Accepting projects that yields a return higher than the                                             hurdle rate
Capital Budgeting DecisionsCapital Budgeting Decisions  Capital budgeting decisions relate to selection of a   long‐term a...
Capital Budgeting Decision ProcessWhile evaluating projects, an attempt is made to:‐1. Reduce costs and benefits to a sing...
Features Large anticipated benefits Relatively high degree of risk   W    Wrong decision may be suicidal            d i...
Features As time passes, fixed assets may become obsolete or   may require an overhaul, requiring financing decisions  I...
Features of Cap‐ex Effect on the profitability, growth & survival    Competitive position    Help in converting and uti...
Features of Cap‐ex Affects revenues or reduce costs Costs incurred and benefits received in different   periods     i d ...
Classification of Projects Helps in standardised estimation & administration of   projects Th  b i   f  l ifi i    The b...
S     i C i lB d i PSteps in Capital Budgeting Process      Planning                      Implementation          Control•...
Assumptions in Capital BudgetingAssumptions in Capital Budgeting1.   All cash flows take place at the end of the time     ...
Problems involved in CapitalProblems involved in Capital Budgeting1.   Forecasting of future costs – both initial and     ...
Cost – Benefit measurement Profit is not a theoretical superior basis of   measurement C h Fl  i    Cash Flow is conside...
Cash Flows of the Project After – tax incremental operating cash flows Only the cash flows which are incremental in natu...
Cash Flows of the Project       Financial charges – ignore in the project flows        Investment & Financing decisions ...
P f      C h Fl St t       tProforma Cash Flow Statement 1.    Cash flow from operations      Profit before tax          f...
Cash flow computationWith the help of following projected Income Statement,  calculate the cash inflow:  Net Sales Revenue...
Cash flow computationsThe cost of a new plant is Rs. 5,00,000. It has an  estimated life of 5 years after which it would b...
Cash flow computationsABC Ltd. is evaluating a capital budgeting proposal for  which relevant figures are as follows:     ...
Illustration 1A company has created computer facility at a cost of Rs.   2 lac. The annual maintenance cost shall be Rs. 2...
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Fm2

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Fm2

  1. 1. Accepting projects that yields a return higher than the  hurdle rate
  2. 2. Capital Budgeting DecisionsCapital 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. 3. Capital Budgeting Decision ProcessWhile evaluating projects, an attempt is made to:‐1. Reduce costs and benefits to a single figure2. Compare this against a predetermined amount,  rate or time period3. Make a choice narain@fms.edu
  4. 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. 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. 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. 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. 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 b1. Size: Large, Medium, Small2. U Urgency: U Urgent, Required, desired  R i d  d i d3. Risk Impact: Risk‐neutral, Risk‐changing4. D Degree of Dependence among projects: Mutually    f D d     j t  M t ll   Exclusive, Complementary narain@fms.edu
  9. 9. S i C i lB d i PSteps 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. 10. Assumptions in Capital BudgetingAssumptions in Capital Budgeting1. All cash flows take place at the end of the time period i d2. No change in the risk i.e. size and timing of cash flow are known with certainty y3. Perfect capital markets4. Projects are infinitely divisible but exhibit decreasing return to scale d i l5. Cash flows are in independent of each other overtime and other investment decisions6. Rational decision parties7. It is a well‐behaved project or conventional cash p j flow projects narain@fms.edu
  11. 11. Problems involved in CapitalProblems involved in Capital Budgeting1. Forecasting of future costs – both initial and  operating 2. Forecasting of benefits F i   f b fi3. Determination of cost of capital or required rate of  return4. Treatment of time element – economic life of project5.5 Treatment of risk element narain@fms.edu
  12. 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. 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. 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. 15. P f C h Fl St t tProforma 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. 16. Cash flow computationWith 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. 17. Cash flow computationsThe 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, pFind 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. 18. Cash flow computationsABC 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. 19. Illustration 1A 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 60,000compute the cash flows for the project if tax rate is 30%  and depreciation is provided at 60%. narain@fms.edu

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