- The document discusses capital budgeting and cash flow analysis for a proposed machinery investment of Rs. 1,20,000 with a 5 year life. - It calculates the annual cash flows after tax over the 5 years, which range from Rs. 24,100 to Rs. 38,800, factoring in revenue, expenses, depreciation and taxes. - The terminal cash flow at the end of 5 years is Rs. 48,800, which includes the final annual cash flow plus the expected scrap value of Rs. 10,000 for the machine.

1. Amity Business School
Investment DecIsIon
moDule III
WeIghtage 25%

2. Amity Business SchoolLearning Outcomes

3. Amity Business School
3
Position of Capital Budgeting

4. Amity Business School
Capital Budgeting- Meaning
• Capital Budgeting refers to the expenditure on the capital
assets.
• Spending money on capital assets is a very important
decision that a finance manager is required to take.
• Capital investment expenditure may be on Plant,
Machinery Equipment, Land, Building etc.

5. Amity Business School
Significance of Capital
Budgeting

6. Amity Business School
 It involves substantially higher amounts than for
other routine expenses.
 The decision is irreversible, i.e. it is not possible to
withdraw your steps easily, once you have taken
few steps in this regard.
 It has long term impact on the affairs of a company
and it, hence determines the future of a company.

7. Amity Business School
An expenditure made on a capital asset has a long
term perspective.
We spend today, to gain some advantages in future.
This expenditure involves a big cash outflow of funds
initially, compensated by small but recurring doses
of inflow of funds in future for some time.

8. Amity Business School
Cash Flow Pattern
• Conventional: Conventional cash flow pattern is
an initial outflow followed by only a series of
inflows
• Non-conventional: Alternating inflows and
outflows and an inflow followed by outflows are
examples of non-conventional cash flow patterns.

9. Amity Business School
Cash Flows in a Conventional Project
+
0
− 1 2 3 4 5 6
Years
+ shows Cash inflows
&
- shows Cash outflows

10. Amity Business School
The essence of the capital budgeting decision making is to
determine, whether the initial expenditure of funds is duly
compensated by the inflow of funds occurring in future.
If greater values can be assigned to the inflow of funds than
the present expenditure, then that capital investment proposal
must be accepted because that will add up to the wealth of the
company.

11. Amity Business School
Types of Capital Budgeting Decisions
• From the point of view of firm’s existence
• From the point of view of Decision Situation

12. Amity Business SchoolFrom the point of view of firm’s existence
(a) New Firm
(b) Existing Firm
• Replacement & Modernization Decision
• Expansion
• Diversification

13. Amity Business School
Mutually Exclusive Decisions
Mutually exclusive projects (decisions) are projects that compete with one
another; the acceptance of one eliminates the others from further
consideration.
Contingent Decisions
They are dependent projects; the choice of one investment necessitatesThey are dependent projects; the choice of one investment necessitates
undertaking one or more other investmentsundertaking one or more other investments
Independent Projects / Accept-Reject Decisions
They are projects whose cash flows are unrelated / independent of oneThey are projects whose cash flows are unrelated / independent of one
another; the acceptance of one does not eliminate the others from furtheranother; the acceptance of one does not eliminate the others from further
consideration.consideration.
From the point of view of Decision Situation

14. Amity Business School
Capital Budgeting Process
• Generation of Investment Ideas
• Estimating Cash Flows
• Evaluating Cash Flows
• Selecting Projects
• Execution and Monitoring

15. Amity Business School
Cash Flow – Concept & Estimation
• Every investment proposal involves cash flows- large initial cash
outflow followed by small but recurring inflows.
• The crux of the whole process is, to assess whether the value of
inflows is greater than the outflows or not.
• If greater value can be assigned to the inflows/ returns than the
outflows/ expenditure, the proposal may be treated as profitable and
therefore, acceptable.

16. Amity Business School
16
CAPITAL BUDGETING DECISION INVOLVES
THREE STEPS:
1. Estimation of costs and benefits of a proposal or of each
alternative ( determination of Cash Flows)
2. Estimation of the required rate of return, i.e., the cost of
capital
3. Selection and applying the decision criterion.

17. Amity Business School
17
1.ESTIMATION OF CASH FLOWS
The costs and benefits for a capital budgeting
decision situation are measured in terms of cash
flows.
An important point is that all cash flows are
considered on after tax basis.
The cash flow from the project are compared with the
cost of acquiring the project.

18. Amity Business School
18
Calculation of different cash flows
INITIAL CASH OUTFLOW:
Cost of new plant
+ Installation expenses
+ Other Capital expenditure
+ Additional working capital
- { }
Salvage value ( Scrap Value)
of old plant -
Tax liability on account
of capital gain on sale of old
plant (if any).

19. Amity Business School
SUBSEQUENT ANNUAL INFLOWS:
Profit after tax (PAT)
+ Depreciation
TERMINAL CASH INFLOW:
Annual cash inflow
+ Working capital released
+ { }Salvage value ( Scrap Value)
of new asset -
Tax liability on account
of capital gain on sale of
new asset (if any).

20. Amity Business School
Capital Gain = Salvage Value of Asset
- Book Value of Asset
( or Written Down Value of
asset)
If the value is negative, then it is Capital Loss

21. Amity Business School
Question

22. Amity Business School
A company desires to make an investment of Rs. 1,00,000 in a new
machinery. Additional installation and transportation cost is Rs. 20,000.
The Machine has a life of 5 years after which it is expected to fetch Rs.
10,000 as scrap value. The machine is expected to generate an output
of 2000 units p.a. in the first 2 years and 3000 units p.a. for the last 3
years. The Product is expected to fetch Rs. 15 in the first 3 years and
Rs. 18 in the last 2 years. The additional cost of operating a machine is
expected to be Rs.5,000 p.a. for the first 3 years and Rs. 8,000 p.a.
thereafter.
Calculate Cash Flow After Tax (CFATs) for the above proposal on the
assumption of Straight line depreciation and tax rate 30%.

23. Amity Business School
Solution

24. Amity Business School
• INITIAL CASH OUTFLOW:
Cost of new machinery 1,00,000
Add : Installation expenses 20,000
1,20,000

25. Amity Business School
Calculation
of
Depreciation
Cost of Machinery 1,00,000
Add: Transportation &
Installation Cost 20,000
1,20,000
Less: Scrap Value 10,000
Total Amount to be depreciated 1,10,000
Annual Depreciation =
1,10,000/5
22,000

26. Amity Business School
Year 1 2 3 4 5
a. Output (Units) 2,000 2,000 3,000 3,000 3,000
b. Price (Rs.) 15 15 15 18 18
c. Revenue [ a x b] 30,000 30,000 45,000 54,000 54,000
Less :Operating Exp. 5,000 5,000 5,000 8,000 8,000
Less: Depreciation 22,000 22,000 22,000 22,000 22,000
d. Profit Before Tax (PBT) 3,000 3,000 18,000 24,000 24,000
Less : Tax @ 30% 900 900 5,400 7,200 7,200
e. Profit After Tax (PAT) 2,100 2,100 12,600 16,800 16,800
Add Back : Depreciation 22,000 22,000 22,000 22,000 22,000
CFAT (PAT + Dep.) 24,100 24,100 34,600 38,800 38,800
SUBSEQUENT ANNUAL INFLOWS

27. Amity Business School
Annual cash inflow 38,800
Scrap Value 10,000
(in Rs.) 48,800
TERMINAL CASH INFLOW: