CAPITAL BUDGETING
CAPITAL BUDGETING
Incremental Cash Flows
o Focus on changes in firm’s cash flows. Compare expected
future cash flows with adopting the project and expected future
cash flows without adopting the project (With & without
principle). Analyse the differential cash flows!
o Project can be looked at and analyzed as a minifirm (NPV)
o Our concern is with cash flows from proposed project,
financing cost should not be included in the cash flow
budgeting (discounting!!!).
Sunk cost
o Costs incurred prior to (adopt/reject) decision are irrelevant.
o e.g. R&D, Consultant’s fee for conducting feasibility, previously
bought in items, items already owned.
o Example: A project requires an immediate investment of Rs. 100 m
(R&D), expenditure next year is expected to be Rs. 120 m on
production facilities, which is expected to produce a NCF of Rs. 80 m
for the next 5 years. The required rate of return is 14%.
Analysis 1
0 1 2 3 4 5 6 NPV IRR
-100 -120 80 80 80 80 80 PKR 35.65 20% Accept
Analysis 2
-1 0 1 2 3 4 5
-140 -150 70 70 70 70 70 (PKR 49.68) 6% Reject
Analysis 3
0 1 2 3 4 5
-150 70 70 70 70 70 PKR 79.22 37% Accept
o Conclusion: Bygones are bygones; consider the costs that could still
be avoided/covered; always perform Scenario and Sensitivity
Analysis.
**SAQIB ALI** 1
CAPITAL BUDGETING
Opportunity Cost
o Foregoing the opportunity to generate cash from an available
alternative is as much a cost as an explicit cash expense. Such
opportunity costs must be accounted for in capital budgeting (cash
equivalents).
o Situations:
Old land already owned but which is not currently in use and
has no alternative except that it can be sold.
Original cost and book value = Rs. 1,000,000 (acquisition was
4 yrs back)
Resale value = Rs. 1,500,000
If this land could be used for a proposed project, the correct
cost is ?
Material stock on hand valuing Rs. 10,000 as per books.
Current market price is Rs. 11,000 and the same stock could be
sold to a neighboring factory for Rs. 9000. The available stock
on hand can be utilized in production of a proposed product.
What is the appropriate cost?
A project requires 100,000 c/feet of storage space, and the
company has a warehouse with space capacity of 120,000
c/feet. What is the opportunity cost of using this space capacity
if there is no other use?
Overhead costs.
o Don’t allocate (e.g., a capital intensive project; Co. allocates OH on basis
of labour hours. What to do?)
o The only OH costs which should be included in the appraisal of a
proposed investment are the additional OHs which can be anticipated if
the investment is undertaken.
Working Capital (Net)
o Most projects require some use of WC
o Provision of WC can be balanced off against CL; but, sometimes
additional provision has to be made through cash.
o Investment in NWC should be recovered at the end of the project life.
o Cash flows for NWC must be included in the analysis so as to allow for
time cost of money. (PV of outlay > PV of inflow – difference represents
the PV of the interest cost).
o It is the investment in WC not the required level of WC that determines
the correct cash flows relevant to WC.
o Example:
0 1 2 3 4 5
Required level (@ cost) 100 200 250 250 250 0
Inv / Recovery -100 -100 -50 0 0 250
**SAQIB ALI** 2
CAPITAL BUDGETING
Practice Cases:
Capital Budgeting, Case 1.
The management of ABC Dairy Company is considering the purchase of a
new bottling machine which is expected to reduce handling costs by Rs.
8,000 per annum. This machine costs Rs. 50,000 and is expected to have a
working life of 10 years. It is anticipated that it could be sold for scrap at the
end of this period for Rs. 4,000. The machine would replace existing
equipment which cost Rs. 30,000 five years ago. The equipment is being
depreciated for tax purposes over a ten year period on straight-line method
and has a current tax based book value of Rs 15,000. Although the existing
equipment requires maintenance costing about Rs. 1,000 per annum, an
expense that would not be incurred if the new machine is adopted; it could
be kept in operation for another 10 years or so. If it is sold now it would
realize about Rs. 2,000.
Is this a profitable investment if the company required a 10 percent return
and tax rate is 40 percent?
**SAQIB ALI** 3
CAPITAL BUDGETING
Capital Budgeting Case 2.
The pharmaceutical division of Amost Chemicals ltd is ready to introduce a
new pain killer designed to focus on muscle injuries incurred by athletes.
The product is the result of a major research and testing programme. The
expenditure incurred on the development of the product already amounts to
Rs. 10 million. To launch the product it will be necessary to spend Rs. 1.5m
on advertising and marketing. The product is expected to sell for Rs. 4 per
package and it is anticipated that sales in the first year will be about 3
million packages, risign to 4 million in year two and staying at this level for
the following three years. It is anticipated that amore effective painkiller will
be available by year five and the product will be withdrawn from the market.
Whilst the product’s life is limited it is expected to provide the company
with valuable experience of new market. The sales expected are lower than
those anticipated when the research on the product started, and this means
that the project’s profitability will also be lower than initially anticipated.
The finance director believes that it is unlidely that the product will allow
the companyh to revocer its expenditure on research, and he favours
abandoning the project now.
To manufacture the medicine it will be necessary to invest Rs. 17 m in
equipment. This equipment will be depreciated for tax purposes on a straight
line basis over five years. It is anitcipted that it will have a residual value of
Rs. 2 million at the end of the five years. The production facility will be
located in one of the company’s existing factories. It will be allocated an
annual cost of Rs. 0.3m based on the rental cost of the building and the floor
space it will occupy. The fixed costs directly attributable to the production,
including, for example, supervisory wages, are expected to be Rs. 0.8 m per
annum, and annual advertising and marketing costs will be Rs. 0.6 m. Each
product sold by the company is allocated an overhead charge equivalent to
20 percent of sales. The overheads include the company’s head office
expenses and research and development expenditure. The direct cost of
producing a package of the painkillers will be Rs. 1.5 per package. The
company will need to hold finished stocks of the medicine equivalent to 20
percent of the sales expected in the subsequent year. The increase in debtors
as a result of introducing the product will be offset by the increase in
creditors. The company requires a rate of return of 16 percent on
investments of this nature, and tax rate is 40 percent.
You as the manager finance, discuss with the director the likely outcomes
from the project.
**SAQIB ALI** 4
CAPITAL BUDGETING
Capital Budgeting Case 3
The Strathclyde Manufacturing Company is considering the possibility of
expanding the output of one of its standard products to meet a new order.
The anticipated order is large in relation to the company’s usual business. It
is for 2,000 units for each of the next four years at a special price of $50
each. The Marketing and Production Director wishes to accept the order but
the Finance Director has some reservations as the profit margin is lower than
the company’s usual business.
To undertake the order the company will have to invest in a new machinery
costing $100,000. This would be sold at the end of the contract for about $
30,000. In addition, it will have to use equipment that had been employed in
the production of other items which have now been discontinued. This
equipment is fully written off for tax purposes, but has a net of tax second
hand value of $50,000. There would be no need to invest in any new
buildings as space is available in the company’s existing factory. An
investment of $15,000 in stocks of raw material would be necessary at the
start of production.
The Finance Director has provided the following analysis of the proposed
transaction:
Annual Revenues (2000 @ $50) $ 100,000
Annual Expenses
Raw Material $ 30,000
Wages 10,000
Other expenses 5,000
Share of overhead 10,000
Depreciation (St. Line) 25,000
(80,000)
Annual Profit before Tax $ 20,000
For tax purposes the machinery can be depreciated at 25 percent reducing
balance method. The company expects a corporate tax at 35 percent, payable
one year in arrears. The company usually requires a minimum rate of return
on investment of this nature of 10 per cent.
**SAQIB ALI** 5
CAPITAL BUDGETING
The Managing Director would like the analysis of the project to be taken
further on the basis of NPV. He would also like to see the main assumptions
underlying the analysis.
**SAQIB ALI** 6