Capital Budgeting Decisions: A Primer

BM63002: Corporate Finance

13 Jan. 2020
 Prologue
• Capital Budgeting: An introduction
• Capital budgeting decisions
• Factors to be considered for such decisions
• Relevant cash flows
• Effect of texes
• Depreciation
• What else?
• Various techniques of project evaluation
• Pay Back Period
• Accounting Rate of Return
• Net Present Value
• Internal Rate of Return
• Profitability Index
• Modified IRR
• Which one to go for?
• NPV vs. IRR: The Battle of the Equals
 Background
• Time value of money
• A rupee today is worth more than a rupee tomorrow!
• Discounting technique: Present value of money
• Compunding technique: Future value of money
• Corporate strategic decisions
• Why do firms invest in projects?
• Long-term projects vs. short-term projects
• Project types: Replacements and mutually exclusive
projects
• Capital-intensive decisions, firm’s value, and market’s
reactions
• Accountning terminology
• Profits
• Cash flows
• Depreciation
• Interest rates
• Working capital
1. Capital Budgeting Decisions: Basics and not-so
basics!
 Capital Budgeting: An Introduction

The process of evaluating and selecting long-term

investments that are consistent with the firm’s goal of
shareholders’ wealth maximization.
• Long-term capital expenditure: benefits expected for more
than one year (typically!)
• Strategic in nature
• Involves huge outlays of funds
• Not easily reversible
• Huge costs/impact: financial, operational, and
reputational!
 Capital Budgeting: Some examples
1. 2000: Airbus Industrie proposed to develop a super jumbo jet
(VLA with seating capacity of 550-990 passengers) with
development cost of $13 billion. List price $216 million;
competition from Boeing’s 747.
2. 2006: Advanced Micro Devices (AMD)’s decision to invest $2.5
billion to set up chip production facilities in Dresden, Germany,
for manufacturing 12-inch silicon wafers (instead of existing
8-inch wafers). Market dominance desired; competition from
Intel, Inc.
3. 2009: GoI’s decision to set up UIDAI to issue a unique
identification number that can be verified and authenticated in
an online, cost-effective manner, for every citizen of India. About
Rs. 4,000 Crore spent; 60 crore persons registered. Benefits!
Rationale!
4. 20XX: An undergrad’s decision to select a graduate school.
Substantial monetary costs (may be not!); Career & life
uncertainties; financial, reputational & other rewards.
 Capital Budgeting: Issues and concerns

1. Risk and uncertainties: The future is uncertain!

• Whole gamut is about forecasting (cashflows, demand,
supply, price, risk, etc.)
2. Time value of money: Logically incomparable.
• Cashflows occur at different time period.
3. Not everything quantifiable: Some intangible benefits.
• It’s not possible to calculate such benefits in strict
quantitative terms.
4. Subjectivity: My game, my rule!
• Biasness towards certain projects for some reason(s) or
others.
• Agency problem.
 Capital Budgeting Decisions
Types of capital budgeting decisions confronted by corporations:
1. Accept-reject decision: Fundamental decision
• If proposal accepted, invest; otherwise, no!
• Criterion: Accept if rate of return > required rate of return i.e. cost of
capital
• All independent projects accepted(Rare in reality!!)

2. Mutually exclusive project: The best one may be

chosen out of several competing projects.
• The acceptance of the ’best one’ automatically eliminates other
alternatives.
• Evaluation and selection done on ’some’ criteria.
• Whether to invest in new machine!

3. Capital rationing decisions: Limitation of available

funds makes choice to invest difficult!
• More acceptable investment projects than we can finance.
• Multiple projects required.
• Ranking of projects based on importance, RoR, etc; then funds
allocated.
Capital Budgeting Decisions: Accept-reject decision

• A company, Bharat, Inc., wants to launch its product,

IndoCell, in six major markets, say Delhi, Chennai,
Bangalore, Ahmedabad, Kolkata, and Mumbai.
• It evaluates the expected cashflows from future sales from
all the territories, and the associated costs.
• Based on the expected RoR, it can launch its product in all
those territories where it expects the revenues exceeding
costs.
• If all regions give positive return, go for all; if none gives
positive return, drop the idea, and so on.
Capital Budgeting Decisions: Mutually exclusive
projects

• Your neighboring Vishnu Xerox is planning to buy an

advanced photo-copying machine that requires an
investment of Rs. 2,00,000.
• It approaches 5 vendors for quotations, who give different
price lists for various models of xerox machine.
• Vishnu Xerox may evaluate the costs of each option with
expected earnings from the same.
• He should go for the one that gives highest RoR.
• Other quotations/options automatically get cancelled.
Capital Budgeting Decisions: Capital rationing

• IIT has established a fund of Rs. 10 crore to be invested in

innovative proposals attracted by the Center for Innovation
(Cφ).
• In year 2016, it receives proposals worth Rs. 15 Crore, but
all the proposals were really good.
• It may evaluate the expected yield from each projects, rank
them based on their RoR, and then allocate proportional
funds on priority basis.
• Subsequent funding, as and if required, can be recouped
from the cash generated by the proposed projects in the
meantime.
Factors being considered in capital budgeting

• Projects evaluated on the basis of estimated future benefits

accruing from the investment.
• Firms more interested in economic value of a project:
• Economic costs (Cash outflows) vs. economic benefits (Cash
inflows)
• Two alternative approaches to quantify the benefits:
• Accounting/book profit: includes non-cash items, and
• Cash flows: includes actual cash flows.
• Cash flow approach superior performance criteria:
• Economic value of a project being considered
• No accounting ambiguities
• Easy to account for TVM
Factors being considered in capital budgeting...

Table: Accounting profits vs. cash flows

Accounting Approach Cash flow approach

Revenues Rs. 1,000 Rs. 1,000
Less: Expenses:
Cash expenses 500 500
Depreciation 300
EBT 200 500
Taxes 35% 70 70
Net Income/Cash flow 130 430
 Factors being considered in capital budgeting...
Incremental Cash Flows: Only the differences due to the
decision need to be considered.
• The cash flows (only those cash flows) directly attributable
to the investment are taken into account.
• e.g. Fixed overhead costs (which remain same) not
considered.
• However, any increase in such expenses due to the
acceptance of the proposal is considerd.
Example: B-Tel, Inc. is considering replacing their existing manufacturing unit
with a new, improved unit that will cost $35 million including installation and
shipping costs. This will increase their annual revenue from $20 million to $35
million. Their annual cash costs will also increase from $10 million to $12.5
million.
Only incremental cash flow ($2.5 million) be considered.
 Factors being considered in capital budgeting...
Effect of Taxes: All the cash flows are adjusted for tax
liability.
• Taxes paid deducted from the cash flows
• More important in case of incremental cash flows
• Examples: Wait!

Table: Relevant and irrelevant outflows for tax consideration

Relevant Cash Outflows Irrelevant Cash Outflows
Variale labor expenses Eixed overhead expenses (existing)
Variable material expenses Sunk Costs
Addl. fixed overhead expenses
Cost of the investments
Marginal taxes
 Factors being considered in capital budgeting...

Effect of Depreciation:Non-cash expenses, deductible

expenditure in determining taxable income.
• Provision in the books of accounts as per Schedule XVI of
the Companies Act.
• Charged at a prescribed rate for each category of assets.
• Methodolgies differ:
• SLM: Flat depreciation over the life of the assets
• WDV: Based on the book value of assets
• Being a non-cash item, added back to the profits while
calculating relevant cash flows
• Only for the block of assets being considered for replacement
• Relevant period depreciation
 Factors being considered in capital budgeting...

Working Capital Requirements: NWC = Current Assets -

Current Liabilities (directly related to the investment project)
• Any change in revenue brings in change in working capital
as well (mostly!).
• The increased working capital: part of the initial cash
outlay.
• Such working capital requirements can be at any point of
time during the life of a project.
Determining relevant cash flows

Table: Cash outflows

Head Rs./$
Initial costs of new project
(+) Installation costs, etc.
(±) Working capital requirements
Total Cash Out Flows
 Determining relevant cash flows

Table: Cash Inflows

Head T1 T2 T.. TN
Revenues
Less: Cash operating costs
CFBT
Less: Depreciation
Taxable income
Less: Taxes
EAT
Add: Depreciation
CFAT(BD)
Plus: Salvage value (in nth year)
Plus: Recovery in WC, if any (in nth year)
Total Cash Inflows
 Example 1

B-Tel, Inc. is considering replacing their existing manufacturing unit

with a new, improved unit that will cost $35 million including
installation and shipping costs. This will increase their annual
revenue from $20 million to $35 million. Their annual cash costs will
also increase from $10 million to $12.5 million. The life of the
machinery is expected to be 5 years and it was decided to be
depreciated using straight-line depreciation approach. If the company
is in the 30% tax bracket and if the applicable discount rate is
8%, should the company go ahead with the investment in the new
manufacturing unit?
Assume that the company can sell the existing unit for $5 million,
which is the book value of the unit. Annual depreciation on the
existing unit is $1 million. The new unit will become obsolete and be
abandoned after 5 years of usage.
 Key factors

Given:
• Cash outflow = $35 mn
• Sale value of old unit = $ 5 mn
• Annual incremental revenue = $15 mn
• Annual incremental cash cost = $2.5 mn
• Life of unit: 5 years
Other info:
• Depreciation: $ 1 mn p.a. (SLM)
• Tax rate: 30%
• Required rate of return: 8%
Whether to invest in new manufacturing unit?
 Pretty simple, isn’t it?

Table: Calculating NPV

$ million $ million
Cash outflow at t0 35.0
− Sale value of old unit (5.0)
− Tax advantage on sale of old unit (0.0)
Total (5.0)
(I) Net Cash Outflows 30.0
Incremental cash inflows (t1 − t5 ):
Revenue ($ 35 − $20) 15.0
Cash costs ($ 12.5 − $10) (2.5)
Depreciation ($ 7 − $ 1) (6.0)
EBT 6.5
− Tax @ 30% (1.95)
EAT 4.55
+ Depreciation 6.00
Net annual cash inflow 11.55
(II) PV of Cash inflows (r = 8%, t = 5yrs) 67.7
NPV (II) − (I) 37.7

Considering replacement? Go for it!

 What next?

We have cash outflows and expected cash inflows from the

project being considered for investment.
• Decision: Inflows > Outflows, Go for it!
What about these?
• Time value of money: cashflows occurring at different
points of time
• Risk and uncertainties: how to account for?
• Intangible benefits!
• Agency problem (!!!)
2. Capital Budgeting Decisions: Tools & techniques
 Q2
Gurgaon Chemicals supplies chemicals and dyes to various units in and around
Delhi NCR. The onsite delivery of chemicals and dyes every month is 2,000
units. The unit sale price is Rs.100. The cost per unit is Rs.50. It is using
a tempo which can carry a maximum of 80 units. The total distance covered in
one trip is 400 kms. The cost of diesel in the Delhi NCR is Rs. 55.5 per liter. The
average consumption of diesel is 8 kms per liter.
Due to increase in demand for dyes for industrial use, Gurgaon Chemicals has an
opportunity to make and deliver 2,500 units per month. To cater to the
increased demand, the company is contemplating buying a mini truck with a
capacity to carry 165 units. The required mini truck is available from Eicher for
Rs.14,00,000. The tempo being currently used has a book value of Rs.6,00,000.
It can be sold for Rs.4,00,000. The annual salary of the tempo driver is Rs.6,000
per month. If the mini truck is acquired, the company would have to increase his
monthly salary to Rs.8,000. The consumption of diesel by the truck would become
average of 5 kms per liter. The annual maintenance cost of the mini truck would
be Rs.8,500 compared to Rs.6,200 maintenance cost of the tempo. The company
uses straight-line method of depreciation for taxation purposes. The tempo has a
remaining useful life of 5 years. The applicable tax rate is 35%. Assume that
loss on sale of existing machine can be claimed as short-term capital loss in the
current year itself.
Nitin Jain, the CEO of the company, has approached you to examine the financial
viability of the proposal to replace the tempo by the mini truck and make
appropriate recommendations in this regard. Assume a required rate of return of
14 per cent.
 Key points
Given that:
• Cash outflow at t0 = Rs. 14,00,000

• Sale value of tempo = Rs. 4,00,000

During t1 through t5 :
• Incremental sale: 500 units p.m.
• Incremental salary to driver: Rs. 2,000 p.m.

• Incremental maintenance cost: Rs. 2,300

Misc. info:
• Tax rate = 35%

• Required rate of return = 14%

Factors to be considered:
• Tax advantage on sale of tempo = ?
• Diesel charges = ?

• Incremental depreciation = ?

Whether to go ahead with replacements?

 Some preliminary calculations

Table: Calculation of tax advantage on sale of tempo

Rs.
Current book value of tempo 6,00,000
Sale value 4,00,000
Loss on sale 2,00,000
Tax advantage @35% ×0.35
(Rs. 70,000)

Table: Calculation of incremental depreciation

Rs.
Rs.14,00,000
Depreciation on truck 5 2,80,000
Rs.6,00,000
Depreciation on tempo 5 1,20,000
Incremental depreciation 1,60,000
 Table: Calculation of savings on diesel costs

Truck Tempo
Mileage KM/litre 5 8
KMs per trip 400 400
2500units
Trips/month 165units/trip 15 -
2000units
80units/trip - 25
KMs annually 12m × 15 × 400 72,000 -
12m × 25 × 400 - 1,20,000
72,000
Diesel consumed 5 14,400 -
1,20,000
(in litres) 8 - 15,000
Total cost 14, 000 × Rs.25.5 Rs. 3,67,700 -
15, 000 × Rs.25.5 - Rs. 3,82,000

Savings in diesel costs = Rs.3, 67, 700 − Rs.3, 82, 000 = (Rs.15, 300)
 Table: Incremental cash outflow in t0
Rs. Rs.
Cost of truck 14,00,000
− Sale value of tempo (4,00,000)
− Tax advantage on sale of tempo (70,000) 9,30,000

Table: Incremental cash inflows in t1 - t5

Rs. Rs.
Incremental revenue (500u × 12m × Rs.100) 6,00,000
− Incrmental costs:
Costs of add’l units 3,00,000
Diesel costs (15,300)
Maintenance costs 2,300
Driver’s salary (Rs.2, 000 × 12m) 24,000
Depreciation 1,60,000 4,71,000
EBT 1,29,000
− Taxes @ 35% 45,100
EAT 83,850
+ Depreciation 1,60,000
Cash flow after tax before depreciation 2,43,850
 Table: Calculation of Net Present Value
Rs. Rs.
Total incremental cash outflows 9,30,000
Annual incremental cash inflow (t1 − t5 ) 2,43,850
PV of agg. incr. cash inflows
r = 14%, t = 5y 8,37,137
NPV (92,863)

Decision: No Replacement!
 Q3

Maharatna Ltd. Is interested in finding the cash flows associated with

the replacement of an old machine with a new machine. The old
machine was bought a few years ago, and has a book value of Rs.
30,00,000, and a resale value of the same. It is expected to be used for
another five years after which its salvage value will become Nil. It is
being depreciated annually at 10% using written down value method.
The new machine will cost Rs. 100,00,000. It is expected to fetch
Rs. 60,00,000 after five years when it will no longer be required. It
will be depreciated annually by 10% using WDV method.
The new machine will, however, bring a savings of Rs. 30,00,000 in
terms of reduced manufacturing costs. However, investment in
working capital would remain unaffected. The tax rate applicable is
50%. Formulate the cash flows associated with the project.
 Table: Computing (absolute) cash flows

Year Outflows Book value Dep. @ 10% Sale value Savings Total
0 (100) 30 (70)
1 100 10 30 30
2 90 9 30 30
3 81 8.1 30 30
4 72.9 7.3 30 30
5 65.6 6.6 59.5* 30 89.5
Total (100) ??

* Here, Book value of machine < Sale value. Hence, net sales proceed from
machine at the end of t5 = Sale value − T (Gross sale value − Book value), where
T is prevailing tax rate i.e. 50%.
 Q4
Thoma Pharmaceuticals Company may buy DNA testing equipment
costing $60,000. This equipment is expected to reduce clinical staff
labor costs by $20,000 annually. The equipment has a useful life of 5
years, but falls in the 3-year property class for cost recovery
(depreciation) purposes. No salvage value is expected at the end. The
corporate tax for Thoma is 38 per cent, and its required rate of return
is 15 per cent. (If profits before taxes on the project are negative in
any year, the firm will receive a tax credit of 38 per cent of the loss in
that year.)
1. On the basis of this information, what is the net present value of the
project? Is it acceptable? Suppose that 6 percent inflation in labor cost
savings is expected over the last 4 years, so that the savings in the first year
are $20,000, savings in the second year are $21,200 and so forth.
2. If the required rate of return is still 15 percent, what is the net present
value? Is it still acceptable?
3. If the working capital requirement of $10,000 were required in addition to
the costs of the equipment and this additional investment were needed over
the life of the project, what would be the effect on net present value? (All
things are the same as in part (b)).
 Table: Cash flow estimation

Y1 Y2 Y3 Y4 Y5
1 Savings 20,000 20,000 20,000 20,000 20,000
2 Depreciation, new
3 Profit before tax (1)−(2)
4 Taxes @ 38%
5 Operating Cash Flow (1)−(4)
6 Salvage value ×(1 − 0.34)
7 Net Cash Flows

Incremental cash out flows: Cost − Sale of old equipment − Tax savings on book
loss
Net Present Value: A Primer
 Back to NPV

”Everything you (never) want to know about NPV.”

Cj
• P VConstantAnnuity = Σnj=0 (1+r)
j

C (1+g)2
• P VGrowingAnnuity = r−g (1 − (1+r)2
)
• P VP erpetuity = Cr
• P VGrowingP erpetuity = C
r−g
• Delayed perpetuity
• Payments occuring at the end of period
• and what else...
 Some more varients...

Try this out:

• Variable interest rates: What if rt1 6= rt2 and so on?
• When further investment is required in future, say in t3 or
t5 ??
• If my proposed project suggests a positive NPV, does
this guarantee a profit at the end of the period?
• Only if borrowing and lending rates remain same over the
period.
• In case any of the assumptions fails, calculate actual cash
flows.
 Perspectives matter...

• Risk attributes
• Sources of funding: Capital structure
• Business objectives, of course!