Capital Budgeting- I

Lecture I
Prof Shanti Suresh
Significance
• Long term effects

• Substantial commitments

• Irreversible decisions

• Affect the capacity and the strength to

compete.
Problems
• Future Uncertainty

• Time element

• Measurement problem
Types of capital budgeting
• From the point of view of firms
existence
• New firm
• Existing firm
• Replacement and modernization
• Expansion
• Diversification
 Types of capital budgeting
• From the point of view of decision
making

• Mutually exclusive decision

• Accept –reject decision

• Contingent decision
Capital budgeting decision making
process
• Capital investment decision making
process involves four steps
• Identification
• Evaluation
• Selection
• Implementation and audit
 Estimating cash flows
In capital budgeting the cost and
benefits of a proposal are
measured in terms of cash flows
and not by means of Accounting
profit .
E.g. –Income statement
 Estimating cash flow
• Assuming all the sales , expenses and taxes have been
effected in cash , the cash flow can be expressed as
follows :
• Cash realized from sales
1,00,000
• -cost of production 60,000
• -Taxes paid 10,000 70,000
• Cash increase –Cash flow = 30,000

• Cash flow = Profit after Tax +Non cash expenses

 E.g. 2
• The cost of the plant is Rs 5,00,000 .Its
estimated life of 5 years after which it
would be disposed off(scrap value is
nil).Profit before depreciation , interest
and taxes(PBIT) is estimated to be Rs
1,75,000 p.a
• Find the yearly cash flow from the plant.
 E.g. 3
• ABC Ltd is evaluating a capital budgeting
proposal for which relevant figures are as
follows :
• Cost of the plant 11,00,000
• Installation cost 3,400
• Economic life 7 yrs
• Scrap value 30,000
• Profit before depreciation and tax 2.00.000
• Tax rate 50%
Cash flow
• Initial Cash outflow :
• Installation cost
• Sunk cost
• Opportunity cost
• Additional working capital
requirement
Subsequent inflows and outflows
Terminal cash inflows
 E.g.
• Calculation of annual cash flows
• Net sales 4,75,000
• Cost of goods sold 2,00,000
• General expenses 1,00,000
• Depreciation 50,000 3,50,000
• Profit before interest and taxes 1,25,000
• -Interest 25,000
• PBT 1,00,000
• Tax@40% 40,000
• Profit after tax 60,000
 Cash flow equations
• Cash flow = PAT +Non Cash Expenses
+Financial charge *(tax rate )

• =PAT +depreciation +Interest –Interest *(tax rate)

• = PAT+ Depreciation +Interest *(1-tax rate)

• =EBIT(1-TAX RATE )+DEPRECIATION

 Cash flow equations

• Cash Flow = PAT+ Depreciation

+Interest –Interest (Tax rate)-increase
in working capital

• Cash Inflow = EBIT (1-Tax rate) +

depreciation – Increase in net working
capital
 Initial cash flow
• Initial cash flow = Cost of the new
plant +Installation Expenses +other
capital Expenditure +additional
working capital –Tax benefits on
account of capital loss on sale of old
plant (if any)-salvage value of old
plant +tax liability on account of
capital gain on sale of old plant (if
any)
Subsequent cash flow
• Subsequent cash inflow= Profit after
tax+ depreciation +financial charge (1-
t)-repairs (if any )-capital
expenditure(if any)
• Terminal cash in flow = Annual cash
inflow +working capital released
+scrap value of the proposal(if any).
Problem
• ABC and Co is considering a proposal to replace
one of its plants costing Rs 60,000 and having a
written down value 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 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 technological superiority is expected to
contribute additional benefit of Rs 60,000.(before
depreciation and tax) Find out the cash flows
associated with this decision given that the tax rate
applicable to the firm is 40%.
THANK YOU