2. Capital Budgeting Decisions
Capital Budgeting Decisions
Capital budgeting decisions relate to selection of a
long‐term asset or investment proposal or
l i l
course of action that generally involves use of
funds today but generate regular and recurring
gene ate egula ecu ing
benefits in future.
Benefit may be in the form of increased revenue or
reduced cost
d d
Capital budgeting decision involves:
Additions
Modifications
Replacements
Disposals
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4. Features
Large anticipated benefits
Relatively high degree of risk
W
Wrong decision may be suicidal
d i i b i id l
Relatively long‐gap between the initial outlay and the
anticipated return
p
Duration of benefits more than one year
Generally, able to measure relevant cash flow and
apply appropriate decision technique
l i t d i i t h i
Sometimes, not possible
Or not asked
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5. Features
As time passes, fixed assets may become obsolete or
may require an overhaul, requiring financing decisions
I
Is a continuing decision
i i d i i
All fixed asset outlays are capital expenditures but all
capital expenditures are not fixed assets
E.g. large Advertisement expenses, R&D etc.
It may be incurred‐
It may be incurred
Voluntary‐ Advt., R&D, Mgt. Consulting, new products
Mandated‐ pollution control, safety devices
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6. Features of Cap‐ex
Effect on the profitability, growth & survival
Competitive position
Help in converting and utilising current assets
Involves huge amount
St t i i
Strategic investment rather than tactical investment
t t th th t ti l i t t
Long Run effects – cost structure
Not reversible without significant financial loss
Draws on scarce capital resources
Benefits to be received in uncertain future
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8. Classification of Projects
Helps in standardised estimation & administration of
projects
Th b i f l ifi i
The basis of classification could be:
ld b
1. Size: Large, Medium, Small
2. U
Urgency: U Urgent, Required, desired
R i d d i d
3. Risk Impact: Risk‐neutral, Risk‐changing
4. D
Degree of Dependence among projects: Mutually
f D d j t M t ll
Exclusive, Complementary
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9. S i C i lB d i P
Steps in Capital Budgeting Process
Planning Implementation Control
• Search & • Investment Outlay • Feedback check
identification • Operations, against Budget
•FFormulation
l i Production, Sales,
P d i S l estimates
• Preliminary Costs, Financing • Post completion
estimates Audit
• Review of estimates • Review of existing
• Economic procedures
Evaluation
pp p
• Appropriation of
Funds
• Approval
• Preparation of
capital budget
it l b d t
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10. Assumptions in Capital Budgeting
Assumptions in Capital Budgeting
1. All cash flows take place at the end of the time
period
i d
2. No change in the risk i.e. size and timing of cash
flow are known with certainty
y
3. Perfect capital markets
4. Projects are infinitely divisible but exhibit
decreasing return to scale
d i l
5. Cash flows are in independent of each other
overtime and other investment decisions
6. Rational decision parties
7. It is a well‐behaved project or conventional cash
p j
flow projects
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11. Problems involved in Capital
Problems involved in Capital
Budgeting
1. Forecasting of future costs – both initial and
operating
2. Forecasting of benefits
F i f b fi
3. Determination of cost of capital or required rate of
return
4. Treatment of time element – economic life of project
5.
5 Treatment of risk element
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12. Cost – Benefit measurement
Profit is not a theoretical superior basis of
measurement
C h Fl i
Cash Flow is considered to be the superior basis of
id d b h i b i f
measurement
Is not affected by the Accounting conventions
Objective and verifiable
Cash Flow models can also be taken at different levels
of analysis –
Operating Free Cash Flow
Free Cash Flow to Equity
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13. Cash Flows of the Project
After – tax incremental operating cash flows
Only the cash flows which are incremental in nature and
directly attributable to the project are relevant
Net of tax effect – tax liability or tax shield
Depreciation & Amortisation
Depreciation & Amortisation – non cash items but affects
taxes
Indirect overheads – ignore if not affected by the project
Effect on other projects – consider with the projects flows
Opportunity costs – consider with the project flows
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14. Cash Flows of the Project
Financial charges – ignore in the project flows
Investment & Financing decisions are considered
separately
t l
Avoids double counting as these charges are reflected
in the hurdle rate
Changes in working capital – consider with the
project flows
Only changes are considered
Need arise because account books are kept on accrual
basis
b i
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15. P f C h Fl St t t
Proforma Cash Flow Statement
1. Cash flow from operations
Profit before tax
f b f
+ Depreciation & other non‐cash items
+ Interest & other non operating items
+ Interest & other non‐operating items
‐ Income tax paid
‐ Increase in Working Capital
2. Cash flow from investing
Cash paid to acquire Fixed Asset
Cash received for disposing Fixed Asset
3. Cash flow from financing
Interest/Dividend paid
/ p
Capital funds raised
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17. Cash flow computations
The cost of a new plant is Rs. 5,00,000. It has an
estimated life of 5 years after which it would be
disposed off (scrap value is nil) Profit before
nil).
depreciation, interest and taxes (PBIT) is estimated to
be Rs. 1,75,000 p.a.
,75, p
Find out the yearly cash flow from the plant, if tax rate is
assumed to be 30% and depreciation is provided on
straight line basis.
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