt of cash, for whatever reason is an inflow.

• Any Non cash expenditure (like depreciation) will not be

accounted for because it does not involve any cash flows.
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• Cash flow should be taken on ‘ After–Tax’ basis. One should

calculate Cash Flow After Tax (CFATs)

• Sunk Costs should be ignored. The cost which have already been
incurred should not be taken in to account while calculating cash
outflows for a period.
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A very important aspect of each cash flow calculation is that cash

flow on account of interest payments are NOT to be considered,
while making the calculation of cash flow, because the discounting of
cash flow for their time value of money automatically takes in to
account the interest cost of any investments.
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Treatment of Working Capital in

Project Evaluation
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• Almost every Investment proposal requires an additional investment

in Working Capital (in some form or the other).

• The proposal, if accepted would require increase in minimum Cash

Balance , higher inventory levels or more receivables.

• Any additional investment in working capital cannot be used

elsewhere and is similar to an investment made in building, plant.
Machinery etc. It has to be viewed as a cash outflow, when it is
made.

• At the end of the proposal , this additional working capital being

invested now will be released . Thus, any decrease in working
capital can be treated as a release of working capital or cash inflow.
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Hence, Cash needs for working capital should be treated as a cash

outflow at the time of commencement of a project and should be
treated as inflow when that cash is released at the time of closure or
termination of projects.
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Requirements of Good Method of Project

Evaluation
• It should be based on cash flows rather than on profits or
expenditures.

• Cash flows to be recovered over the entire expected life of the asset
rather than few years only.

• It should give absolute value of gain or loss.

• It should consider the time value of money.

• It should indicate relative profitability between different alternatives,

so that a ranking can be made between different proposals.

• It should indicate the degree of risk and the chances of getting profit
or loss in a given situation.
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General Rules for Calculation of Cash Flow in

Capital Budgeting Proposals

1. Only “Cash Flows” are relevant : Cash Flow should be

differentiated from accounting profits.

2. Cash flows should be recorded only when they occur and not
when the work is undertaken or liability incurred.

3. Estimate cash flows on an incremental basis that follow from the

project.

4. Estimate Cash flows before interest.

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5. Include effect of Cannibalization .

6. Include Working Capital Requirements.

7. Forget Sunk Costs

8. Include Opportunity Cost

9. Beware of Allocated Overhead Cost : If the amount of overhead

changes as a result of the investment decision, then they are
relevant and should be included.

10. Effect of Depreciation

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Relevant and Irrelevant Outflows

Relevant Cash Outflows Irrelevant Cash Outflow

1. Fixed Overhead expenses
1. Variable Labour expenses
(existing) / Allocated Overheads
2. Variable material expenses 2. Sunk Cost
3. Additional fixed overhead
expenses
 
4. Cost of the investment  
5. Marginal Taxes  
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CAPITAL BUDGETING DECISION INVOLVES

THREE STEPS:

1. Estimation of costs and benefits of a proposal or of each

alternative ( determination of Cash Flows)
2. Estimation of the required rate of return, i.e., the cost of
capital
3. Selection and applying the decision criterion.

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1.ESTIMATION OF CASH FLOWS

The costs and benefits for a capital budgeting

decision situation are measured in terms of cash
flows.
An important point is that all cash flows are
considered on after tax basis.
The cash flow from the project are compared with the
cost of acquiring the project.
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 Calculation of different cash Amity
flows Business School

INITIAL CASH OUTFLOW:

Cost of new plant
+ Installation expenses
+ Other Capital expenditure
+ Additional working capital

Salvage value ( Scrap Tax liability on account

Value) of capital gain on sale of old
-
- { of old plant plant (if any).
}

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SUBSEQUENT ANNUAL INFLOWS:

Profit after tax (PAT)
+ Depreciation
– Repairs (if any)
– Capital Expenditure (if any).

TERMINAL CASH INFLOW:

Annual cash inflow
+ Working capital released
Salvage value ( Scrap Tax liability on account
+{ Value)
of new asset - of capital gain on sale of
new asset (if any). }
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Capital Gain = Salvage Value of Asset

- Book Value of Asset
( or Written Down Value of
asset)

If the value is negative, then it is Capital Loss

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Question
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A company desires to make an investment of Rs. 1,00,000 in a new

machinery. Additional installation and transportation cost is Rs. 20,000.

The Machine has a life of 5 years after which it is expected to fetch Rs.
10,000 as scrap value.

The machine is expected to generate an output of 2000 units p.a. in the

first 2 years and 3000 units p.a. for the last 3 years.

The Product is expected to fetch Rs. 15 in the first 3 years and Rs. 18 in
the last 2 years.

The additional cost of operating a machine is expected to be Rs.5,000

p.a. for the first 3 years and Rs. 8,000 p.a. thereafter.

Calculate Cash Flow After Tax (CFATs) for the above proposal on the
assumption of Straight line depreciation and tax rate 30%.
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Solution
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• INITIAL CASH OUTFLOW:

Cost of new machinery 1,00,000
Add : Installation expenses 20,000
1,20,000
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Calculation Cost of Machinery 1,00,000

of
Add: Transportation &
Depreciation Installation Cost 20,000

1,20,000

Less: Scrap Value 10,000

Total Amount to be depreciated 1,10,000

Annual Depreciation = 22,000

1,10,000/5
 SUBSEQUENT ANNUAL INFLOWS
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Year 1 2 3 4 5
a. Output (Units) 2,000 2,000 3,000 3,000 3,000
b. Price (Rs.) 15 15 15 18 18
c. Revenue [ a x b] 30,000 30,000 45,000 54,000 54,000
Less :Operating Exp. 5,000 5,000 5,000 8,000 8,000
Less: Depreciation 22,000 22,000 22,000 22,000 22,000
d. Profit Before Tax (PBT) 3,000 3,000 18,000 24,000 24,000
Less : Tax @ 30% 900 900 5,400 7,200 7,200
e. Profit After Tax (PAT) 2,100 2,100 12,600 16,800 16,800
Add Back : Depreciation 22,000 22,000 22,000 22,000 22,000
CFAT (PAT + Dep.) 24,100 24,100 34,600 38,800 38,800
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TERMINAL CASH INFLOW:

Annual cash inflow 38,800

Scrap Value 10,000
(in Rs.) 48,800