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Cap Budgeting-Cash Flows

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0% found this document useful (0 votes)
17 views58 pages

Cap Budgeting-Cash Flows

Uploaded by

Ashish Kumar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Capital Budgeting & Estimating Cash

Flow
“Evaluating Proposed Capital Expenditure”
(CAPEX)
is called
“Capital Budgeting”
CAPEX NEWS– NLC
● NLC India invests big money into renewable energy (By
Debjoy Sengupta, ET Bureau|Updated: Jul 12, 2017, 01.15 AM IST)

NLC has firmed up a capex of about Rs 17,400 crore for


setting up 4,200 MW of green energy generation
capacities by 2020 as part of its diversification plan.
● NLC India: A dream saga of energetic & exponential
growth (MPost | 2017-12-12 18:26:06.0)
This is expected to increase power generation capacity by
additional 3,000 MW, taking the cumulative power
capacity to 20971 MW by 2025, planned investment of
Rs.1,28,983 Crore with a debt-equity ratio of 70:30,
derived from diversified sources such as lignite, coal and
renewable energy.
What is Capital Expenditure

● You bought a new MACHINERY

Folio Particular Net Debit Credit

14 Asset ? Or Expenses ? 2000000

Cash 2000000
What is Capital Expenditure

● You bought a new MACHINERY

Folio Particular Net Debit Credit

14 Asset ? Or Expenses ? 2000000

Cash 2000000
● Debiting an ASSET is CAPITAL Expenditure
Capital Expenditure (CAPEX) Planning
● Build a new plant Should We..?

● Start new line of business


● Expand the existing line of
business
● Replace the existing asset
● Modernize existing plant
● Go for high R&D
● Go for new promotion
● Go for acquisitions
Capital Expenditure (CAPEX) Planning
Should we
Go for this
exploration?
Small Businesses also makes CAPEX decisions

● Buying a new shop


● Expansion of new shop
● Buying a deep freezer
● Buying Coffee Vending Machine
● Computerized billing system
CAPEX vs. OPEX
Purpose To buy asset with economic life Operating cost to run the
and benefits beyond the current business
year

When Paid Lump sum with installation charges Periodically


etc.

When More than a year (Economic life of Current financial year


accounted for asset)

Listed as Asset and depreciation is charged Operating cost


Tax treatment Deducted over time as asset Deducted in current
depreciates financial year

Example Buying a laser printer Buying paper and toner


for printer
What is Capital Budgeting ?

Capital budgeting (or investment appraisal) is the


process used to determine whether an organization's long
term investments/projects are worth funding.

“IT HELPS IN DIFFERENTIATING GOOD


PROJECTS FROM NOT SO GOOD PROJECTS”
Why is Capital Budgeting Critical?

● Define firm’s strategic direction

● Create Value for shareholders

● Very important to firm’s future


growth and profitability

● Wrong decisions may lead to


disastrous consequences
» High risk, irreversible, complex
decisions
Why You Should Know CB..
● Helps to decided future of corporations
● Used as valuation principle
● Adapted for many corporate decisions such
as mergers and acquisitions
● Capital budgeting decisions are consistent
with management goal of maximizing
shareholders value
Capital Budgeting : 8 Steps
Key Principles
❑ Ignore sunk cost
❑ Think incrementally
⮚ Decide whether overheads are truly incremental
❑ Consider impact on existing business (synergy, cash
diverted, cannibalization) (+ve and -ve Externalities)
❑ Consider all opportunity cost
❑ Consider timing of cash flows
❑ Analyze on after tax basis
❑ Ignore interest expenses in estimating cash flows (that will
be absorbed in discounting factor)
Some Important Definitions..

● Independent Projects
● Mutually Exclusive Projects
● Project Sequencing/Contingent Project
● Capital Rationing
Cash Flows Versus Profit
● Cash flow is not the same thing
as profit, at least, for two
reasons.
– First, profit, as measured by an
accountant, is based on accrual concept.

– Second, for computing profit, expenditures


are arbitrarily divided into revenue and
capital expenditures.

16
Financial Appraisal Process

❑ Estimation of cash flows

❑ Estimation of the required rate of return (the


opportunity cost of capital, WACC)

❑ Application of a appropriate decision rule for making


the choice (PB, DPB, NPV, IRR or PI)
Components of Cash Flows

● Major Cash Flow Components:


1. Initial Cash Flow (Initial Outlay)
2. Operating Cash Flow (Annual Cash Flows)
3. Terminal Cash Flow
Major Cash Flow Components

Initi Termina
al l
outla Cash
y0 1 2 3 4 5 6 . . flow
. n

Operating Cash Flows


Initial Cash Flow
● Cost of New Asset
– Include shipping and installation.
● After-tax Proceeds from Sale of Old Asset
– Removal/Sale
– Net of tax effect
» Book value, tax profit (recaptured depreciation.
● Initial Working Capital required
Operating Cash Flows (OCF)

● After-tax Incremental Cash Flows from


Operations.
– Be careful, especially under replacement decisions.
» Usually compared to not replacing now.
– After-tax usually is “earnings” less the depreciation
shielded tax

Operating Cash Flow = EBIT(1-T) + Depreciation


Terminal Cash Flow

● Proceeds from Sale of Assets


– Net of sale, removal and cleanup.
● Taxes on Sale of Assets
– Book value and profit.
● Release of Working Capital
– Typically, setting net working capital back the
way it was.
Project’s Free Cash Flows (FCF)
● It is the cash flow available to service both lenders
and shareholders, who have provided, respectively,
debt and equity, funds to finance the firm’s
investments

● FCF = Project’s change in operating CF – Change


in NWC – Change in Capital spending

● FCF = Δ EBIT (1-T) + Δ DEP – Δ NWC


– Δ CAPEX
23
Illustration
● Our firm must decide
whether to purchase a
new plastic molding
machine for Rs127,000.
How do we decide?

● The relevant project


information follows:
● The cost of the new machine is Rs127,000.
● Installation will cost Rs20,000.
● Rs4,000 in net working capital will be needed at
the time of installation.
● The project will increase revenues by Rs85,000 per
year, but operating costs will increase by 35% of
the revenue increase.
● Simplified straight line depreciation is used.
● Life of project is 5 years, and the firm is planning
to keep the project for 5 years.
● Salvage value at year 5 will be Rs50,000.
● 14% cost of capital; 34% marginal tax rate.
Evaluate Cash Flows

● Look at all incremental cash flows occurring as a


result of the project
Initial outlay
Differential Cash Flows over the life of the
project (also referred to as annual cash flows)
Terminal Cash Flows
1) Evaluate Cash Flows

0 1 2 3 4 5 6 ... n
Capital Budgeting Steps

1) Evaluate Cash Flows

Initi
al
outla
y0 1 2 3 4 5 6 ... n
Capital Budgeting Steps:

1) Evaluate Cash Flows

Initi Termina
al l
outla Cash
y0 1 2 3 4 5 6 . . flow
. n
Capital Budgeting Steps:

1) Evaluate Cash Flows

Initi Termina
al l
outla Cash
y0 1 2 3 4 5 6 . . flow
. n

Annual Cash
Flows
● a) Initial Outlay: What is the cash flow at “time
0?”

(Purchase Price of the Asset)


+ (shipping and installation costs)
(Depreciable Asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
Evaluate Cash Flows
● a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000)
+ (shipping and installation costs)
(Depreciable Asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
Evaluate Cash Flows

● a) Initial Outlay: What is the cash flow at


“time 0?”

(127,000)
+ ( 20,000)
(Depreciable Asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
Evaluate Cash Flows

● a) Initial Outlay: What is the cash flow at


“time 0?”

(127,000)
+ ( 20,000)
(147,000)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
Evaluate Cash Flows
● a) Initial Outlay: What is the cash flow at “time
0?”

(127,000)
+ ( 20,000)
(147,000)
+ ( 4,000)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
Evaluate Cash Flows

● a) Initial Outlay: What is the cash flow at


“time 0?”

(127,000)
+ ( 20,000)
(147,000)
+ ( 4,000)
+ 0
Net Initial Outlay
● a) Initial Outlay: What is the cash flow at
“time 0?”

(127,000)
+ ( 20,000)
(147,000)
+ ( 4,000)
+ 0
(151,000)
● b) Annual Cash Flows: What incremental
cash flows occur over the life of the project?
For Each Year, Calculate:

Incremental Revenue
- Incremental Costs
- Depreciation on project
Incremental Earnings before Taxes
- Tax on Incremental EBT
Incremental Earnings after Taxes
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5:
Incremental Revenue
- Incremental Costs
- Depreciation on project
Incremental Earnings before Taxes
- Tax on Incremental EBT
Incremental Earnings after Taxes
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5:
85,000
- Incremental Costs
- Depreciation on project
Incremental Earnings before Taxes
- Tax on Incremental EBT
Incremental Earnings after Taxes
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5
85,000
(29,750)
- Depreciation on project
Incremental Earnings before Taxes
- Tax on Incremental EBT
Incremental Earnings after Taxes
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5
85,000
(29,750)
(29,400)
Incremental Earnings before Taxes
- Tax on Incremental EBT
Incremental Earnings after Taxes
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
- Tax on Incremental EBT
Incremental Earnings after Taxes
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
Incremental Earnings after Taxes
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
+ Depreciation Reversal
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
Annual Cash Flow
For Years 1 - 5
85,000 Revenue
(29,750) Costs
(29,400) Depreciation
25,850 EBT
(8,789) Taxes
17,061 EAT
29,400 Depreciation reversal
46,461 = Annual Cash Flow
Evaluate Cash Flows

● c) Terminal Cash Flow: What is the cash


flow at the end of the project’s life?

Salvage Value
+/- Tax effects of capital gain/loss
+ Recapture of Net Working Capital
Terminal Cash Flow
Evaluate Cash Flows

● c) Terminal Cash Flow: What is the cash


flow at the end of the project’s life?

50,000 Salvage Value


+/- Tax effects of capital gain/loss
+ Recapture of Net Working Capital
Terminal Cash Flow
Tax Effects of Sale of Asset
● Salvage value = 50,000
● Book Value =
depreciable asset - total amount depreciated
● Book Value = 147,000 - 147,000
=0
● Capital Gain = SV - BV
= 50,000 - 0 = 50,000
● Tax payment = 50,000 x .34 = (17,000)

● Which of these are Cash Flows?


Tax Effects of Sale of Asset

● Salvage value = 50,000


● Book Value = depreciable asset - total
amount depreciated
● Book Value = 147,000 - 147,000
=0
● Capital Gain = SV - BV
= 50,000 - 0 = 50,000
● Tax payment = 50,000 x .34 = (17,000)
Evaluate Cash Flows

● c) Terminal Cash Flow: What is the cash


flow at the end of the project’s life?

50,000 Salvage Value


(17,000) Tax on Capital Gain
+ Recapture of NWC
Terminal Cash Flow
Evaluate Cash Flows

● c) Terminal Cash Flow: What is the cash


flow at the end of the project’s life?

50,000 Salvage Value


(17,000) Tax on Capital Gain
4,000 Recapture of NWC
Terminal Cash Flow
Evaluate Cash Flows

● c) Terminal Cash Flow: What is the cash


flow at the end of the project’s life?

50,000 Salvage Value


(17,000) Tax on Capital Gain
4,000 Recapture of NWC
37,000 Terminal Cash Flow
Project NPV

● CF(0) = -151,000
● CF(1 - 4) = 46,461
● CF(5) = 46,461 + 37,000 = 83,461
● Discount rate = 14%
● NPV = 27,721
● We would accept the project.
Calculation of Cash Flows

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