Capital BudgetingCapital Budgeting

25-03-201025-03-2010

Answer the followingAnswer the following What are the finance decisions?What are the finance decisions? What is the finance decision that takes What is the finance decision that takes

care of the assets of the firm?care of the assets of the firm? What is the expenditure which acquires What is the expenditure which acquires

long term benefits for the firm?long term benefits for the firm? What are the steps in capital budgeting?What are the steps in capital budgeting? What are the motives of making capital What are the motives of making capital

expenditure?expenditure? Name a few types of projectName a few types of project

What is capital budgeting?What is capital budgeting?

The process of evaluating and The process of evaluating and selecting long term investments that selecting long term investments that are consistent with the firm’s goal of are consistent with the firm’s goal of maximising owners’ wealthmaximising owners’ wealth

ExpendituresExpenditures

Capital expenditure: (CAPEX)Capital expenditure: (CAPEX) An outlay of funds by the firm that is An outlay of funds by the firm that is

expected to produce benefits over a expected to produce benefits over a period of time greater than one year. period of time greater than one year.

Operating Expenditure: (OPEX)Operating Expenditure: (OPEX) An outlay of funds by the firm An outlay of funds by the firm

resulting in benefits received within a resulting in benefits received within a yearyear

Difficulties in Capital BudgetingDifficulties in Capital Budgeting

Future uncertaintyFuture uncertainty Incomparable periods of cost and Incomparable periods of cost and

benefitsbenefits Non quantifiable costs and benefitsNon quantifiable costs and benefits

Rationale for capital budgeting Rationale for capital budgeting decisionsdecisions

EfficiencyEfficiency Expand revenues – Less certainExpand revenues – Less certain Reduce cost – More certainReduce cost – More certain

Other NamesOther Names

OPEX:OPEX: Operating expenseOperating expense, O, Operational perational

expenseexpense, O, Operational perational expenditureexpenditure

CAPEX:CAPEX:

Distinguish between the capital expenditure Distinguish between the capital expenditure and operating expenditureand operating expenditure

Purchase of a photocopierPurchase of a photocopier Purchase of paper, tonerPurchase of paper, toner Cost of power and maintenanceCost of power and maintenance Establishment of a new plantEstablishment of a new plant Wages to workers in the new plantWages to workers in the new plant Acquisition of a firmAcquisition of a firm Training of a workersTraining of a workers Training of sales forceTraining of sales force

Some new items on capital Some new items on capital budgetingbudgeting

AT & T buys 8 per cent stake in Tech AT & T buys 8 per cent stake in Tech Mahindra for $ 197 millionMahindra for $ 197 million

Maruti Suzuki lines up for Rs. 1260 Maruti Suzuki lines up for Rs. 1260 crore investment to double its crore investment to double its capacity in k-series petrol enginecapacity in k-series petrol engine

Steps in Capital Budgeting ProcessSteps in Capital Budgeting Process

Proposal GenerationProposal Generation Review AnalysisReview Analysis Decision MakingDecision Making ImplementationImplementation Follow-upFollow-up

Key Motives for making capital Key Motives for making capital expenditureexpenditure

ExpansionExpansion ReplacementReplacement RenewalRenewal Other Purposes – Inorganic growth, Other Purposes – Inorganic growth,

Competition, Survival strategy Competition, Survival strategy

Basic TerminologyBasic Terminology

Independent vs. Mutually Exclusive Independent vs. Mutually Exclusive ProjectsProjects

Unlimited Funds vs. Capital RationingUnlimited Funds vs. Capital Rationing Accept-Reject vs. Ranking Accept-Reject vs. Ranking

ApproachesApproaches Conventional vs. Non-conventional Conventional vs. Non-conventional

cash flow patternscash flow patterns

Independent vs. Mutually Exclusive ProjectsIndependent vs. Mutually Exclusive Projects

Independent Projects:Independent Projects: Projects whose cash flows are unrelated Projects whose cash flows are unrelated

or independent of one another; the or independent of one another; the acceptance of one does not eliminate the acceptance of one does not eliminate the others from further considerationothers from further consideration

Mutually Exclusive Projects:Mutually Exclusive Projects: Projects that compete with one another, Projects that compete with one another,

so that the acceptance of one eliminates so that the acceptance of one eliminates from further consideration all other from further consideration all other projects that serve a similar function projects that serve a similar function

Unlimited Funds vs. Capital Unlimited Funds vs. Capital RationingRationing

Unlimited Funds:Unlimited Funds: The financial situation in which a firm is The financial situation in which a firm is

able to accept all independent projects able to accept all independent projects that provide an acceptable returnthat provide an acceptable return

Capital Rationing:Capital Rationing: The financial situation in which a firm has The financial situation in which a firm has

only a fixed amount of funds available for only a fixed amount of funds available for capital expenditures, and numerous capital expenditures, and numerous projects compete for this fundprojects compete for this fund

Accept-Reject vs. Ranking ApproachesAccept-Reject vs. Ranking Approaches

Accept-Reject Approach:Accept-Reject Approach: The evaluation of capital expenditure The evaluation of capital expenditure

proposals to determine whether they meet proposals to determine whether they meet the firm’s minimum acceptance criterion.the firm’s minimum acceptance criterion.

Ranking Approach:Ranking Approach: The ranking of capital expenditure projects The ranking of capital expenditure projects

on the basis of some pre-determined on the basis of some pre-determined measure, such as the rate of return.measure, such as the rate of return.

Conventional vs. Non-conventional Conventional vs. Non-conventional cash flow patternscash flow patterns

Conventional cash Flow Patterns:Conventional cash Flow Patterns: A conventional cash flow pattern A conventional cash flow pattern

consists of an initial outflow followed consists of an initial outflow followed only by a series of inflowsonly by a series of inflows

Non-conventional cash flow patterns:Non-conventional cash flow patterns: An initial outflow followed by a series An initial outflow followed by a series

of inflows and outflowsof inflows and outflows

Relevant Cash FlowsRelevant Cash Flows

The incremental cash outflow The incremental cash outflow (investment) and resulting (investment) and resulting subsequent inflows associated with a subsequent inflows associated with a proposed capital expenditureproposed capital expenditure

Incremental cash FlowsIncremental cash Flows

The additional cash outflows or The additional cash outflows or inflows which are expected to result inflows which are expected to result from a proposed capital expenditurefrom a proposed capital expenditure

Major cash flow componentsMajor cash flow components

Initial investmentInitial investment Operating cash inflowsOperating cash inflows Terminal cash inflowsTerminal cash inflows

Major cash flow componentsMajor cash flow components

Initial Investment:Initial Investment: The relevant cash outflow for a The relevant cash outflow for a

proposed project at time zeroproposed project at time zero Operational Cash Inflows:Operational Cash Inflows: The incremental after-tax cash The incremental after-tax cash

inflows resulting from inflows resulting from implementation of a project during implementation of a project during its lifeits life

Major cash flow componentsMajor cash flow components

Terminal Cash flow:Terminal Cash flow: The after-tax non-operating cash flow The after-tax non-operating cash flow

occurring in the final year of a occurring in the final year of a project. It is usually attributable to project. It is usually attributable to liquidation of the projectliquidation of the project

Expansion vs. Replacement Cash Expansion vs. Replacement Cash flowsflows

Cash Flows for Expansion decisions:Cash Flows for Expansion decisions: Initial InvestmentInitial Investment Operating cash inflowOperating cash inflow Terminal cash inflowTerminal cash inflow Cash Flows for Replacement decisions:Cash Flows for Replacement decisions: ComplicatedComplicated Incremental outflows and inflows of cash Incremental outflows and inflows of cash

need to be identifiedneed to be identified

Replacement Cash flowsReplacement Cash flows

Initial Investment:Initial Investment: Initial investment required to acquire Initial investment required to acquire

new asset – After tax cash inflows new asset – After tax cash inflows from liquidation of old assetfrom liquidation of old asset

Operating Cash Inflows:Operating Cash Inflows: Operating cash inflows from new Operating cash inflows from new

asset – Operating cash inflows from asset – Operating cash inflows from the old assetthe old asset

Replacement Cash flowsReplacement Cash flows

Terminal cash flow:Terminal cash flow: After tax cash flow from termination After tax cash flow from termination

of new asset – After tax cash flow of new asset – After tax cash flow from the termination of old assetfrom the termination of old asset

Cash Flow estimatesCash Flow estimates

Tax effectTax effect Effect on other projectsEffect on other projects Effect of indirect expensesEffect of indirect expenses Effect of depreciationEffect of depreciation

Sunk Cost vs. Opportunity CostSunk Cost vs. Opportunity Cost

Sunk cost:Sunk cost: What is spent and cannot be taken What is spent and cannot be taken

backback Opportunity cost:Opportunity cost: Alternative benefits missed on Alternative benefits missed on

account of a choice/ decisionaccount of a choice/ decision