Session 30 Capital Budgeting

Who estimate?
Capital outlays-----engineering and product outlay dept. Revenue projectionmarketing group Operating cost----- production dept. cost accountants, purchase manager, personnel exe, tax expert Finance manager coordinate the efforts Minimizes the biases inherent in cash flow forecasting

Investment Project Proposals

New Product Expansion of Existing Product Replacement Research and Development

Basic principles
Separation Principle Incremental Principle Post tax Principle Consistency Priciple

Separation Principle
Profit after tax + interest(1- tax rate)

Incremental Principle
Guidelines: Consider all incidental effects Ignore sunk cost Include opportunity cost Question of allocation of overhead cost Estimate working capital properly
Include project-driven changes in working capital net of spontaneous changes in current liabilities

Post tax principle

Since taxes are cash flows, we must include taxes in our cash flow estimates. All estimated cash flows should be after-tax cash flow estimates! Effect of non cash charges Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. Everything else equal, the greater the depreciation charges, the lower the taxes paid by the firm. Depreciation is a non-cash expense.

Consistency Principle
Cash flows and discount rate must be consistent with respect to inflation Cash flow Nominal Cash flow Real Cash flow discount rate nominal discount rate real discount rate

Elements of Cash Flow Stream

Initial investment Operating cash flow Terminal cash flow
Net salvage value of fixed asset + net recovery of working capital margin

Biases in cash flow estimation

Overstatement of profitability
Intentional overstatement Lack of experience

Understatement of profitability
Salvage values are under estimated Intangible benefits are ignored

Initial Cash Outflow

a) b) c) d) e) f) Cost of new assets + Capitalized expenditures + (-) Increased (decreased) NWC Net proceeds from sale of old asset(s) if replacement + (-) Taxes (savings) due to the sale of old asset(s) if replacement = Initial cash outflow

Incremental Cash Flows

a) Net incr. (decr.) in operating revenue less (plus) any net incr. (decr.) in operating expenses, excluding depr. - (+) Net incr. (decr.) in tax depreciation = Net change in income before taxes - (+) Net incr. (decr.) in taxes = Net change in income after taxes + (-) Net incr. (decr.) in tax depr. Charges = Incremental net cash flow for period

b) c) d) e) f) g)

TerminalTerminal-Year Incremental Cash Flows

a) b) c) d) e) + (-) - (+) + (-) = Calculate the incremental net cash flow for the terminal period Salvage value (disposal costs) of any sold or disposed assets Taxes (tax savings) due to asset sale or disposal of new assets Decreased (increased) level of net working capital Terminal year incremental net cash flow

Example of an Asset Expansion Project

X Ltd is considering the purchase of a new basket weaving machine. The machine will cost Rs.50,000 plus Rs.20,000 for shipping and installation and falls under the 3-year MACRS class. NWC will rise by Rs.5,000. Mr. Sengupta forecasts that revenues will increase by Rs.110,000 for each of the next 4 years and will then be sold (scrapped) for Rs.10,000 at the end of the fourth year, when the project ends. Operating costs will rise by Rs.70,000 for each of the next four years. X Ltd. is in the 40% tax bracket.

Initial Cash Outflow

a) b) + c) + d) e) + (-) f) = Rs.50,000 20,000 5,000 0 (not a replacement) 0 (not a replacement) Rs.75,000

Incremental Cash Flows

a) b) c) d) e) f) g) = = + = Year 1 Rs.40,000 23,331 Rs.16,669 6,668 Rs.10,001 23,331 Year 2 Year 3 Year 4 Rs.40,000 Rs.40,000 Rs.40,000 31,115 10,367 5,187 Rs. 8,885 Rs.29,633 Rs.34,813 3,554 11,853 13,925 Rs. 5,331 Rs.17,780 Rs.20,888 31,115 10,367 5,187

Rs.33,332 Rs.36,446 Rs.28,147 Rs.26,075

TerminalTerminal-Year Incremental Cash Flows

a) Rs.26,075 Year 4. 10,000 4,000 The incremental cash flow from the previous slide in Salvage Value. .40*(Rs.10,000 - 0) Note, the asset is fully depreciated at the end of Year 4 NWC - Project ends. Terminal-year incremental Terminalcash flow. flow. b) c) + -

d) e)

+ =

5,000 Rs.37,075

Summary of Project Net Cash Flows

Asset Expansion
Year 0 -Rs.75,000 Year 1 Rs.33,332 Year 2 Rs.36,446 Year 3 Year 4 Rs.28,147 Rs.37,075

Example of an Asset Replacement Project

Let us assume that previous asset expansion project is actually an asset replacement project. The original basis of the machine was Rs.30,000 and depreciated using straight-line over five years (Rs.6,000 per year). The machine has two years of depreciation and four years of useful life remain-ing. X Ltd. can sell the current machine for Rs.6,000. The new machine will not increase revenues (remain at Rs.110,000) but it decreases operating expenses by Rs.10,000 per year (old = Rs.80,000). NWC will rise to Rs.10,000 from Rs.5,000 (old).

Calculation of the Change in Depreciation

a) b) c) = Year 1 Year 2 Year 3 Year 4 Rs.23,331 Rs.31,115 Rs.10,367 Rs. 5,187 6,000 6,000 0 0 Rs.17,331 Rs.25,115 Rs.10,367 Rs. 5,187

a) Represent the depreciation on the new project. b) Represent the remaining depreciation on the old project. c) Net change in tax depreciation charges.

Incremental Cash Flows

a) b) c) d) e) f) g) = = + = Year 1 Year 2 Year 3 Year 4 Rs.10,000 Rs.10,000 Rs.10,000 Rs.10,000 17,331 25,115 10,367 5,187 Rs. -7,331 -Rs.15,115 Rs. -367 Rs. 4,813 -2,932 -6,046 -147 1,925 Rs. -4,399 Rs. -9,069 Rs. -220 Rs. 2,888 17,331 25,115 10,367 5,187 Rs.12,932 Rs.16,046 Rs.10,147 Rs. 8,075

TerminalTerminal-Year Incremental Cash Flows

a) Year 4. + Rs. 8,075 The incremental cash flow from the previous slide in Salvage Value. (.40)*(Rs.10,000 - 0). Note, the asset is fully depreciated at the end of Year 4. Return of added NWC. Terminal-year incremental Terminalcash flow. b) c) 10,000 4,000

d) e)

+ =

5,000 Rs.19,075

Summary of Project Net Cash Flows

Asset Expansion
Year 0 -Rs.75,000 Year 1 Rs.33,332 Year 2 Rs.36,446 Year 3 Year 4 Rs.28,147 Rs.37,075

Asset Replacement
Year 0 -Rs.66,600 Year 1 Rs.12,933 Year 2 Rs.16,046 Year 3 Year 4 Rs.10,147 Rs.19,075

Recapitulation
Basic characteristics of relevant project flows
Cash (non accounting flows) Operating ( non financing Flows) After tax flows Incremental flows

Equivalent Annual Cost

Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

Equivalent Annual Cost

Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.
present value of costs Equivalent annual cost = annuity factor

Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method.
Year 1 15 10

Equivalent Annual Cost

Machine A B

2 5 6

3 5 6

4 5

PV@6% 28.37 21.00

EAC 10.61 11.45

Timing
Even projects with positive NPV may be more valuable if deferred. The actual NPV is then the current value of some future value of the deferred project.
Net future value as of date t Current NPV ! t (1  r )

Timing
Example You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV? Harvest Year
0 % change in value 1 28.8 2 77.5 20.3 3 89.4 4 5 9.4 Net FV (Rs.1000s) 50 64.4 100 109.4

15.4 11.9

Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV? 64.4

NPV if harvested in year 1 !

1.10

! 58.5

Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?

64.4 NPV if harvested in year 1 ! ! 58 .5 1.10

Harvest Year 0 1 2 64.0 3 4

NPV (Rs.1000s) 50 58.5

67.2 68.3 67.9

Fluctuating Load Factors

Two Old Machines 750 units 2 v 750 ! Rs.1,500 1,500/.10 ! Rs.15,000

Annual output per machine Operating cost per machine PV operating cost per pachine

PV operating cost of two machines 2 v 15,000 ! Rs.30,000

Fluctuating Load Factors

Two New Machines Annual output per machine Capital cost per machine Operating cost per machine PV operating cost per pachine 750 units Rs.6, 000 1v 750 ! Rs.750 6,000  750/.10 ! Rs.13,500

PV operating cost of two machines 2 v13,500 ! Rs.27,000

Fluctuating Load Factors

One Old Machine Annual output per machine Capital cost per machine Operating cost per machine PV operating cost per machine 500 units 0 2 v 500 ! Rs.1,000 1,000/.10 ! Rs.10,000 One New Machine 1,000 units Rs.6, 000 1v 1, 000 ! Rs.1,000 6,000  1, 000 / .10 ! Rs.16,000

PV operating cost of two machines ................................Rs.26, 000

Recapitulation
Basic principles that must be adhered to in estimating after tax incremental cash flows
Ignore sunk cost Include opportunity cost Include project driven changes in NWC Includes effects of Inflation