Capital Budgeting

Capital Budgeting Decisions

Nature of Investment Decisions The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.  The firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.  Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions. 

Features of Investment Decisions  They have long term consequences  They may be difficult or expensive to  reverse  The exchange of current funds for future  benefits. 

Implications of Investment  Decisions Growth  

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Risk 

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Funding  

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Irreversibility

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Complexity  

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Capital Budgeting Process

1. Identification of potential  investment opportunities Planning phase  Future sales estimated to serve as a basis for production targets  SWOT analysis being done 

2.Assembling of Investment  Proposals Proposals routed through several persons to ensure its view from several angles.

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3. Decision making Powered authorities okays investment

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proposals upto certain limits

4.Preparation of Capital budget and  Appropriations 5.Implementation Adequate formulation of projects  Use of principle of responsibility accounting  Use of network techniques 

4.Preparation of Capital budget and  Appropriations 5.Implementation Adequate formulation of projects  Use of principle of responsibility accounting  Use of network techniques 

6.Performance review Involves comparing actuals with projected. Helps in: Throws light on how realistic the assumptions were,  Provides a documented log of experience.  Uncovering judgemental bias  Induces a desired caution among project sponsors

Project Classification Mandatory Investments

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Replacement Projects

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Expansion Projects

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Diversification Projects

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R & D Projects

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Miscellaneous Projects

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Estimation of project Cash Flows  Main emphasis is on Investment criteria.  most difficult step in capital budgeting is to estimate cash flow, investment outlays and cash inflows.  While forecasting capital budget, the errors are quite large specially in complex projects.  The major pitfall in forecasting the budget is that sometimes the estimated cost is less than the actual cost.

Forecasting project cash flow involves various variables i.e. Capital Outlays Revenue Projections Operating cost

Principles to develop cash flow forecast     

Elements of the cash flow stream Principles of cash flow estimation Cash flow illustrations Cash flow for a replacement project Biases in cash flow estimation

Elements of Cash Flow Stream Initial Investment Operating Cash Inflow Terminal Cash Inflow

Terminal cash inflow 50,000 Operating cash inflows

10,000

0

15,000

1

2

150000 Initial investment

30000

3

50000

50000

40000

30000

20000

4

5

6

7

8

End of year

Time Horizon for Analysis o Physical life of the plant o Technological life of the plant o Product market life of the plant o Investment planning horizon of the firm

BASIC PRINCIPLES OF CASH FLOW ESTIMATION There are 4 types of principles :1) SEPARATION PRINCIPLE : There are 2 sides of a project- the investment side and the financing side. For ex: PROJECT

FINANCING SIDE

INVESTMENT SIDE

Time Cash flow 0 +1000 1 -1150 Cost of capital:15%

Time cash flow 0 -1000 1 +1200 rate of return:20%

2) INCREMENTAL PRINCIPLE : It is used to know what happens to the cash flows of the firm with the project and without the project. Project cash flow for year t = Cash flow for the firm - cash flow for the With the project for year t firm without the pjt

GUIDELINES     

Consider all incidental effects Ignore sunk cost Include opportunity costs Overhead costs Working capital

3) POST-TAX PRINCIPLE : Cash flows should be measured on an after tax basis. Tax rate- average tax rate and marginal tax rate. EFFECT OF NON CASH CHARGES: It includes depreciation. It is calculated asDEP1= BV0r DEP2=BV0(1-r)r

TREATMENT OF LOSSESScenario

Project

Firm

Action

1

Incurs losses Incurs losses

Defer tax savings

2

Incurs losses Makes profits

Takes tax savings in the year of loss

3

Makes profits Incurs losses

Defer taxes until the firm makes profits

4

Makes profits Makes profits

Consider taxes in the year of profit

5

Incurs losses

Defer tax saving until the project makes profit

4) CONSISTENCY PRINCIPLE: Investor group Cash flows to all investors=PBIT+dep-cap expchange in WC Cash flow to Eq shareholders=PAT+deppreference div-cap exp-change in WC -repayment of debt  Inflation nominal cash flow=real cash flowt(1+expected inflation rate) nominal dis rate=(1+real dis rate)(1+exp inf rate) -1

Cash Flow For Replacement Projects….

Developing cash flow estimates for new projects is relatively straight forward. In such cases the main concerned areas are: •

Initial Investments

•

Operating cash flows

•

Terminal cash flows This is complicated because……. Incremental cash outflows and inflows

Determination of The Components…. 1) The Initial Investment….

COST OF THE NEW ASSETS INITIAL INVESTMENT

+ NET WORKING CAPITAL REQUIRED FOR THE NEW ASSETS

AFTER TAX SALVAGE VALUE REALISED FROM THE OLD ASSET + NET WORKING CAPITAL REQUIRED FOR THE NEW ASSETS

Operating cash inflows….

OPERATING CASH INFLOWS

OPERATING CASH INFLOWS FROM THE NEW ASSET

OPERATING CASH INFLOWS FROM THE OLD ASSET

TERMINAL CASH FLOW….

TERMINAL CASH FLOWS

AFTER TAX SALVAGE VALUE OF THE NEW ASSET + RECOVERY OF NET WORKING CAPITAL ASSOCIATED WITH THE NEW ASSET

AFTER TAX SALVAGE VALUE OF THE OLD ASSET + RECOVERY OF NET WORKING CAPITAL ASSOCIATED WITH THE OLD ASSET

QUESTION….???????? Once we have assumed that the old asset is replaced,why should we consider the operating cash inflows and terminal cash inflows simultaneously????????

ILLUSTRATION….. Suppose you own a plot of land that presently has a market value of 1 million.If you keep it for a year it is expected to fetch you Rs. 1.2million.You come across another plot of land that will cost you 1.5 million now .If you buy this land you hope to sell it for 2.0 million a year hence.You are debating whether you should replace the existing plot of land with the new plot that costs 1.5 millions.If you ignore the taxes and assuming there is no operating cash flow then……..

INITIAL INVESTMENT:… Cost of the new plot - salvage value of the old plot =15,00,000 – 1,00,000 =5,00,000 OPERATING CASH INFLOW:….. Op.inflow from the new plot- from the old plot =0 – 0 =0 TERMINAL FLOW Salvage value from the new plot-from

Biases In Cash Flow Estimation….. 

Overstatement of profitability….. knowledgeable observers of capital budgeting believe that profitability is often overstated because the initial Investments is under estimated and operating inflows are exaggerated. The main reasons of this are……

1.

Intentional overstatement

2.

Lack of experience

3.

Myopic euphoria

Biases continued…… 

Under-statement of profitability…. There can also be the opposite kind of bias relating to a terminal benefit which may depress a project’s true profitability.These can be…..

1.

Salvage values are under estimated

2.

Intangible benefits are ignored

3.

The value of future options is overlooked

YEAR

0

Format/Specimen 5

I. INVESTMENT OUTLAY 1.COST OF NEW ASSET (16000) 2.SALVAGE VALUE OF OLD ASSET 500 3.INC. IN NET WORKING CAPITAL (100) 4.TOTAL NET FLOW (1-2+3) (1200) • OPERATING CASH INFLOWS 1.DEP. ON NEW MACHINE 400 2.DEP. ON OLD MACHINE 100 • TERMINAL CASH FLOW 1.NET TERMINAL VALUE OF THE NEW MACHINE 800 2.NET TERMINAL VALUE OF OLD MACHINE 150 IV. NET CASH FLOW

1

2

3

4