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Here is the problem...

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  1. Hi!!!! I am Arjun. I have just joined a company as a management trainee after my studies. My boss has given me a decision problem which looks to be straight forward but I do not know really… how to go about it. Can you help me, plz? Here is the problem...

  2. Decision Problem - the management is considering a project whose cost is Rs. 100 crores and the estimated cash inflows over its life of 5 years are as follows: Besides, I am told that the cost of funds of the company is estimated at 15%. Please show me the way!!!!!!!

  3. Can you help him?

  4. But, before you agree to help him, do you know the nature of the problem?

  5. The problem is that of …INVESTMENT DECISIONorCAPITAL BUDGETING !!!


  7. CAPITAL BUDGETING DECISIONS • The capital budgeting decisions are related to the allocation of investible funds to different long-term assets. • They denote a situation where the lump-sum funds are invested in the initial stages of a project and the returns are expected over a long period.

  8. CAPITAL BUDGETING DECISIONS Cont…. • The capital budgeting decision involves the entire process of decision making relating to acquisition of long-term assets whose return are expected to arise over a period beyond one year.

  9. BASIC NATURE OF CAPITAL BUDGETING DECISION • Long - term decisions. • Involves one or few times outflow of cash but promises a future stream of cash inflows. • Involves huge amount of investment. • Generally irreversible decision; if tried then it is very costly to undone it.

  10. BASIC NATURE OF CAPITAL BUDGETING DECISION Cont… • Determines the assets side of a firm’s balance sheet. • Determines the earning capacity of a firm. • These decisions are highly risky. • These decisions are of strategic importance. • These decisions are taken at comparatively higher levels in the management.

  11. TYPES OF INVESTMENT DECISIONS MADE BY A COMPANY • Project Selection • Decisions related to Modernization, expansion and renovation etc. • Purchase of Machines • Replacement of machines

  12. Proper Evaluation of Capital Budgeting Decisions requires… • One, proper estimation of cash outlays; and • Second, proper estimation of subsequent cash flows. • Third, proper choice of selection criteria. Therefore, we discuss them one by one.

  13. First, estimation of the initial cash outlays…

  14. Why cash flows and not Profits • The accounting profits ignores the concept of time value of money, whereas the cash flow concept takes into account the time value. • In capital budgeting a finance manager is concerned with measuring the economic value created by a decision, rather than book value.

  15. Why cash flows and not Profits Cont…. In cash flow analysis, the cost and the benefits are measured in terms of actual cash inflows and outflows rather than an imaginary profit figure. • The accounting profits are influenced and affected by adopting one or the other accounting policy, however the cash flow are the actual flows and are not affected by any such discretionary policy of the firm.

  16. Estimation of relevant cash outlays for a capital expenditure • The cost of a fixed assets comprises • its purchase price, including import duties and other non-refundable taxes; • cost of bringing the asset to its working condition; • cost of site preparation; • initial delivery and handling charges;

  17. Estimation of relevant cash outflow for a capital expenditure(continued)… • installation cost; • interest cost during construction period; and • professional fees of architects and engineers. • Such a cost be reduced by the inflows from the sale of the old asset.

  18. SOME GUIDING RULES TO DETERMINE RELEVANT CASH FLOWS • Rule#1: All costs and revenue generated before/prior to the investment appraisal decisions should be ignored. It basically means that ignore SUNK COST. • Rule#2: Ignore all non-incremental cashflows. That is, exclude all those cashflows that would be there whether there is project or not. • Rule#3: All allocated costs should be ignored. • Rule#4: Any increase in net working capital due to a project should be taken as a part of Project Cost.

  19. SOME GUIDING RULES TO DETERMINE RELEVANT CASH FLOWS (continued…) • Rule#5: Cost to the project of resources that a firm is already having in its stock. Three possible options: • Historic Cost • Current Replacement Cost • Resale value or disposal value • Rule#6: The costs of those resources that are limited/scarce but are in use in the firm for some other purpose should be taken as their opportunity cost. • Rule#7: Remember that all the cash flows are to be determined from the firm’s point of view and not from the equity point of view.

  20. Second, estimation of the cash flows subsequently…

  21. Estimation of relevant cash flows subsequently-some guiding principles… • It requires determination of net cash flows due to operation/use of the asset. • Ignore all financingcash flows and their tax effects as capital budgeting decisions are real decisions and hence, their analysis should not be affected by the financing decisions. • Cash flows should be determined as if they are occurring to the firm and not to shareholders.

  22. Estimation of relevant cash flows subsequently-some guiding principles… Cont… • Ignore all allocated expenses • Depreciation and all other non-cash charges should be ignored. • Do not forget to take into account the effect of an investment decision on the remaining business.

  23. Estimation of relevant cash flows subsequently-some guiding principles (continued)… • Take the net cash flows after tax without recognizing the benefits of tax on interest amount as the discount rate used for discounting future cash flows is determined after tax. • Remember to incorporate the opportunity cost of resources used to generate cash flows and ignore the sunk cost.

  24. Classification of cash flows • Original cash outflows Installation Cost Sunk Cost Opportunity cost Additional working capital Requirement • Subsequent Inflows and outflows • Terminal cash inflows

  25. Taxation and Cash Flows All Financial Decisions are subservient to Tax Laws. The cash flows that are related to capital decisions are the after tax cash flows only. The after tax cash flows resulting from a project are in fact the relevant incremental cash flows. These after tax cash flows would not occur if the project is not undertaken.

  26. Treatment of Depreciation • Accounting Treatment- The depreciation is provided for the entire period for which the asset has been used. At the time of scraping the asset, the capital gain or losses has to be adjusted in the income of the year in which the asset is discarded. Consequently the capital gain or losses will have its tax effect.

  27. Treatment of Depreciation Cont…. • Depreciation is allowed on the basis of block of assets under the income tax Act,1961: Block consisting of one asset- • In the terminal year, no depreciation is allowed • The selling price/scrap value will be compared with the WDV. The difference between the two is treated as short term capital gain or loss and is treated as ordinary income/loss.

  28. Treatment of Depreciation Cont…. Block consisting of more than one asset— When a new asset is purchased and is added to the existing block of asset, the cost of the new asset is added to the opening written down value of the block and depreciation for that year is provided on the total value. At the time of acquisition of new asset or even otherwise, any part of the block

  29. Treatment of Depreciation Cont…. is sold or scrapped away then the scrap value is deducted from the opening written down value. The depreciation is to be provided on the net balance only. 2. There will not be any capital gain/loss on the sale of asset unless the entire block of asset is scraped away.

  30. Determination of relevant cash inflows (Single Proposal) • Cash Outflows Cost of new project +Installation Cost of Plant and Equipment +/- Working Capital Requirements Cash Inflows Cash Sales Revenues Less cash operating cost Cash inflows before Taxes (CFBT) Less Depreciation Taxable income

  31. Determination of relevant cash inflows (Single Proposal) (continued)… Taxable Income Less Tax Earning after taxes Plus Depreciation Cash inflows after Tax (CFAT) Plus Salvage value (in Nth year) Plus Recovery of Working Capital (in nth year)

  32. Determination of relevant cash inflows (Replacement Proposal) Incremental Cash Outflows Cost of the new Machine + Installation Cost +/_ Working Capital _ sale proceeds of existing Machine Incremental Cash Inflows Incremental Cash flows before Taxes (CFBT) Less TAXES Incremental CFAT(a)

  33. Determination of relevant cash inflows (Replacement Proposal) (continued)… Incremental CFAT (a) Add Depreciation (New- old) Tax Saving on excess Depreciation (b) Incremental CFAT (a+b) +Working capital recovery in the terminal (nth) Year +Salvage Value in the terminal year + tax Advantage on short term capital loss on sale of asset in the terminal year( if the block of asset ceases to exist) -Tax on short term capital gain

  34. Third, proper selection criteria …

  35. TECHNIQUES OF EVALUATING CAPITAL BUDGETING DECISIONS • Techniques of capital budgeting decisions are tools/ benchmarks/methods/decision-criterion that helps in making a final choice for an investment project. • They are only guides and means to final decision-making. • All they do is help to communicate information to the decision maker.

  36. TECHNIQUES OF EVALUATING CAPITAL BUDGETING DECISIONS (continued)… • They can never replace managerial judgements, but they can help to make that judgment more sound. • Two broad types of techniques of evaluating capital budgeting decisions: • Traditional Techniques • Modern Techniques

  37. TECHNIQUES OF EVALUATING CAPITAL BUDGETING DECISIONS (continued…) • Traditional Techniques • Pay Back Period Method • Discounted Payback Period • Rate of Return on Investment Method • Modern Techniques • Net Present Value • Internal Rate of Return • Modified Internal Rate of Return • Profitability Index

  38. Evaluation Techniques • Traditional Techniques: Average Rate Of return: This method is also called as accounting rate of return method and is calculated on accounting profits rather than cash flows. There is no unanimity regarding the definition but most commonly acceptable is: =Average Annual profits after taxes/Average profits*100 Where:

  39. Accounting Rate of return Cont…. Average Investment=1/2(initial investments-Salvage value)+ salvage value+ Net working capital Annual average profits after taxes= Total expected after tax profits/Number of years Accept–Reject decision: Projects with higher ARR will be Preferred to projects with lower ARR.

  40. ARR- Shortcomings • It uses the accounting income rather than cash flows. • It does not take into account the time value of the money. • It does not differentiate between the size of the investment required for each project. • It does not take into consideration the any benefits which can accru to the firm from the sale of the equipment which is replaced by the new equipment.

  41. Evaluation Techniques Pay Back Method: Annuity Cash Flows: PB= Initial investment/ annual CFAT Mixed Cash Flows: PB is calculated by cumulating cash flows till the cumulative cash flows equal the initial investments. Accept –Reject decision: Projects with shorter pay back period will be selected

  42. Pay Back Method-Shortcomings • It completely ignores all cash inflows after the pay back period. • It does not distinquish the projects in term of the timings or magnitude of the cash flows as it does not discounts the cash flows but rather treat a rupee received in the second or third year as valuable as a rupee received in the first year. • It does not consider the entire life of the project during which the cash flows are generated.

  43. ILLUSTRATION-1 The investment data for a new product are as follows: Capital outlay: Rs. 200,000 Depreciation : 25% p.a. on WDV basis Forecasted annual income before charging depreciation are as follows: ___________________________ Year 1 Rs. 100,000 2 100,000 3 80,000 4 80,000 5 40,000 ____________________________ 400,000

  44. ILLUTRATION-1 contd. On the basis of available data, set out calculations, illustrating and comparing the following methods of evaluating capital budgeting decisions: (a) PB method & (b) Rate of Return on original investment. Solution: (a) PB period = Rs. I lakh, year 1 + • Rs. 1lakh, year 2 = 2 years

  45. Solution to Illustration-1 Cont……. (b) Rate of return on original investment =Average income/Average Investment*100 ={49,330(2,46,651/5 years)} /2,00,000*100 =24.7%

  46. Discounted Cash flow Techniques These techniques take into account the time value of the money while evaluating the cost and benefits of the project. The cash flows are to be discounted at the minimum required rate of return or cost of capital. These techniques also takes into account all the benefits and costs occurring during the entire life of the project.

  47. Discounted Cash flow Techniques • Net Present Value method: NPV={CF1/(1+K)1+CF2/(1+K)2+…….+CF1/(1+K)n}—{CFo} Where CF =Cash Inflows K =Cost of Capital n =Life of the project CFo=Cash Outflows Accept –Reject decision: Projects with highest positive NPV will be selected and projects with negative NPV will be rejected.

  48. WHAT SHOULD BE AN APPROPRIATE DISCOUNT RATE …??? An appropriate discount rate should take into account the following: • Various sources of finance • expectations of return of the funds - suppliers • After - tax cost of each source of finance

  49. WHAT SHOULD BE AN APPROPRIATE DISCOUNT RATE …??? Risk associate with the project under consideration capital structure of the firm average cost of capital and not the marginal cost of capital the nature of discount rate and the nature of the cash flows should be same.