Capital budgeting deals with the allocation of funds to competing projects; they involve commitment of funds to receive future benefits.
Characteristics of Capital Budgeting Decisions
- They involve investment in fixed assets whose useful life is more than the effect of the investment decision and therefore felt longer
- They affect the firm’s cash flows and therefore may change the risk complexion of the firm.
- They affect the company’s profitability and therefore will affect the valve of the firm.
- Most are irreversible because it is difficult to get a second hand market for fixed assets
Steps in Investment Decisions
- Generating investment proposals
- Estimating future cash flows
- Evaluating the cash flows
- Making the selection decision & implementation
- Re – evaluation (for replacement decision)
Generating Investment Proposals
Usually, investment proposals are generated by other departments, not the finance department. E.g. the marketing department will generate proposal on new product development; production department would generate replacement proposals; Research
and development would come up with new technology, exploration etc. Other external sources include the government through law legislation, competitors etc.
Estimating Cash Flows
In capital budgeting we are interested in after tax incremental cash flows. We are interested in operating as opposed to financing cash flows. In calculating the incremental cash flow, it is helpful to place the project cash flows in to three categories based on timing:
1. Initial cash out flow :The initial net cash investment
2. Interim incremental net cash flows: Those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.
3. Terminal year incremental net cash flow: The final period net cash flow (it is singled out for attention because a particular set of cash often occur at project termination)
Basic Format for Determining Initial Cash Flows
- Cost of new assets
- + Capitalized expenditures (e.g. installation costs, shipping costs)
- + (-) Increased (decreased) level of “net” working capital
- – Net proceeds from sale of old assets(s) if the investment is a replacement decision.
- + (-) Taxes (tax savings) due to the sale of “old” assets if the investment is a\ replacement decision
- = Initial cash out flow
Basic Format for Determining Interim and Terminal Year Incremental Net Cash Flow
- Net increase (decrease) in operating revenue less (plus) any net increases (decrease) in operating expenses excluding depreciation
- – (+) Net increase (decrease) in depreciation charges
- = Net change in income before taxes
- – (+) Net increase (decrease) in taxes
- = Net change in come after taxes
- + (-) Net increase (decrease) in tax depreciation charges
- = Incremental cash flow for the terminal year before project wind up
- + (-) Final salvage valve (disposal/ reclamation) of ‘new’ assets
- – (+) Taxes (tax saving) due to sale or disposal of “new” assets
- + (-) Decrease (increase) level of net working capital
- = Terminal year incremental net cash flow\
Note: Items (a) to (g) constitute interim cash flows while (h) to (k) constitute terminal year net cash flows