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Capital Budgeting & Estimating Cash Flows
Meaning & Significance1. Fixed assets account for
sizeable
proportion of firms total assets and their
life extends over a considerable number
of years.
2. Long-term assets are usually
specialized.3. To maintain the value of corporate
wealth, the management has to visualize
the returns spread over the long life of
the project.
4. It forces co-ordination amongdifferent departments within a
firm.
Types of proposals
1. Expansion
2. Replacement
3. Strategic4. Safety and/or environmental
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Characteristics/Elements of cash flows
1. Initial cash flow Cash Outflow in the form of
gross investment for the purchase of
assets.
Expenditure incurred for making
machines operational.
Opportunity cost of the assets.
Increase in net working capital.
2. Operating cash flow
3. Terminal cash flow
Principles of cash flow estimation1. Separation principle
Investment side
Financing side
2. Incremental principle
Consider all incidental effects Ignore sunk costs
Include opportunity costs
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1. Resource may be rented
out.
2. Resource may be sold.3. Resource is required
elsewhere in the firm.
Question the allocation of overhead
costs
Estimate working capital properly
3. Post-tax principle
Tax rate
1. Average tax rate
2. Marginal tax rate
Treatment of losses
Scenario Project Firm Action1 Incurs
losses
Incurs
losses
Defer tax
savings
2 Incurs
losses
Makes
profits
Take tax
savings in the
year of loss
3 Makes
profits
Incurs
losses
Defer taxes
until the firm
makes profit
4 Makes Makes Consider
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profits profits taxes in the
year of profit
Effect of non cash charges
4. Consistency principle
Investor group
CF to investors=PBIT (1-tax rate)
+ Depreciation and non cash charges
-Capital expenditure-Change in working capital
CF to Equity shareholders=Profit after
tax + Depreciation and non cash charges
-Pref. dividend-Capital expenditure
-Change in working capital
-Repayment of debt
+Proceeds from debt issues
-Redemption of preference capital
+Proceeds from preference capitalCash Flow Discount rate
Cash Flow to all
investors
WACC
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Cash Flow to
equity
Cost of equity
Inflation : NCF = RCF (1+ I)
Biases in Cash Flow Estimation
Overstatement of Profitability
1. Intentional overstatement
2. Lack of experience
3. Myopic euphoria
4. Capital rationing
Understatement of Profitability
Terminal cash flow = Net salvage value of fixed
assets + Net recovery of working capital margin
1. Salvage Values are Under-estimated
2. Intangible benefits are ignored
3. The value of future options is overlooked
