Treatise on Capital Budgeting: Estimation of Cash Flows

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Capital Budgeting Estimation of cash flow

Table of Contents

1. Introduction
2. Features and Significance
3. Problems and Difficulties in Capital Budgeting
4. Types of Capital Budgeting Decisions
5. Capital Budgeting Decisions and Funds Availability
6. Capital Budgeting Decisions : Assumptions and Procedure
7. Estimation of Costs and Benefits of a Proposal
8. Incremental Approach to Cash Flows
9. Taxation and Cash Flows
10. Depreciation, non-cash items and Cash Flows
11. Treatment of Depreciation and Profit/Loss on Sale/Scrapping of an Asset
12. Financial Cash Flows
13. Calculation of Annual Cash Inflows
14. Cash Flows from the point of view of different perspectives
15. Points to Remember
16. Graded Illustrations

Check out Taxmann's [6th Revised Reprint Edition] of Financial Management authored by Dr. R.P. Rustagi. A self-sufficient treatise presenting concepts & theories underlying financial management in a systematic, precise & analytical manner. Maximization of shareholders' wealth within the risk-return set-up of the firm is the unifying concept of the textbook. The objective of this book is first to present the concepts, models, and theories of finance in a simple, comprehensive and lucid form. Second, to help practising managers apply these concepts in dealing with operational situations.

1. Introduction

Many important business decisions require the selection of projects (investments) whose outlays or benefits are spread out over several periods of time. The decision to acquire a factory building, for example, may require a large immediate outlay of funds, and also commits the company to the maintenance and operation of the building for a long period of years. In evaluating investments proposals, it is important to weigh the expected benefits of the investments against the expenses associated with it. For capital budgeting decisions, the costs and benefits are measured more appropriately by the cash flows attributable to the investment.

Capital budgeting decisions are related to the allocation of funds to different long term assets. Broadly speaking, the capital budgeting decision denotes a decision situation where the lump sum funds are invested in the initial stages of a projects and the returns are expected over a long period. Though there is no hard and fast rule to define the long term, yet period involving more than a year may be taken as a long period for investments decisions. The capital budgeting decision involve the entire process of decision making relating to acquisition of long term assets whose returns are expected to arise over a period beyond one year.

Some of the capital budgeting decisions may be to buy land, building or plants; or to undertake a program on research and development of a product, to diversify into a new product line; a promotional campaign, etc. Some of these decisions may directly affect the profit of the firm e.g., launching a new product, whereas some other decision may affect the profit by reducing the costs e.g. replacing an existing machine by a more efficient one. But in both the cases, the decision once taken set the profit line of the firm for several years.

All the relevant a functional departments play a crucial role in the capital budgeting decision process of any organization, yet for the time being, only the financial aspects of capital budgeting decisions are considered. The role of a finance manager in the capital budgeting basically lies in the process of critical and in-depth analysis and evaluation of various alternative proposals and then to select one out of these. The objective of capital budgeting is to select those long-term investment projects that are expected to make maximum contribution to the wealth of the shareholders.

2. Features and Significance

Capital budgeting decisions are those decisions that involve current outlay in return for a series of benefits in coming years. The capital budgeting decisions are often said to be the most important part of corporate financial management. Any decision that requires the use of resources is a capital budgeting decision; thus the capital budgeting decisions cover everything from broad strategic decisions at one extreme to say computerization of the office, at the other. The capital budgeting decisions affect the profitability of a firm for a long period, therefore the importance of these decisions is obvious. Even a single wrong decision by a firm may endanger the existence of the firm as a profitable firm. There are several factors and considerations which make the capital budgeting decisions as the most important decisions of a finance manager. The relevance and significance of capital budgeting may be stated as follows :

(a) Long-Term Effects : Perhaps, the most important features of a capital budgeting decision and which makes the capital budgeting so significant is that these decisions have long term effects on the risk and return composition of the firm. These decision affect the future position of the firm to a considerable extent as the capital budgeting decisions have long term implications and consequences. By taking a capital budgeting decision, a finance manager in fact makes a commitment into the future, both by committing to the future needs of funds of the projects and by committing to its future implications.

(b) Substantial Commitments : The capital budgeting decisions generally involve large commitment of funds and as a result substantial portion of capital funds are blocked in the capital budgeting decisions. In relative terms therefore, more attention is required for capital budgeting decisions, otherwise the firm may suffer from the heavy capital losses in time to come. It is also possible that the return from a projects may not be sufficient enough to justify the capital budgeting decision.

(c) Irreversible Decisions : Most of the capital budgeting decisions are irreversible decisions. Once taken, the firm may not be in a position to revert back unless it is ready to absorb heavy losses which may result due to abandoning a project in midway. Therefore, the capital budgeting decisions should be taken only after considering and evaluating each and every minute detail of the project, otherwise the financial consequences may be far reaching.

(d) Affect the Capacity and Strength to Compete : The capital budgeting decisions affect the capacity and strength of a firm to face the competition. A firm may loose competitiveness if the decision to modernize is delayed or not rightly taken. Similarly, a timely decision to take over a minor competitor may ultimately result even in the monopolistic position of the firm.

Thus, the capital budgeting decisions involve a largely irreversible commitment of resources i.e., subject to a significant degree of risk. These decisions may have far reaching effects on the profitability of the firm. These decisions therefore, require a carefully developed decision making process and strategy based on a reliable forecasting system.

3. Problems and Difficulties in Capital Budgeting

The capital budgeting decisions are not only critical and analytical in nature, but also involve various difficulties which a finance manager may come across. The problems in capital budgeting decisions may be as follows :

(a) Future Uncertainty : All capital budgeting decisions involve long term which is uncertain. Even if every care is taken and the project is evaluated to every minute detail, still 100% correct and certain forecast is not possible. The finance manager dealing with the capital budgeting decisions, therefore, should try to be as analytical as possible. The uncertainty of the capital budgeting decisions may be with reference to cost of the project, future expected returns from the project, future competition, expected demand in future, legal provisions, political situation etc.

(b) Time Element : The implications of a capital budgeting decision are scattered over a long period. The cost and benefit of a decision may occur at different point of time. As a result, the cost and benefits of a capital budgeting decision are generally not comparable unless adjusted for time value of money. The cost of a project is incurred immediately, however, it is recovered in number of years. These total returns may be more than the cost incurred (in absolute terms), still the net benefit cannot be ascertained unless the future benefits are adjusted to make them comparable with the cost. Moreover, the longer the time period involved, the greater would be the uncertainty.

(c) Measurement Problem : Some times a finance manager may also face difficulties in measuring the cost and benefits of a projects in quantitative terms. For example, the new product proposed to be launched by a firm may result in increase or decrease in sales of other products already being sold by the same firm. But how much ? This is very difficult to ascertain because the sales of other products may increase or decrease due to other factors also.

4. Types of Capital Budgeting Decisions

Every capital budgeting decision is a specific decision in the given situation, for a given firm and with given parameters and therefore, an almost infinite number of types or forms of capital budgeting decisions may occur. Even if the same decision being considered by the same firm at two different points of time, the decision considerations may change as a result of change in any of the variables. However, the different types of capital budgeting decisions undertaken from time to time by different firms can be classified on a number of dimensions. In general, the projects can be categorized as follows:

4.1 From the Point of view of Firm’s existence 

The capital budgeting decisions may be taken by a newly incorporated firm or by an already existing firm.

(a) New Firm : A newly incorporated firm may be required to take different decisions such as selection of a plant to be installed, capacity utilization at initial stages, to set up or not simultaneously the ancillary unit etc.

(b) Existing Firm : A firm which is already existing may also be required to take various decisions from time to time to meet the challenges of competition or changing environment. These decision may be :

(i) Replacement and Modernization Decision : This is a common type of a capital budgeting decision. All types of plant and machineries eventually requires replacement. If the existing plant is to be replaced because the economic life of the plant is over, then the decisions may be known as a replacement decision. However, if an existing plant is to be replaced because it has become technologically outdated (though the economic life may not be over), the decision may be known as a modernization decision. In case of a replacement decision, the objective is to restore the same or higher capacity, whereas in case of modernization decision, the objective is to increase the efficiency and/or cost reduction. In general, the replacement decision and the modernization decisions are also known as cost reduction decisions.

(ii) Expansion : Sometimes, the firm may be interested in increasing the installed production capacity so as to increase the market share. In such a case, the finance manager is required to evaluate the expansion program in terms of marginal costs and marginal benefits.

(iii) Diversification : Sometimes, the firm may be interested to diversify into new product lines, new markets, production of spare parts etc. In such a case, the finance manager is required to evaluate not only the marginal cost and benefits, but also the effect of diversification on the existing market share and profitability. Both the expansion and diversification decisions may also be known as revenue increasing decisions.

(iv) Contingent Decisions : Sometimes, a capital budgeting decision is contingent to some other decision. For example, computerization of a bank branch may require not only air-conditioning but also transfer of some staff member to other branches. Similarly, installing a project at some remote location may require expenditure or development of infrastructure also. Any capital budgeting decision must be evaluated by the finance manager in its totality. The contingent decision, if any, must be considered and evaluated simultaneously.

4.2 From the Point of view of Decision situation

The capital budgeting decisions may also be classified from the point of view of the decision situation as follows :

(a) Mutually Exclusive Decisions : Two or more alternative proposals are said to be mutually exclusive when acceptance of one alternative result in automatic rejection of all other proposals. The mutually exclusive decisions occur when a firm has more than one alternative but competitive proposals before it. For example, selecting one advertising agency to take care of the promotional campaign out rightly rejects all other competitive agencies. Similarly, selection of one location out of different feasible locations is a mutually exclusive decision.

(b) Accept-Reject Decisions : An Accept-Reject decision occurs when a proposal is independently accepted or rejected without regard to any other alternative proposal. This type of decision is made when:

(i) proposal’s cost and benefit neither affect nor are affected by the cost and benefits of other proposals

(ii) accepting or rejecting one proposal has not impact on the desirability of other proposals

(iii) the different proposals being considered are not competitive.

5. Capital Budgeting Decisions and Funds Availability

No business firm can possibly afford to undertake all the profitable proposals. The reason is obvious i.e., no firm has unlimited funds. Had the funds available been un-limited, the firms could have accepted and implemented all the projects which were expected to contribute to the wealth of the firm, however small such contribution was. But this is not so in actual practice. Every firm has only limited funds available and these funds are to be invested in such a way so as to bring maximum contribution to the wealth of the firm.

Therefore, only those decisions are to be implemented which fulfil the following two conditions :

(i) The cost of the project does not exceed the funds available, and

(ii) The benefits expected from the project are more than the cost.

The situation where the firm is not able to finance all the profitable investment opportunities is known as capital rationing. If the total funds required by the profitable opportunities at any particular point of time exceed the available funds with the firm, then the firm is said to be operating under conditions of capital rationing. The capital rationing implies that the firm is unable or unwilling to procure the additional funds needed to undertake all the capital budgeting proposals before it. The problem faced by a finance manager in this situation is as to how to allocate the available scarce capital among various proposal. Out of different independent proposals (accept reject decisions), only those may be accepted in order of priority which entails the total cost within the limit of available fund. In case of mutually exclusive proposals, the cost of selected proposal must not exceed the available fund.

6. Capital Budgeting Decisions : Assumptions and Procedure

The capital budgeting decision process, as already stated is a complete multifaceted and analytical process. A finance manager however, has to concentrate only on the financial aspects of the proposal and therefore he is likely to ignore the non-financial considerations. A number of assumptions are required to be made in order to concentrate on the financial aspects. These assumptions in fact constitute a general set of conditions within which the financial aspects of different proposals are to be evaluated. Some of these assumptions are :

1. Certainty With Respect to Cost and Benefits : This assumption implies that the cost and benefits associated with a proposal are known with certainty. It may be difficult to estimate the cost and benefits proposals for a period beyond 2-3 years in future. However, for a capital budgeting decision, it is assumed that accurate forecast of cost and benefits of a proposals is available for the entire economic life of the proposal. Moreover, it is reasonable to resolve the certainty problem before being concerned with the process of capital budgeting decisions.

2. Profit Motive : Another assumption is that the capital budgeting decisions are taken with a primary motive of increasing the profit of the firm. No other motive or goal affect the underlying efforts of the finance manager.

3. No Capital Rationing : The capital budgeting decisions being discussed here assume that there is no scarcity of capital funds and the firm is not faced with capital rationing.

The capital budgeting decision procedure basically involves the evaluation of the desirability of an investment proposal. It is obvious that the firm must have a systematic procedure for making capital budgeting decisions. The procedure must be consistent with the objective of wealth maximization. In view of the significance of capital budgeting decisions, the procedure must consist of step by step analysis. The finance manager should use the best information and techniques available to take the capital budgeting decisions. In the process, he may undertake the following steps:

(a) Estimation of Costs and Benefits of a Proposal : The most important step required in the capital budgeting decisions is to estimate the cost and benefit associated with all the proposals being considered. The cost of a proposal is generally the capital expenditure required to install a project or to implement a decision. However, the benefits of a proposal may be in the form of increased output, increased sales, reduction in labour cost, reduction in wastages etc. Every proposal is to be examined in the light of its cost and benefits. The estimation of cost and benefit has been discussed at a later stage in the same chapter.

(b) Estimation of the Required Rate of Return : The rate of return expected from a proposal is to be estimated in order to (i) adjust the future cost and benefit of a proposal for time value of money, and (ii) thereafter, determining the profitability of the proposal. This required rate of return is also known as Cost of Capital and has been discussed in detail in Chapter 10. The funds available to a firm can either be invested in a capital budgeting proposal or can be invested elsewhere. So, a firm should invest the funds in a capital budgeting proposal, only if the return is at least equal to the return available from investments made elsewhere. This rate of return is known as opportunity cost or minimum required rate of return. It is used as a discount rate in capital budgeting.

(c) Using the Capital Budgeting Decision Criterion : A proper capital budgeting technique is to be applied to select the best alternative. So, in the first instance the technique itself is to be selected and then is to be applied for a better decision making.

However, in the following paragraphs, the first step i.e., the estimation of cost and benefits has been discussed in detail.

7. Estimation of Costs and Benefits of a Proposal

The selection or rejection of a proposal is based on the careful evaluation of costs and benefits related to the proposal. In the capital budgeting procedure, the estimation of cost and benefits of different proposals being considered for decision making is the first step. The estimation of cost and benefits may be made on the basis of input data being provided by production, marketing, accounting or any other department. What is required is the synchronization of this data and to make an attempt to forecast the costs and benefits of a proposal. But the question at this stage is how to measure the cost and benefits of a proposal ?

Two alternatives are suggested for measuring the cost and benefits of a proposal i.e., the accounting profits and the cash flows.

1. Accounting Profit : The benefits of a proposal may be measured in terms of the profit generated by it or in terms of a measure based on accounting profits. However, the accounting profit, which otherwise is a good, estimate of judging the efficiency of any firm, may not be a good measure to estimate the value/benefit created by a proposal. The accounting profit as a measure of benefits of a proposal is discarded on the following grounds :

(a) The accounting profit is, to a large extent, affected by the discretionary accounting policies being followed by the firm. These policies, which usually differ from one firm to another or from one period to another, may be depreciation policy, inventory valuation policy, capital expenditure and revenue expense policy, etc. Thus, the accounting profit is not an objective figure.

(b) The accounting profit is affected by so many non-cash items such as depreciation, writing off the accumulated losses, etc. The balancing profit figure after these items is not a true measure of benefits contributed by a proposal.

(c) The accounting profit measures the profit of any particular year in terms of the money of that year. However, the cost and benefits of a proposal may occur over a period of number of years. The benefits if measured in terms of accounting profit, are expressed in monies of different time period and are not comparable. Similarly, if two mutually exclusive proposals have different economic lives, then the accounting profits emerging over different periods are not comparable.

(d) The accounting profit is based on the accrual concepts. For example, the sales revenue and the expenses, both are recorded for the period in which they occur instead of the period in which they are actually received or paid.

Thus, in view of these flaws, the accounting profit as a measures of benefits of a proposal is outrightly rejected. Instead, the cost and benefits are measured in terms of cash flows.

2. Cash Flows : In capital budgeting, the cost and benefits of a proposal are measured in terms of cash flows. The term cash flow is used to describe the cash movement arising because of a proposal. Though it may not be possible to obtain exact cash-effect measurement, it is possible to generate useful approximations based on available accounting data. The costs are denoted as cash outflows whereas the benefit are denoted as cash inflows. It may be noted that the cash outflows represent outflows of purchasing power and cash inflow is an inflow of purchasing power. The cash outflows and inflows are used to denote the cost and benefit of a proposal.

It may be noted that the accounting profit figure is the resultant figure on the basis of several accounting concepts and policies. Some of the costs which are deducted from the sales revenue to arrive at the profit figure do not involve any cash flow. These charges against profit are simply book entries. For example, depreciation, provision for bad and doubtful debts, writing off the goodwill, etc., do not involve any cash flow. Similarly, a capital expenditure though involving a cash payment is not considered as the cost for the period and hence is not deducted from the sales revenue. Therefore, there is a difference between accounting profit and cash flow. This difference arises because of non-cash transactions.

The following is the income statement of a firm :

Amount   Amount  
Sales Revenue ` 1,00,000
– Cost of Production ` 60,000
– Depreciation 15,000 75,000
Profit before Tax 25,000
– Tax @ 40% 10,000
Profit after Tax 15,000

Now, presuming that all the sales, expenses and taxes have been effected in cash, the cash flow position of the firm can be expressed as follows :

Amount   Amount  
Cash realized from sales ` 1,00,000
– Cost of Production ` 60,000
– Taxes paid 10,000 70,000
Cash increase
(i.e., cash inflow) 30,000

The difference between the Profit after tax (i.e., ` 15,000) and cash inflow (i.e., ` 30,000) is due to the existence of non-cash expense of depreciation of ` 15,000. On the basis of this example, the cash flow may be stated as follows :

Cash flow    =   Profit after Tax (PAT) + Non-cash Expenses (N/C Exp.)

Further, if the firm has spent ` 5,000 on capital expenditure, then this will not affect the profit figure but the cash flow will be reduced by ` 5,000 as follows :

Cashflow = PAT + N/C Exp. – Capital Expenditures
(6.1)
= ` 15,000 +` 15,000 – ` 5,000
= ` 25,000

Equation 6.1 depicts that even if sales and operating expenses are effected in cash, the profit of the firm and the cash flows may be different. The reason for this difference may be the non-cash expenses and the existence of capital expenditure.

Example 1

The cost of a plant is ` 5,00,000. It has an estimated life of 5 years after which it would be disposed of (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is estimated to be ` 1,75,000 p.a. Find out the yearly cash flow from the plant, (given the tax rate @ 30%).

Solution :

Annual depreciation charge (` 5,00,000/5) ` 1,00,000
Profit before depreciation, interest and taxes 1,75,000
– Depreciation 1,00,000
Profit before Tax 75,000
Tax @ 30% 22,500
Profit after Tax 52,500
+ Depreciation (added back) 1,00,000
Therefore, cash flow 1,52,500

Example 2

ABC Ltd. is evaluating a capital budgeting proposal for which relevant figures are as follows :

Cost of the Plant ` 11,00,000
Installation cost ` 3,400
Economic life 7 years
Scrap value ` 30,000
Profit before depreciation and tax ` 2,00,000
Tax rate 50%

Solution :

Annual depreciation charge

(` 11,03,400 – ` 30,000)/7 ` 1,53,343
Profit before depreciation and taxes 2,00,000
– Depreciation 1,53,343
Profit before Tax 46,657
– Tax @ 50% 23,329
Profit after Tax 23,328
+ Depreciation (added back) 1,53,343
Cash inflow (yearly) 1,76,671

The plant has an initial cash outflow of ` 11,03,400 (` 11,00,000+` 3,400), and its annual cash inflows for 7 years will be ` 1,76,671 p.a. However, in the 7th year, there will be an additional cash inflow of ` 30,000 i.e., the scrap value. Therefore, in the 7th year, the total cash inflow will be ` 2,06,671.

Examples 6.1 and 6.2 make an assumption that all the sales and expenses have been effected in cash. However, in practice there is a time gap between the occurrence of sales and expenses and their incidence on cash flow. Thus, pattern of receipts from receivables (debtors and bill) and the pattern of payments to payable (creditors and bills) should also be analyzed to assess the effect on cash flow.

Cash Flows versus Accounting Profit : The accounting profits are calculated for stewardship purposes and are period-oriented. Moreover, the accounting policies relating to depreciation, inventory valuation, and allocation of indirect costs may cause wide discrepancies in accounting profit in identical situation. These problems may all be overcome by focusing on the cash flows which will be identical irrespective of the person making estimation thereof. The concept of cash flows as a measure of evaluating the cost and benefits of a proposal is better than the concept of accounting profit in more than one ways as follows :

(a)   The accounting profit ignores the concept of time value of money, whereas the cash flow incorporates the time value of money also.

(b)   In capital budgeting, a finance manager is concerned with measuring the economic value created by a decision rather than book entry value. In cash flow analysis, the cost and benefits are measured in terms of actual cash inflows and outflows rather than profit figure.

(c)   The accounting profit may be 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.

Thus, the cash flows as a measure of cost and benefits of a proposal is a better technique to evaluate a proposal. The cash flows associated with a proposal may be classified into :

(i) Original or Initial cash outflow,

(ii) Subsequent cash inflows and outflows, and

(iii) Terminal cash flow

1. Original or Initial Cash Outflow : All the capital projects require a sizeable initial cash outflow before any future inflow is realized. This initial cash outflow is needed to get a project operational. In most of the capital budgeting proposals, the initial cost of the project i.e., the initial investment cost is the cash outflow occurring in the initial stages of the projects. Since the investment cost occurs in the beginning of the project, it is relatively easy to identify the initial cash outflows. It reflects the cash spent to acquire the asset. There are several points worth noting here as follows:

(a) Installation cost : The initial cash outflow includes the total cost of the project in order to bring it in workable condition. Thus, the initial cash outflow includes not only the cost of plant, but also the transportation cost, installation cost and any other incidental cost.

(b) Sunk cost : Sunk cost is that cost which the firm has already incurred and thus has no effect on the present or future decisions. If a firm which owns a plot of land which is lying idle for the time being, is now considering to construct a factory at this plot, then the cost of the plot is a sunk cost for the factory proposal, and is irrelevant. However, if the plot of land is to be purchased now, then the cost of the land will be included in the initial cost of the project.

Suppose, the firm had spent ` 50,000 to erect a fence on this plot of land, when it was lying idle. This cost of fence is also a sunk cost even if the fence is required for the factory project. However, if the fence is not required and is to be removed before the new factory building is constructed, then the cost of removal would be a relevant cost and is to be added to the initial cost of the project.

Similarly, expenses incurred on conducting a market survey to assess the potential market, or associated with research and development activities occurring well before the product is considered for introduction are sunk costs for a product now under full investment analysis. The sunk costs are neither re-covered if the proposal is rejected nor incremental if the project is accepted, and therefore, should not be considered in the capital budgeting decision process.

The sunk cost is an irrelevant cost for the investment proposal and is to be ignored. If the sunk cost is included in the initial cash outflow then the finance manager may commit the sunk cost fallacy. It may be noted however that although the sunk costs are irrelevant for capital budgeting proposals yet the firm does need to recover these costs over time otherwise the firm will cease to exists.

(c) Salvage value of existing asset : In case of replacement decisions, the salvage value of the existing asset is an inflow. If the firm decides to replace the existing asset then the outflow would occur on the new asset and simultaneously, an inflow would occur from the sale of the old. This salvage value is deducted from the outflow to find out the net initial outflow. Further, that the sale of old asset may result in some profit or loss on sale of asset. For example, if the book value of the asset, being scrapped, is ` 1,00,000 and it is sold for ` 1,80,000. This would be result in a capital loss of ` 20,000. Or, if the asset is sold for ` 1,25,000, there would be a capital gain of ` 25,000. This profit or loss would affect the taxable income and the tax liability. The profit on sale would involve additional tax payment and loss on sale would result in tax saving, while finding out the initial outflows of a capital budgeting decision situation. The salvage value of the existing asset, as well as the tax effect of profit or loss on sale, both are considered.

(d) Opportunity Cost : In some cases the finance manager may overlook some of the costs of proposal. Such costs may be the opportunity costs of some resources which are already available or being procured in the firm. Using of some resources, such as office space, for a new proposal by divesting them from some other existing use, causes the opportunity costs. When a firm uses such resources, by divesting, there is a potential for opportunity cost i.e., the cost created for the rest of the business as a consequence of the proposal. This opportunity cost may be a significant portion of the total cost of the proposal.

The general framework for analyzing the opportunity costs begins by asking the question, “Is there any other use for this resource right now?” For many resources, there will be an alternative use if the project being analyzed is not undertaken. The opportunity cost may occur as follows :

(i) The resource might be rented out, in which case the rental revenue is the opportunity lost by taking this project.

(ii) The resource could be sold, in which case the sales price (net of tax liability and lost depreciation tax benefits) would be the opportunity cost of taking this project.

(iii) The resource might be used elsewhere in the firm, in which case the cost of replacing the resource is considered as the opportunity cost.

Thus, the transfer of experienced employees from established divisions to a new project creates a cost to these divisions and has to be considered for decisions making. Similarly, if the office building is to be constructed on an idle plot of land, then the cost of land is a sunk cost for the building project and be ignored therefore. But, if the firm did not use the plot for building purpose, it could sell it or use it for some other project and thus the plot of land has an opportunity cost. So, the firm should include the market value of the land as the part of the initial cost of the project. The amount originally paid for acquiring the plot is a sunk cost and is irrelevant.

(e) Additional Working Capital Requirement : Another item that needs consideration to ascertain the initial cash outflow is the working capital required for the proposal or more precisely, the change in working capital due to the proposal. Since the change in working capital affects the cash flows, it is important that the working capital requirement of every alternative proposal be analyzed and considered for the capital budgeting decision.

An investment proposal if accepted, would require increase in minimum cash balance to be maintained, higher inventory level and more receivables. The new project may require the firm:

(i) to extend additional credit to its customers

(ii) to carry additional inventory to serve customer orders

(iii) to enlarge its cash balance to meet its enlarged transactions

This additional working capital is the additional investment to be made in the project, and is therefore, also included in the initial cash outflows of the project. However, the additional working capital is required only for the period equal to the life of the proposal. At the end of the proposal, this additional working capital being invested now will be released and recaptured by the firm. Thus, the cash inflow for the last year of the life of the project would also include the working capital released by the project.

Failure to consider the working capital needs in the capital budgeting decision may have two consequences i.e.

(i) the cash flows will be over-estimated

(ii) even if, working capital is salvaged fully at the end of the project life, the net present value of the cash flows created by change of working capital will be negative and hence the capital budgeting decision may be taken wrongly.

2. Subsequent Annual Inflows and Outflows : The original investment cost or the initial cash outflow of the proposal is expected to generate a series of cash inflows in the form of cash profits contributed by the project. These cash inflows may be same every year throughout the life of the project or may vary from one year to another. The timings of the inflows may also be different. The cash inflows mostly occur annually, but in some cases may occur half-yearly or biannually also. These cash inflows generated during the life of the project may also be called operating cash flows. There are different ways of finding out the operating cash inflows. These can be explained as follows :

Sales ` 1,50,000
– Costs 70,000
– Depreciation 60,000
Profit before tax 20,000
Tax @ 34% 6,800
Profit After Tax 13,200

Operating cash inflows (OCF) may be found as under :

(i)    OCF    =   PBT + Dep. – Tax

=   ` 20,000 + 60,000 – 6,800 = ` 73,200

(ii)   OCF    =   PAT + Dep.

=   ` 13,200 + 60,000 = ` 73,200

(iii)  OCF    =   Sales – Costs – Taxes

=   ` 1,50,000 – 70,000 – 6,800 = ` 73,200

(iv)  OCF    =   (Sales – Costs) (1 – t) + Dep. (t)

=   (` 1,50,000 – 70,000) (1 – .34) + ` 60,000 (.34) = ` 73,200

The Operating cash flows are positive cash flows for most of the conventional revenue generating proposals, however, in case of cost reduction proposals these cash flows may be negative.

Following points are worth noting here :

a. Sometimes, the project may require some subsequent cash outflows also in the form of periodic intensive repair, periodic shunting cost, etc. All these cash inflows and outflows are to be considered for the capital budgeting decision.

b. If additional working capital is required by the proposal in any of the subsequent years then it should be considered as outflow for that year. However, if the working capital is released in any of the subsequent years, then it should be considered as cash inflow for that year.

c. It is important to recognize the timing of these subsequent cash inflows and outflows, as these are to be adjusted for the time value of money. The more quickly and earlier, the cash inflows occur, the more valuable these are.

So, subsequent annual cashflow can be described as :

Annual Inflow = PAT + Non-cash expenses – Capital expenditure ± Change in working capital

3. Terminal Cash Inflows : The cash inflows for the last year will also include the terminal cash flows in addition to annual cash inflows. Two common terminal cash inflows may occur in the last year. First, as already noted, the estimated salvage or scrap value of the project realizable at the end of the economic life of the project or at the time of its termination is the cash inflow for the last year. At the time of disbanding or termination of the project, the market value of the land etc. also become cash inflows from the project. Second, as already noted, the working capital which was invested (tied up) in the beginning will no longer be required as the project is being terminated. This working capital released will be available back to the firm and is considered as a terminal cash inflow. So,

Terminal CF = Sale Price of asset ± Tax effect of sale of asset + Working capital released.

8. Incremental Approach to Cash Flows

In capital budgeting, the cash flows are measured in the incremental terms i.e., only those cash flows are considered, that differ or occur as a result of undertaking/accepting the particular proposal. These incremental cash flows are also known as relevant cash flows. These refer to those cash flows which can be associated and attributed to adoption of a particular proposal.

So, what is a relevant cash flow? In general, a relevant cash flow for a project is a change (in the firm’s future cash flows) that occurs as a direct consequence of the decision to accept that project. As the relevant cash flows are defined in terms of changes in a increments to the existing cash flows, these are called incremental cash flows. The concept of incremental cash flows is central to the process of capital budgeting.

Any cash flows that exists or is expected to occur regardless of whether a project is taken up or not, is not a relevant cash flow and is ignored in capital budgeting. Following points are worth nothing about incremental cash flows :

(i) Stand Alone Principle : If an existing firm is taking up a new project, then it would be very tedious and cumbersome to actually calculate the total future cash flows of the firm with or without that project. In order to avoid this situation, the stand alone principle is applied and only the effect of project’s cash flows on the firm’s otherwise cash flows is identified.

‘Stand Alone Principle’ implies that each project is a ‘minifirm’ within the larger firm. Each ‘minifirm’ has its costs, revenues and cash flows. So, the ‘minifirm’ be evaluated on the basis of its own cash flows, rather than the total cash flows of the firm. Thus, a project is evaluated purely on its own merits, in isolation from other activities of the firm.

(ii) Co-existence with the proposal : The incremental cash flows are those which co-exist with a proposal i.e., the particular cash flows may appear only if the project is undertaken. For example, ABC & Co. is evaluating project X and project Y. The project X requires an intensive repairs costing ` 1,00,000 at the end of 5th year, while the project Y necessitates an annual service contract for ` 25,000 p.a. In this case, the repair cost of ` 1,00,000 is relevant for project X only, while the annual cash outflow of ` 25,000 is relevant for project Y only. The repair cost is not required if project Y is implemented and the service contract is not required if the project X is installed.

(iii) Allocated Overhead costs : The overhead costs are those which are not directly related to a product. These are allocated to a product on some rational basis such as machine-hour rate etc. These overhead costs which are already being incurred by the firm and perhaps also being charged from the goods produced presently, are irrelevant from the point of view of new project. If therefore, some existing overhead cost is allocated to the new proposal, then this is not to be considered for finding out relevant cash flows of the proposal. Moreover, it is not incremental. However, if the overhead costs is expected to increase after the new project is implemented, then only this incremental overhead cost will be considered as costs and the cash outflow for the proposal.

For example, any increase in administrative or staff cost that can be traced to the project is an incremental cost and should be considered. One way to estimate the incremental component of these costs is to break them down on the basis of whether they are fixed or variable, and, if they are variable, what they are a function of.

(iv) Product Cannibalization : This refer to the phenomenon whereby a new product introduced by a firm competes with and reduces sales of some other existing product of the same firm. The product cannibalization refers to the sales generated by one product, which come at the expense of other products being sold by the same firm. On one level, it can be argued that this is a negative incremental effect of the new product, and the lost cash flows or profit from the existing products should be treated as costs in analyzing whether or not to introduce the product.

The decision whether or not to include the cost of lost sales created by product cannibalization will depend on the potential for a competitor to introduce a close substitute to the new product being considered. Two extreme possibilities exist :

(i) If the business in which the firm operates is extremely competitive and there are no barriers to entry, it can be assumed that the product cannibalization will occur any way, and the costs associated with it have no place in an incremental cash flows analysis.

(ii) If a competitor cannot introduce a substitute, because of legal restrictions such as patents, the cash flows lost as a consequence of product cannibalization should be included in the capital budgeting analysis, at least for the period of the patent protection.

In most cases, there will be some barriers to entry, ensuring that a competitor will either introduce an imperfect substitute, leading to much smaller erosion in existing product sales, or that a competitor will not introduce a substitute for some period.

In this case, an intermediate solution whereby some of the product cannibalization costs are considered, may be appropriate. Firms with stronger brand name loyalty should include into their capital budgeting analysis, most of the cost of lost sales resulting as a consequence of new product.

The principle of incremental cash flows in capital budgeting analysis is critical. A finance manager while evaluating a proposal should note whether a particular cash flow is incremental or not. Only the incremental cash flows should be considered for capital budgeting. Any cash inflow or outflow that can be directly or indirectly traced to a project must be considered. Obviously, the incremental cash flows analysis also implies that any reduction in cash inflow or outflow that occurs as a consequence of a project should also be considered.

9. Taxation and Cash Flows

The cash flows that are related to capital budgeting 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.

The annual cash inflow from a project will result in increase in the taxable profit. So, the cash flow from a project would also affect the tax liability of the firm. The increase in tax liability will be equal to the cash inflow multiplied by the tax rate. Or, the net cash inflow will be equal to cash inflow (before tax) multiplied by (1-tax rate). Therefore, the relevant cash flow for a capital budgeting decision is the cash flow net of incremental tax liability. It may be noted that in Chapter 1, one of the axioms of financial management has been given as “All financial decisions are subservient to tax laws”.

So, the capital budgeting analysis should be done in after-tax terms. This implies that all items that affect taxes, even non-cash item such as depreciation, should be considered in the analysis.

10. Depreciation, non-cash items and Cash Flows

The fixed assets acquired as a result of capital budgeting decision would be depreciated in the usual way. The depreciation of the assets would reduce the expected profit being generated by the project, reducing the tax liability. Even though this depreciation does not involve any cash flow as such, it definitely affects the cash outflows by affecting the tax liability. One consequence of dealing with after tax cash flows in capital budgeting decision process is that non-cash charges can have a significant impact on the cash flows, if they affect the tax liability. Some non-cash charges, particularly depreciation, reduces the taxable income and hence reduces the tax liability, without however affecting the cash flows.

Every capital budgeting decision should therefore, consider this depreciation tax-shield i.e., reduction in tax liability as a result of depreciation. The depreciation is added back to the figure of profit after taxes to arrive at the cash inflows from the project. Similarly, any other non-cash expense which has already been deducted to arrive at the figure of profit after tax, is added back to ascertain the cash inflows even though they may not provide any tax benefit to the firm.

11. Treatment of Depreciation and Profit/Loss on Sale/Scrapping of an Asset

In order to find out the relevant cash inflows for a capital budgeting proposal, the amount of depreciation should be carefully ascertained. As already said, the depreciation is tax deductible and provides a tax-relief. At the end of useful life of an asset, it might be sold for some scrap value. The cash inflow in the form of scrap value is also considered in the evaluation process. The tax-effect of depreciation and scrap value may be incorporated in the capital budgeting evaluation procedure in any of the following two ways :

11.1 Accounting Treatment

In accounting, an asset can be depreciated as per any of several methods of depreciation. The depreciation charge for a particular year is deducted from the opening written down value of the asset to get the closing written down value. The depreciation is provided for the entire period for which the asset has been used. At the time of scrapping of an assets, its salvage value is compared with the written down value till date. The difference between the two i.e., capital gain (when salvage value is more than the written down value) or the capital loss (when the salvage value is less than the written down value) is adjusted in the income of the year in which the asset is discarded. Consequently, the capital gain/loss will have its tax effect.

Example 3

A firm buys an asset costing ` 1,00,000 and expects operating profits (before depreciation @ 20% WDV and tax @ 30%) of ` 30,000 p.a. for the next four years after which the asset would be disposed of for ` 45,000. Find out the cash flows for different years.

Solution :

Initial Outflow : Cost of the Asset ` 1,00,000.

Subsequent Annual Inflows : The subsequent cash inflows from the asset may be found as under :

Year WDV Dep. PBD PBT Tax PAT CF
  (1) (2) (3) (4=3-2) @30% (5) (5+2)
1. 1,00,000 20,000 30,000 10,000 3.000 7,000 27,000
2. 80,000 16,000 30,000 14,000 4,200 9,800 25,800
3. 64,000 12,800 30,000 17,200 5,160 12,040 24,840
4. 51,200 10,240 30,000 19,760 5,928 13,832 24,072

Terminal Cash Inflow:

          Scrap Value of the Asset ` 45,000
          Profit on sale :
          Sale Value 45,000
          WDV (51,200 – 10,240) 40,960
Profit 4,040
Tax @ 30% on ` 4,040 ` 1,212
Net Cash Inflow (45,000 – 1,212) ` 43,788

11.2 Treatment under the Income-tax Act, 1961

The taxable income of an assessee in India is calculated as per the provisions contained in the Income-tax Act, 1961. The relevant provisions are given in sections 32 and 43 of the Act. The treatment of depreciation and capital gain/loss to find out the tax liability is different from the accounting treatment given above. The treatment under the Income-tax Act may be summarised as follows :

Block of Assets : The provisions of the Act introduces the concept of block of assets. The block of assets means a group of assets falling within a class of assets being buildings, machinery, furniture etc., in respect of which the same rate of depreciation is admissible. Depreciation is allowed on the basis of block of assets. A block of assets may consist of one asset or several assets.

Block consisting of one asset only : If there is only one asset in a particular block of assets then the following provisions are worth noting :

(a) In the terminal year (i.e., the year in which the asset is discarded/sold or scrapped away), no depreciation is allowed.

(b) The selling price/scrap value will be compared with the written down value. The difference between the two is treated as short term capital gain or loss and is treated as ordinary income/loss.

Block consisting of more than one asset : In case, there are more than one asset in a block, the following provisions are worth noting :

(i) When a new asset is purchased and is added to the existing block of asset, the cost of new asset is added to the opening written down value of the block and depreciation for that year is provided on the total value.

(ii) If at the time of acquisition of new asset or even otherwise, any part of the block is sold or scrapped away, then the scrap value (realised from sale) is deducted from the opening written down value. The depreciation for the year is provided on the net balance only. For example, if the opening written down balance of a block of asset is ` 10,00,000. During the year, assets costing ` 7,50,000 are added to the block. The depreciation for the year will be provided on ` 17,50,000. However, if a part of this block is sold away for ` 3,50,000 (irrespective of the WDV), the depreciation for the year would be provided on ` 14,00,000 only.

(iii) There will not be any capital gain/loss on sale of asset unless the entire block of asset is scrapped away. In such a case, the difference between the written down value and the scrap value will be the short term capital gain/loss and treated accordingly.

In the Example 3 above, if the block is consisting of one asset only, then the depreciation for different years would be ` 20,000, ` 16,000, ` 12,800 and NIL for years 1-4 respectively. The WDV in the beginning of the year 4 would be ` 51,200 and short term capital loss would be ` 6,200 i.e., (` 51,200 – 45,000)

However, if the block is consisting of several assets, and the WDV of the existing assets (on the date of purchase of new asset) is say, ` 5,00,000, then the depreciation for different years would be calculated @ 20% WDV on ` 6,00,000. The depreciation would be ` 1,20,000, ` 96,000, ` 76,800 for years 1-3 respectively. The WDV of the block in the year 4 would be ` 3,07,200 and the depreciation for the year 4 would be ` 52,440 i.e., 20% of (` 3,07,200 – 45,000).

Further, there would not be any capital gains/loss in the year 4 when a part of block of asset is sold for ` 45,000. It may be noted from the above discussion that the depreciation under the accounting treatment and the depreciation as per the Income-tax Act, 1961 would be different. This implies that the tax benefit available from depreciation will also be different. This will result in different cash flows under two methods of depreciation.

12. Financial Cash Flows

Any new project being considered for implementation may require the firm to raise additional funds. This may also entail further cash flows in the form of payment of interest or dividend to the supplier of the funds. In the capital budgeting decision process, these financial cash flows i.e., cash inflows in the form of raising the funds and cash outflows in the form of interest and dividend payments, are ignored. The reason for the exclusion of financial cash flows is obvious.

The cash inflow arising at the time of raising of additional fund results in an immediate cash outflow also when these funds are used to procure the project. As such, there is no net cash inflow. Further, the cost of financing in the form of interest and dividend is truly reflected in the weighted average cost of capital which is used to evaluate the proposals. The concept of weighted average cost of capital has been discussed in Chapter 10. If the cost of debt or equity (i.e., interest or dividends) is deducted from the cash inflows, then this cost of raising fund will be counted twice, first in the cash inflows and second, in the weighted average cost of capital. This is also known as Interest Exclusion Principle.

The interest payable to the lenders and the dividend payable to the shareholders are cashflows to the supplier of funds and not cash flow from the project. In capital budgeting, the cash flow from the project are compared with the cost of acquiring that project. A particular capital mix, the firm uses to finance the project is a managerial variable and primarily determines how project cash flows are divided between lenders and owners.

Thus, neither, the additional funds raised nor the interest/dividend payable on these funds are treated as relevant cash flows for a proposal. Otherwise, there will be an error of double counting. The general principle is that the investment decision and the financing decision should be considered separately. In other words, only the operating cash flows of a proposal should be brought into and evaluated in the capital budgeting process. The financial cash flows should be taken as constant and be kept outside the analysis. Example 4 illustrates this point.

Example 4

Following is the income statement of a project, on the basis of which calculate the annual cash inflows.

Income Statement of the Project

Net Sales Revenue ` 4,75,000
– Cost of Goods Sold ` 2,00,000
– General Expenses 1,00,000
– Depreciation 50,000 3,50,000
Profit before interest and taxes 1,25,000
– Interest 25,000
Profit before tax 1,00,000
– Tax @ 40% 40,000
Profit after tax 60,000

Solution :

The Income statement of the project shows that an interest charge of ` 25,000 is payable on the funds raised for financing the project. This interest payment is a charge for ascertaining the accounting profit, but is irrelevant for ascertaining the cash flows. Therefore, the annual cash flow from the project can be calculated as follows :

13. Calculation of Annual Cash Inflows

Net Sales Revenue ` 4,75,000
– Cost of Goods Sold ` 2,00,000
– General Expenses 1,00,000
– Depreciation 50,000 3,50,000
Profit before interest and taxes 1,25,000
– Tax @ 40% 50,000
75,000
+ Depreciation (added back) 50,000
Net cash inflow 1,25,000

The cash inflow can also be ascertained as follows :

Net profit (as shown in Income Statement) ` 60,000
+ Depreciation 50,000
+ Interest 25,000
1,35,000
– Tax-effect of interest (` 25,000 × 40%) 10,000
Annual cash inflow 1,25,000

On the basis of the above analysis of financial cash flows, the annual cash inflow may be defined in terms of the following equation :

Cash inflow    =   PAT + Non – Cash Expenses + Financial Charge – Financial charge × (Tax rate)

=   PAT + Depreciation + Interest – Interest × (Tax rate)

=   PAT + Depreciation + Interest × (1 – Tax rate)

or,                  =   EBIT × (1 – Tax rate) + Depreciation

If there is a change in net working capital in any year, then it should also be incorporated as follows : Cash inflow = PAT + Depreciation + Interest – Interest (Tax rate) – Increase in working capital. Cash inflow = EBIT (1 – Tax rate) + Depreciation – Increase in Net Working Capital.

The cash flows may be grouped into relevant and irrelevant cash flows as follows :

Relevant Cash Flows Irrelevant Cash Flows
Cost of new project Sunk Cost
Scrap value of old/new plant Allocated Overheads
Trade-in-value of old plant Financial cashflows
Cost reduction/savings
Effect on tax liability
Incremental repairs
Tax benefit of Incremental
depreciation
Working capital flows
Revenue from new proposal

In the ultimate analysis, the calculation of different cash flows may be summarized as follows :

Initial Cash Outflow = Cost of new plant + Installation Expenses + Other Capital Expenditure + Additional Working Capital – Tax benefit on account of Capital loss on sale of old plant (if any) – Salvage value of old plant + Tax Liability on account of Capital gain on sale of old plant (if any).
Subsequent Cash Inflow = Profit after Tax + Depreciation + Financial charge (1 – t) – Repairs (if any) – Capital Expenditure (if any).
Terminal Cash Inflow = Annual Cash inflow + Working Capital released + Scrap value of the proposal (if any).

 

Basic Principles for calculation of Cash Flows of a Capital Budgeting Project
1. All relevant cash flows are considered.
2. Cash Flows are considered on after-tax basis.
3. Cash Flows are considered on incremental basis.
4. Tax saving is considered as an inflow.
5. Sunk costs are ignored (as these are not incremental).
6. Opportunity costs are considered (as these are sacrificed).
7. Additional working capital required for a project is considered as an outflow (as the funds are blocked for the life time of the project). At the end of life of project, these funds (blocked in working capital) are released back and are considered as Terminal Inflow.
8. Unless given otherwise, inflows are assumed to have occurred at the end of the year and outflows are assumed to have occurred in the beginning of the year.
9. In Replacement Decisions, savings in costs are considered as inflow on after-tax basis.
10. Allocated Overheads are not outflows (as these are not incremental and are being already recovered elsewhere).

14. Cash Flows from the point of view of different perspectives

Capital Budgeting proposals are considered and evaluated from the point of view of the firm. Consequently, all cash flows are considered in the decision process to find out the feasibility of a project. This is also known as Total Funds Point of View or Firm’s Point of View. However, a project can be viewed from the points of view of the basic supplier’s of funds. There are two basic suppliers : The Equity Shareholders and the Debt investors. Cash flows related to a project can be calculated from the point of view of Equity and Total Long-term Funds.

Cash Flows to Equity : Cash flows to equity refer to those cash flows which can be identified with the equity shareholders. In other words, these cash flows are the inflows and outflows from the point of view of equity shareholders. For example, preference dividend is an outflow from the point of view of equity shareholders. Different cash flows to equity are as follows:

Initial Outflows : Out of total funds committed to the project, only equity funds component is considered.
Subsequent Annual Inflows : PAT- Preference Dividend + Depreciation + Other Non-cash Expenses.
Terminal Inflows : Salvage Value (Net of tax) + Release of Working Capital – Repayment loans – Redemption of Preference Share Capital

Cash Flows to Long-term Funds : Long-term funds include Equity Share Capital, Reserves & Surplus and Long-term loans Debt and Debentures. Cash flows to long-term debt refers to the cash flows from the point of view of supplier of these funds. Different types of cash flows are as follows :

Initial Outflows : Long-term funds invested + Margin required for Working Capital loan
Subsequent Annual : PAT + Int. (1 – t) + Deprecia-
Inflows tion + Non-Cash Expenses.
Terminal Inflows : Salvage Value (Net of tax) + Release of Working Capital Margin.

15. Points to Remember

    • Investment decisions are concerned with the allocation of funds to different types of assets, long-term as well as short-term Capital budgeting is concerned with long-term decision.
    • The basic features of Capital budgeting are long-term effects, substantial commitments, irreversible decisions, determine the profit capacity etc. However, the capital budgeting decisions deal with future uncertainty, time value of money and problem of measurement of future cashflows.
    • Capital budgeting decisions may be classified as (1) Replacement decision, Expansion decision. Diversification decision, Contingent decisions or (2) Mutually exclusive decision or Accept-reject decision.
    • In any Capital budgeting decision, there are 3 steps : (1) Estimation of costs and benefits of a proposal, (2) Estimation of required rate of return, and (3) Using techniques of capital budgeting and selection of a proposal.
    • In Capital budgeting, the costs and benefits of a proposal are measured in terms of cash flows, and not the accounting profits (because accounting profits are affected by the discretionary accounting policies). The cashflows relating to a proposal may be classified as (a) Initial cash outflows, (b) Subsequent cash inflows and outflows, and (c) Terminal cash inflows.
    • All cash flows are calculated on After-Tax basis.
    • In Capital budgeting, only relevant cashflows are considered. Sunk cost, for example, is irrelevant and hence ignored. The cashflows are considered on after tax basis and financial cashflows relating to raising of finance for the proposal are ignored. Similarly, allocated overheads are considered as irrelevant and hence ignored in capital budgeting decision process. Opportunity cost is a relevant cost and is considered in calculation of cash flows.
    • There are several principles to be followed in calculation of cash flows.

16. Graded Illustrations 

Illustration A

NIRC Ltd. in considering an investment proposal for which the relevant information is as follows :

Purchase price of the new asset ` 10,00,000
Installation costs 2,00,000
Increase in working capital in year zero 2,50 000
Scrap value of the new asset after 4 years 3,50,000
Revenues from new asset (Annual) 21,50,000
Cash expenses on new asset (Annual) 9,50,000
Current Book value (old asset) 4,00,000
Present scrap value (old asset) 5,00,000
Revenue from old asset (Annual) 19,25,000
Cash expenses on old asset (Annual) 11,25,000

Planning period, 4 years.

Depreciation on new asset : 92% the cost is to be depreciated in the ratio of 5 : 8 : 6 : 4 over 4 years.

Existing asset is depreciated at a rate of ` 1,00,000 p.a.

Tax rate is 40% on both revenues as well as capital gains/losses.

Solution :

Initial Cash Outflow :

Purchase price ` 10,00,000
+ Installation Cost 2,00,000
+ Working Capital increase 2,50,000
– Scrap value of old asset 5,00,000
+ Tax on gain on sale of old asset 40,000
(40% of ` 1,00,000) 9,90,000

Subsequent Cash Flow (Annual) :

New Machine   Year 1     Year 2     Year 3     Year 4  
    `     `     `     `  
Annual Revenue 21,50,000 21 ,50,000 21,50,000 21,50,000
Cash expense 9,50,000 9,50,000 9,50,000 9,50,000
Profit before dep. 12,00,000 12,00,000 12,00,000 12,00,000
– Depreciation 2,40,000 3,84,000 2,88,000 1,92,000
Profit before tax 9,60,000 8,16,000 9,12,000 10,08,000
–Tax @ 40% 3,84,000 3,26,400 3,64,800 4,03,200
Profit after Tax 5,76,000 4,89,600 5,47,200 6,04,800
Dep. (added back) 2,40,000 3,84,000 2,88,000 1,92,000
Annual Cash Flow 8,16,000 8,73,600 8,35,200 7,96,800
– Cash flow (old asset) 5,20,000 5,20,000 5,20,000 5,20,000
Incremental cash flows 2,96,000 3,53,600 3,15,200 2,76,800

The annual cash flow of old machine can be calculated as follows :

Annual revenue ` 19,25,000
– Cash expenses 11,25,000
– Depreciation 1,00,000
Profit before tax 7,00,000
– Tax @ 40% 2,80,000
Profit after tax 4,20,000
Depreciation (added back) 1,00,000
Therefore, annual cash inflow 5,20,000

The depreciation on new asset has been calculated as follows:

(` 10,00,000 + ` 2,00,000) × 92% = ` 11,04,000. This amount of ` 11,04,000 is to be depreciated over next 4 years in the ratio of 5 : 8 : 6 : 4 i.e., ` 2,40,000, ` 3,84,000, ` 2,88,000 and ` 1,92,000. The depreciation on the old asset is ` 1,00,000 p.a. i.e., ` 4,00,000/4.

Terminal Cash Flow:

Salvage Value (A) ` 3,50,000
– Book value (8% of ` 12,00,000) 96,000
Gain on sale 2,54,000
Tax @ 40%(B) 1,01,600
Net cash inflow (A-B) 2,48,400
+ Working capital released 2,50,000
Total 4,98,400

In addition to this terminal cash flow of ` 4,98,400, there will be annual incremental cash inflow of ` 2,76,800 also in the last year. Therefore, the total inflow in the last year will be ` 7,75,200.


Illustration B

XYZ is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old machine bought a few years ago has a book value of ` 90,000 and it can be sold for ` 90,000. It has a remaining life of five years after which its salvage value is expected to be nil. It is being depreciated annually at the rate of 20 per cent (written down value method).

The new machine costs ` 4,00,000. It is expected to fetch ` 2,50,000 after five years when it will no longer be required. It will be depreciated annually at the rate of 331/3 per cent (written down value method). The new machine is expected to bring a saving of ` 1,00,000 in manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable to the firm is 50 per cent. Find out the relevant cash flow for this replacement decision. (Tax on capital gain/loss to be ignored).

Solution :

Initial Cash Flow : Amount
Cost of new machine `  4,00,000
– Salvage value of old machine 90,000
3,10,000

Subsequent Annual Cash Flows:

(Amount ` ’000)

    Yr. 1     Yr. 2     Yr.3     Yr.4     Yr.5  
Savings in costs (A) 100 100 100 100 100
Depreciation on
new machine 133.3 88.9 59.3 39.5 26.3
–Depreciation on
old machine 18.0 14.4 11.5 9.2 7.4
Incremental
depreciation (B) 115.3 74.5 47.8 30.3 18.9
Net incremental
saving (A – B) –15.3 25.5 52.2 69.7 81.1
Less: Incremental
Tax @ 50% –7.6 12.8 26.1 34.8 40.6
Incremental Profit –7.7 12.7 26.1 34.9 40.5
Depreciation
(added back) 115.3 74.5 47.8 30.3 18.9
Net cash flow 107.6 87.2 73.9 65.2 59.4

Terminal Cash Flow : There will be a cash inflow of ` 2,50,000 at the end of 5th year when the new machine will be scrapped away. So, in the last year the total cash inflow will be ` 3,09,400 (i.e., ` 2,50,000 + ` 59,400).


 

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One thought on “Treatise on Capital Budgeting: Estimation of Cash Flows”

  1. A splendid article, I just given this onto a colleague who was doing a little analysis on this. And he in fact purchased me lunch because I found it for him :). So let me rephrase that: Thanks for the treat! But yeah Thankx for taking the time to talk about this, I feel strongly about it and enjoy learning more on this topic. If possible, as you become expertise, would you mind updating your blog with more info? It is extremely helpful for me. Two thumb up for this article!

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