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Chapter 4
Capital Budgeting
Unit 2
Long-term investment decisions
After reading this lesson you will be able to: -
Understand what capital investments are -- and what the capital budgeting
decision process involves.
Understanding the different types of project.
Be able to understand and explain the process to generate project proposals
within the firm.
Determine initial, interim, and terminal period after-tax incremental
operating cash flows associated with a capital investment project.
Understand why cash, not income, flows are the most relevant.
Our main focus in this lesson is identifying relevant cash flows
In the previous session we discussed the basics of capital budgeting. In this session our
discussion will be mainly on identifying relevant cash flows.
As you know that the funds available with the firm are always limited and it is not
possible to invest funds in all the proposals at a time. Therefore, it is very essential to
select from amongst the various competing proposals, those which give the highest
benefit. A firm may face a situation where more investment proposals may be available
than investible funds. Some proposals may be good, some moderate and some may be
poor. The management has to select the most profitable project or to take up the most
profitable project first. There are many considerations, economic as well as non-
economic, which influence the capital budgeting decisions. Because of the utmost
importance of the capital budgeting decision, a sound appraisal method should be
adopted to measure the economic worth of each investment project. Capital expenditures
represent long-term commitment in the sense that current investment yields benefits in
future. As discussed the capital expenditure decisions assume great importance for the
future development of the concern. The important factor that influences the capital
budgeting decision is the profitability of the prospective investment. The risk involved in
the proposal cannot be ignored because profitability and risk are directly related, that is,
higher the profitability, the greater the risk and vice-versa. The goal of financial
management of a firm is the worth maximisation of the firm, and in order to achieve this
goal, the management must select those projects deserve first priority in terms of their
profitability. While evaluating, two basic principles are kept in mind, namely, the bigger
benefits are always preferable to small ones and early benefits are always better than the
deferred ones. The essential property of sound evaluation technique is that it should
maximise the shareholders' wealth.
How you as an individual will make an investment decision & how will you evaluate
it?
For evaluating the project there is a need of a data. The data required is basically
the cash flows, inflows as well as outflows. Your understanding of cash flows needs
to be very clear, before you start with the evaluation.
IMPORTANT
In the capital budgeting procedure, the first step required is the estimation of cost and
benefits of different proposals being considered for decision-making. The estimation of
cost and benefits may be made on the basis of input data being provided by production,
marketing, accounting or any other department. What is required is the synchronization
of this data and to make an attempt to forecast the costs and benefits of a proposal. But
the question at this stage is how to measure the cost and benefits of a proposal?
Usually, two alternatives are suggested for measuring the 'Cost and benefits of a
proposal i.e., the accounting profits and the cash flows.
Accounting profit:
a) The accounting profit is, to a large extent, affected by the accounting policies
being followed by the terms. These policies, which usually differ from one firm to
another or from one period to another, may be depreciation policy, inventory
valuation policy, capital expenditure and revenue expense policy etc. Thus, the
accounting profit is not a standard figure.
b). So many non-cash items such as depreciation, writing off the accumulated
losses etc, affect the accounting profit. The balancing profit figure after these
items is not a true measure of benefits contributed by a proposal.
c) The accounting profit measures the profit of any particular year in terms of the
money of that year. However, the cost and benefits of a proposal may occur over
a period of number of year. The benefits if measured in terms of accounting
profit, are expressed in monies of different time period and are not comparable.
Similarly, if two mutually exclusive proposals have different economic lives, then
the accounting profits emerging over different periods are not comparable.
d) The accounting profit is based on the accrual concepts. For example, the sales
revenue and the expenses, both are recorded for the period in which they occur
instead of the period in which they are actually received or paid.
Thus, in view of these serious flows, the accounting profit as a measure of benefits of a
proposal is out rightly rejected. Instead, the cost and benefits are measured in terms of
cash flows.
Cash Flows:
In capital budgeting, the cost and benefits of a proposal are measured in terms of cash
flows. The term cash flow is used to describe the cash oriented measures of return
generated by a proposal. Though it may not be possible to obtain exact cash-effect meas-
urement, it is possible to generate useful approximations based on available accounting
data. The costs are denoted as cash outflows whereas the benefits are denoted as cash
inflows. It maybe noted that the cash outflows represent outflows of purchasing power
and cash inflow is an inflow of purchasing power. The cash outflows and inflows are
used to denote the cost and benefit of a proposal.
It may be noted that the accounting profit figure is the resultant figure on the basis of sev-
eral accounting concepts and policies. Some of the costs, which are deducted from the
sales revenue to arrive at the profit figure, do not involve any cash flow. These charges
against profit are simply book entries. For example, depreciation, provision for bad and
doubtful debts; writing off the goodwill etc. do not involve any cash flow Similarly, a
capital expenditure though involving a cash payment is not considered as the cost for the
period and hence is not deducted from the sales revenue. Therefore, there is a difference
between accounting profit and cash flow. This difference arises because of non-cash
transactions: This can be substantiated as follows:
Now, presuming that all the sales, expenses and taxes have been affected in cash, the cash
flow position of the firm can be expressed as follows:
Note the difference between the profit after tax (i.e., Rs. 15,000) and cash inflow (i.e., Rs.
30,000). This difference is due to the existence of non-cash expense of depreciation of
Rs. 15,000. On the basis of this example, the cash flow may be stated as follows:
Cash flow = Profit after Tax (PAT) + Non cash expenses (N/C exp.)
Further, if the firm has spent Rs. 5,000 on capital expenditure (Cap. Expd.), then this will
not affect the profit figure but Rs. 5,000 will reduce the cash flow as follows:
Equation 1 above depicts that even if sales and operating expenses are affected in cash,
the profit of the firm and the cash flows may be different. The reason for this difference is
the non-cash expenses and the existence of capital expenditure.
Example
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 (PBT) is
estimated to be Rs. 1,75,000 p.a. Find out the yearly cash flow from the plant. (Given the
tax rate @ 30%).
Solution
ABC Ltd. Is evaluating a capital budgeting proposal for which relevant figures are as
follows:
Solution:
Annual depreciation charge
(Rs. 11,03,400 – Rs. 30,000)/7 1,53,343
- Depreciation 1,53,343
The plant has an initial cash outflow of Rs. 11,03,400 (Rs. 11,00,000 + Rs. 3,400), and its
annual cash inflows for 7 year will be Rs. 1,76,671 p.a. however, in the 7th year, there
will be an additional cash inflow of Rs. 30,000 i.e., the scrap value. Therefore, in year,
the total cash inflow will be Rs. 2,06,671.
In the above two examples all the sales and expenses have been effected in cash.
However, in practice there is a time gap between the occurrence of sales and expenses
and their incidence on cash flow. Thus, each transaction of sales and expenses need to be
analyzed to find out the cash flow associated with it. Similarly, pattern of receipts from
receivables (debtors and bill) and the pattern of payments to payable (creditors and bills)
should also be analyzed to assess the effect on cash flow. But this is too difficult and
rather impossible to apply. Moreover, in capital budgeting, the emphasis is on yearly
basis cash flows rather than on intra-year cash flows. Therefore, in capital budgeting,
only the total cash flows are relevant and so, the profit figure is adjusted only for non-
cash items.
Cash Flows versus Accounting Profit: In a capital budgeting decision situation, the
measurement of cost and benefits should result in identical estimates irrespective of the
person making the estimates, but the vagaries of accounting always do not permit this.
The accounting policies relating to depreciation, inventory valuation, and allocation of
indirect costs may cause wide discrepancies in accounting profit in identical situation.
These problems may all be overcome by focusing on the cash flows, which will be
identical irrespective of the person making estimation thereof. The concept of cash flows
as a measure of evaluating the cost and benefits of a proposal is better than the concept of
accounting profit in more than one ways as follows:
a) The accounting profit ignores the concept of time value of money, whereas the
cash flow technique incorporates the time value of money also.
Thus, it is clear that the cash flows, as a measure of cost and benefits of a proposal is a
better technique to evaluate a proposal.
Computation of Cash flows will depend on the nature of proposal. Projects can be
categorized into:
Single Proposal
Replacement situations
Mutually exclusive
We will discuss components of cash flow keeping in mind above categories of Capital
projects
(1). ORIGINAL OR INITIAL CASH OUTFLOW: All the capital projects require a
sizeable initial cash outflow before any future inflow is realized. This initial cash outflow
is needed to get a project operational. In most of the capital budgeting proposals, the
initial cost of the project i.e., the initial investment cost in the cash outflow occurring in
the initial stages of the projects. Since the investment cost occurs in the beginning of the
project, it is relatively easy to identify the initial cash outflows. It reflects the cash spent
to acquire the asset.
Case A: Single Proposal / New Project
In case of a new project the calculation of outflow is quite easy. It is presented below
Cash outflow of New Project {(Beginning of the period at zero time (t=0)}
1. Cost of new project
2. (+) Installation cost
3. (+/-) Working capital
2. Installation cost:
The initial cash outflow includes the total cost of the project in order to bring it in
workable condition. Thus, the initial cash outflow includes the cost of plant, but also the
transportation cost, installation cost and any other incidental cost.
Almost every investment proposal requires an additional investment in all or any of the
three main components of working capital. The proposal if accepted would require
increase in minimum cash balance to be maintained, higher’ inventory level and more
receivables. Though, every firm tries to keep its investment in working capital to the
minimum level, yet the new project, if undertaken, would require the firm (i) to extend
additional credit to its customers, (ii) to carry additional inventory to serve customer
orders, and (iii) to enlarge its cash balance to meet its enlarged transactions.
Generally speaking, the working capital requirement of a proposal will be a function of
the expected growth in revenues and expenses from that project, although the exact
linkage will vary from business to business. Thus, if the firm undertakes the projects, it
requires additional working capital to support the operations of the project and therefore,
this additional working capital required is the additional investment to be made in the
project, and is therefore, also included in the initial cash outflows of the project.
Any additional investment in working capital cannot be used elsewhere and is similar to
an investment in building or plant or furniture etc. It has to be viewed as a cash outflow
when it is made. On the similar lines, any decrease in working capital resulting from
the proposal can be viewed as a release of working capital or cash inflow.
However, it may be noted that the additional working capital is required only for the
period equal to the life of the proposal. At the end of the proposal, this additional
working capital being invested now will be released and recaptured by the firm. Thus the
cash inflow for the last year of the life of the project would also include the working
capital released by the project.
Failure to consider the working capital needs in the capital budgeting decision may have
two consequences i.e., (i) the cash flows will be over-estimated and (ii) even if working
capital is salvaged fully at the end of the project life, the net present value of the cash
flows created by change of working capital will be negative and hence the capital
budgeting decision may be taken wrongly.
In case of replacement situation we are replacing the old machinery by the new one. We
will be selling the old machinery therefore our outflows in form of purchase price will be
reduced.
Cash outflow in a replacement situation {(Beginning of the period at zero time (t=0)}
1. Cost of new project
2. (+) Installation cost
3. (+/-) Working capital
4. (-) Sale proceeds of existing machine
5. (+/-) Taxes (tax savings) due to the sale of “old” asset(s) if the investment is a
replacement decision
Sometimes, the project may require some subsequent cash outflows also in the form of
periodic intensive repair, periodic shunting cost etc. All these cash inflows and outflows
are to be considered for the capital budgeting decision.
It is important to recognize the timing of these subsequent cash inflows and outflows, as
these are to be adjusted for the time value of money. The more quickly and earlier, occur,
the more valuable these are.
Salvage value is the market price of an investment at time of its sale. A company will
incur loss if an asset is sold for a price less than the asset’s book (depreciated) value.
On the other hand, the company will make a profit it the asset’s salvage value is more
than its book value. The profit on the sale of an asset may be divided into ordinary
income and capital gain. Capital gain is equal to salvage value minus original value of the
asset, and ordinary income is equal to original value minus book value of the asset.
Capital gains are generally taxed at a rate lower than the ordinary income. Does a
company pay tax on profit or get tax credit on loss on the sale of an asset? In a number of
countries the sale of an asset has implications. This was also a practice in India till
recently. But as per the changed Income Tax rules, the depreciable bases of the block of
assets are adjusted for the sale of assets and no taxes are computed.
Assuming tax implications of the sale of an asset, the net proceeds can be
calculated as follows:
In the capital budgeting, the cash flows are measured in the incremental terms i.e., only
those cash flows are considered, that differ or occur as a result of undertaking/accepting
the particular proposal. These refer to those cash flows, which can be associated and
attributed to adoption of a particular proposal.
What do we mean by incremental cash flows? Every investment involves a comparison
of alternatives. The problem of choice will arise only if there are at least two possibilities.
The minimum investment opportunity, which a company will always have, will be either
to invest or not to invest in a project. Assume that the question before a company is to
introduce a new product. The incremental cash flows in this case will be determined by
comparing cash flows resulting with and without the introduction of the new product. If,
for example, the company has to spend Rs. 50,000 initially to introduce the product, we
are implicitly comparing cash outlay for introducing the product with a zero cash outlay
of not introducing the product. When the incremental cash flows for an investment are
calculated by comparing with a hypothetical zero-cash-flow project, we call them
absolute cash flows.
Assume now that the question before a company is to invest either in Project A or
in Project B. One way of analysing can be to compute the absolute cash flows for each
project and determine their respective NPVs. Then, by comparing their NPVs, a choice
can be made. Alternatively, two projects can be compared directly. For example, we can
subtract (algebraically) cash flows of Project B from that of Project A (or vice versa) to
find out incremental cash flows (of Project A minus Project B). The positive difference in
a particular period will tell how much more cash flow is generated by Project A relative
to Project B. The incremental cash flows found out by such comparison between two real
alternatives can be called relative cash flows. NPV of this series of relative cash flows
will be equal to NPV of the absolute cash flows from Project A minus NPV of the
absolute cash flows from Project B. Thus, NPV (A-B) = NPV (A) – NPV (B). The
principle of incremental cash flows assumes greater importance in the case of
replacement decisions.
The principle of incremental cash flows in capital budgeting analysis is critical. A
finance manager while evaluating a proposal should note whether a particular cash flow
is incremental or not. Only the incremental cash flows should be considered for capital
budgeting. Any cash inflow or outflow hat can be directly or indirectly traced to a project
must be considered. Obviously, the incremental cash flows analysis also implies that any
reduction in cash inflow or outflow that occurs as a consequence of a project should also
be considered.
Example
Ojus Enterprises is determining the cash flow for a project involving replacement of an
old machine by a new machine. The old machine bought a few years ago has a book
value of Rs. 400,000 and it can be sold to realize a post-tax salvage value of Rs 500,000.
It has a remaining life of five years after which its net salvage value is expected to be Rs
160,000. It is being depreciated annually at a rate of 25 per cent under the written down
value method. The working capital required for the old machine is Rs 400,000.
Solution
2. The estimated benefits from a capital budgeting project are expected as cash flows
rather than income flows because __________.
3.In estimating "after-tax incremental operating cash flows" for a project, you should
include all of the following except __________.
4. All of the following influence capital budgeting cash flows except __________.
6. Place the following items in the proper order of completion regarding the capital
budgeting process. I. Perform a post audit for completed projects; II. Generate project
proposals; III. Estimate appropriate cash flows; IV. Select value maximizing projects; V.
Evaluate projects.
8. Interest payments, principal payments, and cash dividends are __________ the typical
budgeting cash-flow analysis because they are ________ flows.
i. Funds spent last year to renovate a building that could be used to house a new
project that is currently being evaluated.
ii. Installation costs necessary to use a machine that was just purchased.
iii. The necessary increase in inventories needed to support a project that is currently
being implemented.
iv. All of the above are examples of capitalized expenditures.
Answers to above
1.Operating
2. It is cash, not accounting income that is central to the firm's capital budgeting decision
3. Costs that have previously been incurred that are unrecoverable
4. Sunk costs of the project
5. Include opportunity costs, but ignore sunk costs
6. The correct answer: II, III, V, IV, and I.
7. Include effects of inflation, and include project-driven changes in working capital net
of spontaneous changes in current liabilities
8.Excluded from; financing
9.Only the installation costs are considered capitalized expenditures.
True or False
1. The stream of cash flows produced by the project directly influences the value of a
capital expansion project.
3. Cash flow calculations require adding back depreciation to net income since it is a non-
cash expense.
4. A capital investment involves making a future cash outlay in the expectation of current
benefits.
Answers to above
1. TRUE
2. TRUE
3. TRUE
4. FALSE
ESSAY QUESTIONS
1. Adam Smith is considering automating his pen factory with the purchase of a $475,000
machine. Shipping and installation would cost $5,000. Smith has calculated that
automation would result in savings of $45,000 a year due to reduced scrap and $65,000 a
year due to reduced labor costs. The machine has a useful life of 4 years and falls in the
3-year property class for depreciation purposes. The estimated salvage value of the
machine at the end of four years is $120,000. The old machine is fully depreciated, but
has a salvage value today of $100,000. The firm's marginal tax rate is 34 percent.