Capital budgeting is a method of estimating financial viability of a project. Capital budgeting uses future cash flows discounted into present value for making its cash flows comparable. Hence, the required tools for the entire process of capital budgeting are:
- How do we generate the cashflow, and this requires estimation, judgement and knowledge.
- Given the cashflows, how do we decide whether the project is viable or not
1. Cashflows are computed from the long term funds point of view. There are 3 types of cash flow:
- Initial cash flow (eg. Initial capital investments)
- Operating cash flow(CFAT) (Periodically cash flow of future)
- Terminal cash flow (Salvage value of asset, release of working capital)
1. Initial cash flow:
initial cash flow = Capital Investment-long term debt+ initial net working capital
2. Operating Cash flows: It is cash flow earned every period or over the period for useful life of the asset. If the company’s new project has the same business and financial risk then the business existing discount rate can be used and existing earning per share could be used. We can estimate cash flow from cash flow statement too or Profit or loss account.
How periodic cash flows are determined ?
Particular
Sales
Purchase
Labor cost
Variable overhead
Contribution
Fixed cost
Earning before Depreciation, interest and tax
Depreciation
Earning before interest and tax
Interest
Earning before tax
Tax@ 25%
Earning after tax
Add: Depreciation
Cash flow after tax
Add: Interest on long term debts net off tax
[Interest x (1-tax rate)]=[50 x (1-.25)]
Net operating cash flow after tax (NOCFAT)
Amount
1000
(200)
(200)
(100)
500
(200)
300
(50)
250
(50)
200
(50)
150
50
200
37.5
237.5
All figures of above are estimation made by responsible party using historical data if any and future forecasts.
All figures are assumed as cash basis receipt and payment. If any credit sales are made then it is to be deducted from NOCFAT and Cost whose payments are due are to be added in NOCFAT because we are computing cash inflows and outflows.
Depreciation has been written in calculation only for the purpose of computing profit before tax for levying tax. As it is not actually cash outflow, for nullifying the effect of depreciation, it has been added back.
Interest expenses are long term expenses. Interest expense has also been deducted from cash flow because we are computing the feasibility of total investment i.e. Equity + Long term debt.
The rate at which those cash flow will be discounted is computed through after tax cost of long term debt and equity. Hence, on discounting interest will be automatically discounted from the given cashflows.
We are computing cashflows from long term funds point of view, so its not logical to show repayment of term loan as outflow.
3. Terminal cash flow: It is the cash flow which will happen at the end of the useful life of the asset. They are salvage value of the asset and release of working capital. These are also discounted into present value for making capital budgeting decisions.
Hence, we can conclude that on capital budgeting decisions are made only based on cash flows.
Important points to be considered while computing cash flows:
- Ignore sunk cost: Sunk cost are those whose cost have already been incurred and are irrelevant for decision making. Even if the project is not being carried out, these cost cannot be controlled. Example: Cost of research and development & market survey
- Consider opportunity cost of the project. The cashflow that entity forgone if entity accepts the project is opportunity cost. For eg. if the project requires land then the opportunity cost will be rental income from land. This will be deducted from cash flow computed.
- Ignore existing allocated overhead such as head office expense
- Consider additional overhead expenses due to project, if any.
2. Given the cash flow how do we decide whether the project is viable or not?
We could fund capital investment from our own fund or debts or both. Debt could be long term and short term. Short term debts contribute to cash requirement for short period of time such as credit from suppliers, bank overdraft which do not count as initial funding source it is deducted from current asset to come to net current asset.
Initial investment is made by long term sources of finance. They need certain return on their investment.
Long term debt require cost of debt and Equity shareholder requires cost of equity. The weighted average of both funds cost is called weighted average cost of capital. These cost can be estimated from risk of the project plus rates prevailing in market.
For eg.
- Cost of debt (Kd)= 10%
- Cost of equity (Ke)= 15%
- Debt equity ratio= 1:1
WACC=
- Kd(1-t) x weight of equity/total weight of fund + Ke*weight of equity/total weight of fund
- 10%(1-0.75) x 1/2 + 15%*1/2
- 11.25%
This rate (i.e 11.25% in eg.) is the hurdle rate in capital budgeting. Project will be viable only if it generates post tax per annum return greater than cost of capital.
There are three popular criteria for checking the viability of project:
- Net present value
- Profitability index / Benefit-cost ratio/ Desirability ratio
- Internal rate of return
Net present value shows the net addition to the wealth of shareholder. It is difference between present value of cash flow and present value of cash outflow. NPV is derived from concept of time value of money
For instance: You have amount 100,000/- now. The value of 100,000/- now and after 1 year is different, the value after 1 year is less valuable because inflation erodes its purchasing power. If the same amount is invested now it will provide you with interest (Lets say: at 10% interest). Hence, the value of 1,00,000/- now is 110,000/- after 1 year. That’s how time value of money works.
There may be a mutually exclusive projects that we have to make decision upon or only a single project to make its decisions
Special decision making situation like make or buy decision, we could have to make decision about whether to make or buy a product or material.
For eg: A company sells lamp. There may be variety of lamps whose price differs from certain range. It introduce a new lamp, which can be made in own factory or bought from the suppliers. The sales price per unit of lamp is 200/-. On production it has to invest amount 100,0000/- having useful life of 5 years( SLM depreciation), cost of production per lamp is 50/-. Supplier quotes price of 60/- per lamp. How a company makes a decision? Tax rate is 40% and cost of capital is 15%. Estimated sales unit is 50,000 units per annum.
Solution:
Separate alternative- Cost approach
- Sales amount: 50,000 x 200 x .6 = 60,00,000/-
- Post tax cost of buying per unit- 60 x .6= 36
Alternative I: Buy the lamps
- Post tax cost per unit = 60 x .6 = 36
- Annual requirements of lamp = 50,000
- Annual cost= 50,000 x 36= 18,00,000/-
- Net present value= (Sales receipt -Annual costs) x PVAF(15%, 5)= 42 lakhs x 3.3516= 1,40,76,720/-
Alternative II: Make the lamp
- Post tax cost of production per unit= 50 x .6 = 30
- Annual cost of production= 30 x 50,000 = 15,00,000/-
- Depreciation: 10,00,000/5 = 2,00,000/-
- Tax saving on depreciation: 2,00,000 x .4 = 80,000/-
- Annual net cost of production= 15,00,000 – 80,000/- = 14,20,000/-
- Net Present value= (Sales receipt -Annual costs) x PVAF(15%, 5) x Annuity factor(15%,5)- initial outflow = x 3.3516 – 10,00,000= 1,43,50,328/-
Decision : NPV under producing lamp has come lower by 2,73,608/- . Hence, the lamp should be produced.
Note: sales price is same under both
Alternative Solution:
Let us make decision as per incremental approach:
We will compute net advantage of making the lamp instead of buying
- Cost of buying- 60/unit
- Cost of making- 50/unit
- Saving – 10/unit
- Post tax saving- 6/unit
- Quantity – 50,000/-
- Annual net cost saving on producing lamp= 6 x 50,000 = 300,000/-
- Annual tax savings from depreciation = (10 lakhs’/5) x 0.4= .8lakhs
- Annual savings on making=Annual net saving on producing lamp +Annual tax savings from depreciation = 300,000/-+.80,000/- = 3,80,000/-
- Present value of net advantage of producing lamp= Annual saving on making x Annuity factor(15%,5) – Initial outflow =3,80,000 x 3.3516 – 10,00,000 = Rs. 2,73,608/-
