The document discusses the steps involved in capital budgeting decisions and cash flow calculations for capital projects. It provides an example calculation for a company considering investing Rs. 100,000 in new machinery. The summary is: 1) Capital budgeting involves estimating cash flows, cost of capital, and selecting a decision criterion. 2) For a new machinery investment, the initial cash outflow is Rs. 120,000 and annual cash flows are calculated over 5 years based on revenues, expenses, depreciation, and taxes. 3) The example calculates the annual and terminal cash flows after tax for the machinery project.

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Amity Business School
Financial Management

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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.

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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.

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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).

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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).

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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

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Question

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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%.

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Solution

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• INITIAL CASH OUTFLOW:
Cost of new machinery 1,00,000
Add : Installation expenses 20,000
1,20,000

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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

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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

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