Capital Budgeting

Definition
A capital budgeting decision may be defined as the firms decision to invest its current funds most efficiently in long term assets in anticipation of an expected flow of benefits over a series of years. Long term assets are those that affect the firms operations beyond one year period.

Importance of Capital Budgeting decisions

Long term effects on risk and return Substantial commitments Irreversible decisions Affects the capacity and strength to compete

Problems and Difficulties in Capital Budgeting

Future Uncertainty Time Element Measurement Problem

Types/Classification of Capital Budgeting Decisions

On the basis of firms existence

I. Cost Reduction Decisions 1. Replacement Decisions 2. Modernisation Decisions

On the basis of decision situation

I. Mutually Exclusive Decisions

II. Accept Reject Decisions II. Revenue Expansion Decisions 1. Expansion Decisions 2. Diversification Decisions 3. Set up of New Business Decision III. Contingent Decisions

Capital Budgeting Decisions: Assumptions

1. Certainty with respect to cost and benefits 2. Profit Motive 3. No Capital Rationing

Capital Budgeting Decisions : Process

1. Estimation of Costs and Benefits of a Proposal 2. Estimation of the Required Rate of Return 3. Using the Capital budgeting Decision Criterion/Technique

Cash Flow Analysis

1. Why should cash flows be preferred to accounting profits? 2. Why should cash flows be considered after tax? 3. How does depreciation affect the cash flows of a project? 4. Treatment of Financial cash flows vs operating cash flows ?

Cash Flows versus Accounting Profit

The concept of cash flows as a measure of evaluating the costs and benefits of a proposal is better than the concept of accounting profit. Reasons: - Time value of money - Precise and not ambiguous

Cash Flows
Cash flows may be classified into:

1. Initial Cash Outflow/Investment Cost

i. ii. iii. iv. Installation Cost Sunk Cost Opportunity Cost Additional Working Capital requirement
Operating Cash flows Additional Working Capital Subsequent cash flows like Periodic Intensive repair, etc. Salvage /Scrap value Working Capital Land sold

2.

Subsequent Inflows and Outflows

i. ii. iii.

3.

Terminal Cash Inflows

i. ii. iii.

Q1. The cost of a plant is Rs 5,00,000. It has an estimated life of 5 years after which it would be disposed off (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is estimated to be Rs. 1,75,000 p.a. Find out the yearly cash flow from the plant. (given the tax rate @ 30%)

Q2. ABC Ltd. is evaluating a capital budgeting proposal for which relevant figures are as follows: Cost of the plant Rs. 11,00,000 Installation Cost Rs. 3,400 Economic life 7 years Scrap value Rs. 30,000 Profit before depreciation and tax Rs. 2,00,000 Tax rate 50% Compute Cash Flows.

Q3. A firm buys an asset costing Rs. 1,00,000 and expects operating profits (before depreciation @ 20% WDV and tax @ 30%) of Rs. 30,000 p.a. for the next four years after which the asset would be disposed off for Rs. 45,000. Find the cash flows for different years.

Q4. Calculate the annual cash flows on the basis of the following income statement: Income Statement of the Project (Figures in Rs.) Net Sales Revenue 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 - Profit before tax 1,00,000 - Tax @ 40% 40,000 Profit after tax 60,000

Incremental Cash Flows

Q. Assume that a firm wants to replace an old equipment, which is capable of generating cash flows of Rs.2,000, Rs.1,000 and Rs.500 during the next 3 years. It has a book value of Rs.5,000 and a market value of Rs.3,000. The firm is considering a new equipment, which will require an initial cash outlay of Rs.10,000, and is estimated to generate cash flows of Rs.8,000, Rs.7,000 and Rs.4,500 for the next 3 years. Both old and new equipments may be assumed to have a zero resale value after 3 years. Assume taxes do not exist.(Therefore depreciation becomes irrelevant) Q. Do the above question assuming that the old equipment will realise Rs.500 and the new one Rs. 2,500 as salvage value after 3 years.

Q5. ABC & 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 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 technological 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 40 %.(The capital gain or loss may be taken as not subject to tax.)

Q6. XYZ is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old machine bought a few years ago has a book value of Rs. 90,000 and it can be sold for Rs.90,000. It has a remaining life of five years after which its salvage is expected to be nil. It is being depreciated annually at the rate of 20% (written down value method.) The new machine costs Rs.4,00,000. It is expected to fetch Rs.2,50,000 after five years when it will no longer be required. It will be depreciated annually at the rate of 33 1/3 % (written down value method.) The new machine is expected to bring a saving of Rs. 1,00,000 in manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable to the firm is 50%. Find out the relevant cash flow for this replacement decision. (Tax on capital gain/loss to be ignored)

Q7. XYZ is trying to decide whether it should replace a manually operated machine with a fully automatic version of the same machine. The existing machine, purchased 10 years ago, has a book value of Rs.2,40,000 and remaining life of 20 years. Salvage value was Rs.40,000. The machine has recently begun causing problems with breakdowns and is costing the company Rs. 20,000 per year in maintenance expenses. The company has been offered Rs.1,00,000 for the old machine as a trade-in on the automatic model which has a deliver price (before allowance for trade-in ) of Rs2,20,000. It is expected to have a ten year life and a salvage value of Rs.20,000. The new machine will require installation modifications costing Rs.40,000 to the existing facilities, but it is estimated to have a cost savings in materials of Rs.80,000 per year. Maintenance costs are included in the purchase contract and are borne by the machine manufacturer. The tax rate is 40% (applicable to both revenue income as well as capital gains/losses). Straight line depreciation over 10 years will be used. Find out the relevant cash flows.

Q8 A firm is currently using a machine which was purchased two years ago for Rs.70,000 and has a remaining useful life of 5 years. It is considering to replace a machine with a new one which will cost Rs.1,40,000. The cost of installation will amount to Rs.10,000. The increase in working capital will be Rs. 20,000. The expected cash inflows before depreciation and taxes for both the machines are as follows: Year Existing Machine New Machine 1 Rs. 30,000 Rs. 50,000 2 Rs. 30,000 Rs. 60,000 3 Rs. 30,000 Rs. 70,000 4 Rs. 30,000 Rs. 90,000 5 Rs. 30,000 Rs. 1,00,000 The firm uses Straight Line Method of depreciation. The average tax on income as well as on capital gains/losses is 40%. Calculate the incremental cash flows assuming sale value of existing machine is: i. Rs.80,000 ii. Rs.60,000 iii. Rs.50,000 iv. RS.30,000

Q9. NIRC Ltd. is considering an investment proposal for which the relevant information is as follows: (all figures in Rs.) Purchase Price of the new asset 10,00,000 Installation costs 2,00,000 Increase in working capital in year zero 2,50,000 Scrap value of the new asset after 4 years 3,50,000 Revenues from new asset (annual) 21,50,000 Cash expenses on new asset (annual) 9,50,000 Current book value (old asset) 4,00,000 Present scrap value (old asset) 5,00,000 Revenue from old asset (annual) 19,25,000 Cash expenses on old asset (annual) 11,25,000 Planning Period 4 years Depreciation on new asset: 92% of the cost is to be depreciated in the ratio of 5:8:6:4 over 4 years. Existing asset is depreciated at a rate of Rs. 1,00,000 p.a. Tax rate is 40% on both revenues as well as capital gains/losses. Compute Cash flows.