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Capital Budgeting
Capital Budgeting is the process of identifying, analyzing and
selectinginvestment projects whose returns areexpected to extend
beyond one year.
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Capital Budgeting involves-
Generating investment projects consistent with thefirms
strategic objectives
Estimating after tax incremental operating cash flow Evaluating
incremental operating cash flow Selecting projects based on value
maximizing
criterion
Reevaluating implemented projects continually andperforming
postaudits for completed projects
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Types of Projects
New product or expansion of existing products Replacement of
equipment or building
Research and Development Exploration Other9safety related or
pollution control
devices)
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Characteristics of project flows
Cash flow (not accounting flow) Operating cash flow (not
financing)
After tax flow Incremental flow
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Basic principles in estimating projectflow
Ignore sunk cost Include opportunity cost
Include project driven changes in NWC Include effects of
inflation
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Calculating incremental CF
Initial Cash Outflow Interim incremental cash flow
Terminal cash flow
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Basic format for estimating ICO
Cost of new asset+ Capitalized exp. (installation/shipping
cost)
+(-) Increase (decrease) in NWC- Proceed from the sale of old
asset
(Replacement)
+ (-) Tax (tax advantage) due to sale of old asset(Replacement)=
ICO
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Basic format for estimating InterimIncremental CF
Inc. (dec.) in operating revenue less (plus) inc.(dec.) in
operating exp.
- (+) Inc. (dec.) in depreciation charges= Net change in income
before tax- (+) Inc. (dec.) in tax= Net change in income after
tax+(-) Increase (decrease) in depreciation charges= Interim
Incremental CF
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Basic format for estimating TerminalCF
Inc. (dec.) in operating revenue less (plus) inc. (dec.) in
operatingexp.
- (+) Inc. (dec.) in depreciation charges= Net change in income
before tax- (+) Inc. (dec.) in tax= Net change in income after
tax+(-) Increase (decrease) in depreciation charges= terminal CF
before wind up consideration+ Final salvage value-(+) tax (tax
advantage) due to sale of asset= Terminal CF
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Asset expansionNew asset price= Tk. 100000Useful life= 4 years3
year property classInstallation cost= Tk. 15000Salvage= Tk.
15000Tax rate= 35%Depreciation basis= Tk.100000
Net operating revenueyr. 1- Tk. 34267
yr. 2- Tk. 38260yr. 3- Tk. 57372yr. 4- Tk. 32358
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Asset Replacement
New asset price= Tk. 18000Useful life= 4 years3 year property
classInstallation cost= Tk. 2000
Salvage of new equipment= Tk. 2500Old equip wont have any
salvage Old equip remaining life = 2 yr.Old equip original life
4yrs.
3 year property classOld equip depreciation basis= Tk. 8000Tax
rate= 35%Net operating revenue Tk. 7100
