1. Accepting projects that yields a return higher than the
hurdle rate

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
narain@fms.edu

3. Capital Budgeting Decision Process
While evaluating projects, an attempt is made to:‐
1. Reduce costs and benefits to a single figure
2. Compare this against a predetermined amount,
rate or time period
3. Make a choice
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

7. Features of Cap‐ex
 Affects revenues or reduce costs
 Costs incurred and benefits received in different
periods
i d
 Not comparable
 Time value of money
 Generally, precise identification of all the benefits and
costs relating to a particular investment decision not
possible
 Are subject to internal and external capital rationing
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

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
narain@fms.edu

16. Cash flow computation
With the help of following projected Income Statement,
calculate the cash inflow:
Net Sales Revenue
N S l R 475000
Cost of goods sold 200000
General expenses 100000
Depreciation 50000 350000
Profit before interest and taxes 125000
Interest 25000
Profit before tax 100000
Tax @30% 30000
Profit after tax 70000
narain@fms.edu

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.
narain@fms.edu

18. Cash flow computations
ABC Ltd. is evaluating a capital budgeting proposal for
which relevant figures are as follows:
Cost of Plant
C f Pl Rs. 11,00,000
R
Installation cost Rs. 3,400
Economic life 7 years
Scrap value Rs. 30,000
Profit before depreciation and tax Rs. 5,00,000
Tax rate 30%
Compute cash flows for the relevant period assuming
written down method of providing depreciation.
written down method of providing depreciation
narain@fms.edu

19. Illustration 1
A company has created computer facility at a cost of Rs.
2 lac. The annual maintenance cost shall be Rs. 20,000.
After 5 years the system will be phased out. The
After 5 years the system will be phased out The
expected scrap value is Rs. 40,000. The project gross
cash inflows are expected to be:
p
1st yr 2nd yr 3rd yr 4th yr 5th yr
50,000 80,000 1,00,000 80,000 60,000
compute the cash flows for the project if tax rate is 30%
and depreciation is provided at 60%.
narain@fms.edu