FINANCIAL MANAGEMENT

ITM-XMBA

Financial Management

Topics to be covered
Capital Budgeting
Concepts
Capital Budgeting Techniques

Problem Solving

Financial Management

Capital Budgeting

Financial Management

Capital Budgeting
Capital Budgeting decisions relate to long-term assets which are in operation and yield a return over a period of time. It therefore involves current outflows in return for series of anticipated flows of future benefits. Such decisions are of paramount importance as they affect the profitability of a firm and are the major determinants of its efficiency and competing power. While an opportune investment decision can yield spectacular returns, an ill-advised/incorrect decision can endanger the very survival of the firm. A few wrong decisions and the firm may be forced into bankruptcy.
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 Capital decisions are faced with a number of difficulties. The two major difficulties are:
1) The benefits from long-term investments are received in some future periods which are uncertain. Therefore, an element of risk is involved in forecasting future sales revenue as well as the associated costs of production and sales.

2) It is not often possible to calculate in strict quantitative terms all the benefits or costs relating to a specific investment decision.

Financial Management

 Capital decisions are of two types, namely:

1) Revenue expanding investment decisions subject to more risk as it is difficult to estimate revenues and costs of a new product line. 2) Cost reducing investment decisions subject to less risk as potential savings can be estimated better from past production and cost data

Financial Management

Accounting Profit v/s Cash Flow Approach

The capital outflows and revenue benefits associated with such decisions are measured in terms of cash outflows after taxes. The cash flow approach for measuring benefits is theoretically superior to the accounting profit approach as it:
Avoids the ambiguities of the accounting profits concepts Measures the total benefits and Takes into account the time value of money.

The major difference between the cash flow and the accounting profit approach relates to the treatment of depreciation.

Financial Management

 While the accounting approach considers depreciation in cost computation, it is recognised, on the contrary, as a source of cash to the extent of tax advantage in the cash flow approach.
Profit as per Cash Flow Approach = Accounting Profit + Depreciation For taxation purposes, depreciation is charged on a block of assets and not on an individual asset. A block of assets is a group of assets (Say of plant & machinery) in respect of which the same rate of depreciation is prescribed by the Income Tax Act. Depreciation is charged on the year end balance of the block which is equal to the opening balance plus purchases made during the year minus the sale proceeds of the assets during the year. In case the entire block of assets is sold during the year, no depreciation is charged at the year end.
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 If the sales proceeds of the block sold is higher than the opening balance, the difference is a short-term capital gain which is subject to tax. In case vice versa, there is a short-term capital loss and the firm is entitled to tax shield on short-term capital loss. Any such adjustment related to the payment of tax/tax shield us made in terminal cash inflows of the projects. (Terminal cash inflows relate to cash flows in the final year of the asset)

Financial Management

What to consider & what to ingnore

The data required for capital budgeting are after tax cash outflows and cash inflows. These cash flows should be incremental in the sense that they are directly attributable to the proposed investment project. The existing fixed costs are therefore ignored for capital budgeting decisions. Incremental after-tax cash flows are the only relevant cash flows in the analysis of new investment projects.

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Categories of Capital Projects

The investments in new capital projects can be categorised into:
(i) A single proposal (ii) A replacement proposal (iii) Mutually exclusive proposals

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Single/Independent Proposals
In case of single/independent investment proposal, cash outflows primarily consist of:
(i) Purchase cost of the new plant & machinery (ii) Its installation costs (iii) Working capital requirement to support production & sales

The cash inflows after taxes (CFAT) are computed by adding depreciation (D) to the projected earnings after taxes (EAT) from the proposal. In the terminal year, the project, apart from operating CFAT, the cash inflows include salvage value (if any, net of removal costs), recovery of working capital and tax advantage/tax paid.
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Replacement Proposals
In the case of replacement situations, the sale proceeds from the existing machine reduce the cash outflows required to purchase the new machine. The relevant CFAT are incremental after-tax cash inflows.

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Mutually Exclusive Proposals

In the case of mutually exclusive proposals, the selection of one proposal precludes the selection of the other(s). The computation of the cash outflows and cash inflows are on lines similar to the replacement situation.

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Capital Budgeting Techinques

The capital budgeting evaluation techniques are as under: 1) Traditional methods
(a) Average/Accounting Rate of Return (ARR) (b) Pay Back (PB) period

2)

Discounted Cash Flow (DCF) methods

(a) Net Present Value (NPV) method (b) Internal Rate of Return (IRR) (c) Profitability / Present Value Index (PI)

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Traditional Methods
ARR Method
The ARR is obtained by dividing annual average profits after taxes by average investments. ARR = Annual Average profits after taxes Average investments Average Investments = (Intial cost of machine Scrap/Salvage Value) + Salvage Value + Net Working Capital Annual average profits after taxes = Total expected after tax profits Number of years. ARR method is unsatisfactory method as it is based on accounting profits and ignores time value of money
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Problem Solving
ARR Method

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Traditional Methods
Pay Back (PB) period Method
This method measures the number of years required for the CFAT to pay back the initial capital investment outflow, ignoring interest payment. It is determined as follows:
In case of annuity CFAT: Initial Investment Annual CFAT In case of mixed CFAT: Calculated by obtaining the cumulating CFAT till the cumulative CFAT equals the initial investment.

Although the pay back period method is superior to the ARR method in that sense that it is based on cash flows, it also ignores time value of money and disregards the total benefits associated with the investment proposal.
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Problem Solving
Pay Back period method

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Discounted Cash Flow (DCF) method

The DCF methods satisfy all the attributes of a good measure of appraisal as they consider the total benefits (CFAT) as well as the timing of benefits. The concept of time value of money comes in use in the DCF methods. Time value of money refers to ascertaining the value of money to be received in future in context of the present value. Rs 100 received today is more valuable than the same Rs. 100 received after one year. Rs. 100 to be received after one year will not be treated at the same value today. It may be equivalent to only Rs. 90 received today.
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Discounted Cash Flow (DCF) method

Net Present Value (NPV) Method
The NPV may be described as the summation of the present values of: (i) operating CFAT (CF) in each year, and (ii) salvage values (S) and working capital (W) in the terminal years (n) minus the summation of present values of the cash outflows (C O) in each year. MINUS the present value of Capital Investment done today NPV = PV of Cash Inflows (-) PV of Capital Investment The NPV is computed using the cost of capital (k) as a discount rate for calculating the present values of future cash flows.

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Discounted Cash Flow (DCF) method

Internal Rate of Return (IRR) Method
The IRR is defined as the discount rate (R) which equates the aggregate present value of the operating CFAT received each year and terminal cash flows (working capital recovery and salvage value) with aggregate present value of cash outflows of an investment proposal. The project will be accepted when IRR exceeds the required rate of return.

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Discounted Cash Flow (DCF) method

Profitability Index (PI) Method
The profitability index / present value index measures the present value of returns per rupee invested. It is obtained dividing the present value of future cash inflows (both operating CFAT & terminal) by the present value of capital cash outflows.

PI

PV of Future Cash inflows PV of Capital Investment

The proposal will be worth accepting if the PI exceeds one.

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Problem Solving

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THANK YOU

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