Capital Budgeting Decisions: Accepting Projects That Yields A Return Higher Than The Hurdle Rate

CAPITAL BUDGETING DECISIONS
Accepting projects that yields a return higher than the hurdle rate
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Capital Budgeting Decisions

Capital budgeting decisions relate to selection of a longterm asset or investment proposal or course of action that generally involves use of funds today but generate regular and recurring benefits in future. Benefit may be in the form of increased
revenue or reduced cost Capital budgeting decision involves:

Additions Modifications Replacements Disposals
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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
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Assumptions in Capital Budgeting

1. All cash flows take place at the end of the time period 2. No change in the risk i.e. size and timing of cash flow
3. 4. 5. 6. 7.
are known with certainty Perfect capital markets Projects are infinitely divisible but exhibit decreasing return to scale Cash flows are in independent of each other overtime and other investment decisions Rational decision parties It is a well-behaved project or conventional cash flow projects
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Problems involved in Capital Budgeting

1. Forecasting of future costs both initial
2. 3.
4.
5.
and operating Forecasting of benefits Determination of cost of capital or required rate of return Treatment of time element economic life of project Treatment of risk element
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Cost Benefit measurement

Profit is not a theoretical superior basis of
measurement Cash Flow is considered to be the superior basis of 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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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 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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Cash Flows of the Project

Financial charges ignore in the project flows
Investment & Financing decisions are considered separately 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 narain@fms.edu
Proforma Cash Flow Statement

1. Cash flow from operations Profit before tax + Depreciation & other non-cash 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 Capital funds raised narain@fms.edu
Cash flow computation

With the help of following projected Income Statement, calculate the cash inflow:
Net Sales Revenue 475000
Cost of goods sold General expenses

Depreciation Profit before interest and taxes Interest
200000 100000
50000 350000 125000 25000
Profit before tax Tax @30%

Profit after tax
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100000 30000
70000
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 depreciation, interest and taxes (PBIT) is estimated to be Rs. 1,75,000 p.a. 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
Cash flow computations

ABC Ltd. is evaluating a capital budgeting proposal for which relevant figures are as follows:
Cost of Plant Installation cost Economic life Scrap value Rs. 11,00,000 Rs. 3,400 7 years Rs. 30,000
Profit before depreciation and tax

Tax rate
Rs. 5,00,000
30%
Compute cash flows for the relevant period assuming written down method of providing depreciation. narain@fms.edu
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 expected scrap value is Rs. 40,000. The project gross cash inflows are expected to be:
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%.
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Illustration 2
A firm is using a two year old machine that was purchased for Rs. 70,000. The remaining life is 5 years. Depreciation rate is 40%. Firm is considering its replacement with a new machine costing Rs. 1,40,000 which would be used for 5 years. The installation charges will be Rs. 10,000. The increase in the working capital requirement will be Rs. 20,000 as a result of using the new machine. The firm is subject to income tax rate of 35% and capital gains tax rate of 30%. Determine the initial cash flow if salvage value of existing machine is (a) 80,000 (b) 60,000 (c) 50,000 (d) 20,000.
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Illustration 3
A machine has a book value of Rs. 90,000. and remaining life of 5 years. It is depreciable @ 20%. Its present salvage value is its book value but nil after 5 years. It can be replaced with a new machine worth Rs. 4,00,000. It will have a salvage value of Rs. 2,50,000 after 5 years. The new machine will save Rs. 1,00,000 p.a. in manufacturing costs. It will depreciate @ 33.33%. The tax rate is 35%. Determine the post tax incremental cash flow.
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Exercise
A machine purchased for Rs. 96,000 has a book value of Rs. 24,000 and remaining life of 4 years. It is depreciable @ 50%. Its present salvage value is Rs. 20,000 but nil after 4 years. It can be replaced with a new machine worth Rs. 1,30,000. It will have a salvage value of Rs. 8,000 after 4 years. The new machine will save Rs. 60,000 in manufacturing costs. It will depreciate @ 40%. The tax rate is 35%. Determine the post tax incremental cash flow.
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Illustration
Find incremental CFAT from the following information:
Purchase price of the new asset
Installation costs Increase in working capital in year zero Scrap value of the new asset after 4 years Annual revenues from new asset
10,00,000
2,00,000 2,50,000 3,50,000 21,50,000
Annual cash expenses on new asset

Current book value of old asset Present scrap value of old asset Annual revenue from old asset Annual cash expenses on old asset
9,50,000
4,00,000 5,00,000 19,25,000 11,25,000
Planning period
Depreciation on new asset Depreciation on old asset Tax rate
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4 years
20% 25% 30%
Exercise
A company is considering to install a machine costing Rs. 5,00,000 with an additional investment of Rs. 1,50,000 for its installation. The salvage value at the end of year 10 is estimated at Rs. 2,50,000. The machine is estimated to generate a sales revenue of Rs. 20,00,000 in the first year and the sales are expected to grow at 5% p.a. for the remaining life of the machine. The profit after tax is expected at 10% of the sales while the working capital requirement are expected to be 5% of the sales. Compute the cash flows assuming SLM depreciation and additional working capital is required at the beginning of each year and is fully salvageable.
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Solution
Initial investment outlay Rs. 7,50,000 First Year CFAT Rs. 2,35,000 Second Year CFAT Rs. 2,44,750 Third Year CFAT Rs. 2,54,987 Fourth Year CFAT Rs. 2,65,737 Fifth Year CFAT Rs. 2,77,024 Sixth Year CFAT Rs. 2,88,875 Seventh Year CFAT Rs. 3,01,319 Eighth Year CFAT Rs. 3,14,385 Ninth Year CFAT Rs. 3,28,104 narain@fms.edu Tenth Year CFAT Rs. 7,55,396

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CAPITAL BUDGETING DECISIONS

Capital Budgeting Decisions

revenue or reduced cost Capital budgeting decision involves:

Capital Budgeting Decision Process

Assumptions in Capital Budgeting

Problems involved in Capital Budgeting

Cost Benefit measurement

measurement Cash Flow is considered to be the superior basis of measurement

Cash Flow models can also be taken at different

Cash Flows of the Project

Cash Flows of the Project

Proforma Cash Flow Statement

Cash flow computation

Cost of goods sold General expenses

Profit before tax Tax @30%

Cash flow computations

Cash flow computations

Profit before depreciation and tax

Annual cash expenses on new asset

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