capital budgeting
TRANSCRIPT
Capital BudgetingCapital Budgeting
25-03-201025-03-2010
Answer the followingAnswer the following What are the finance decisions?What are the finance decisions? What is the finance decision that takes What is the finance decision that takes
care of the assets of the firm?care of the assets of the firm? What is the expenditure which acquires What is the expenditure which acquires
long term benefits for the firm?long term benefits for the firm? What are the steps in capital budgeting?What are the steps in capital budgeting? What are the motives of making capital What are the motives of making capital
expenditure?expenditure? Name a few types of projectName a few types of project
What is capital budgeting?What is capital budgeting?
The process of evaluating and The process of evaluating and selecting long term investments that selecting long term investments that are consistent with the firm’s goal of are consistent with the firm’s goal of maximising owners’ wealthmaximising owners’ wealth
ExpendituresExpenditures
Capital expenditure: (CAPEX)Capital expenditure: (CAPEX) An outlay of funds by the firm that is An outlay of funds by the firm that is
expected to produce benefits over a expected to produce benefits over a period of time greater than one year. period of time greater than one year.
Operating Expenditure: (OPEX)Operating Expenditure: (OPEX) An outlay of funds by the firm An outlay of funds by the firm
resulting in benefits received within a resulting in benefits received within a yearyear
Difficulties in Capital BudgetingDifficulties in Capital Budgeting
Future uncertaintyFuture uncertainty Incomparable periods of cost and Incomparable periods of cost and
benefitsbenefits Non quantifiable costs and benefitsNon quantifiable costs and benefits
Rationale for capital budgeting Rationale for capital budgeting decisionsdecisions
EfficiencyEfficiency Expand revenues – Less certainExpand revenues – Less certain Reduce cost – More certainReduce cost – More certain
Other NamesOther Names
OPEX:OPEX: Operating expenseOperating expense, O, Operational perational
expenseexpense, O, Operational perational expenditureexpenditure
CAPEX:CAPEX:
Distinguish between the capital expenditure Distinguish between the capital expenditure and operating expenditureand operating expenditure
Purchase of a photocopierPurchase of a photocopier Purchase of paper, tonerPurchase of paper, toner Cost of power and maintenanceCost of power and maintenance Establishment of a new plantEstablishment of a new plant Wages to workers in the new plantWages to workers in the new plant Acquisition of a firmAcquisition of a firm Training of a workersTraining of a workers Training of sales forceTraining of sales force
Some new items on capital Some new items on capital budgetingbudgeting
AT & T buys 8 per cent stake in Tech AT & T buys 8 per cent stake in Tech Mahindra for $ 197 millionMahindra for $ 197 million
Maruti Suzuki lines up for Rs. 1260 Maruti Suzuki lines up for Rs. 1260 crore investment to double its crore investment to double its capacity in k-series petrol enginecapacity in k-series petrol engine
Steps in Capital Budgeting ProcessSteps in Capital Budgeting Process
Proposal GenerationProposal Generation Review AnalysisReview Analysis Decision MakingDecision Making ImplementationImplementation Follow-upFollow-up
Key Motives for making capital Key Motives for making capital expenditureexpenditure
ExpansionExpansion ReplacementReplacement RenewalRenewal Other Purposes – Inorganic growth, Other Purposes – Inorganic growth,
Competition, Survival strategy Competition, Survival strategy
Basic TerminologyBasic Terminology
Independent vs. Mutually Exclusive Independent vs. Mutually Exclusive ProjectsProjects
Unlimited Funds vs. Capital RationingUnlimited Funds vs. Capital Rationing Accept-Reject vs. Ranking Accept-Reject vs. Ranking
ApproachesApproaches Conventional vs. Non-conventional Conventional vs. Non-conventional
cash flow patternscash flow patterns
Independent vs. Mutually Exclusive ProjectsIndependent vs. Mutually Exclusive Projects
Independent Projects:Independent Projects: Projects whose cash flows are unrelated Projects whose cash flows are unrelated
or independent of one another; the or independent of one another; the acceptance of one does not eliminate the acceptance of one does not eliminate the others from further considerationothers from further consideration
Mutually Exclusive Projects:Mutually Exclusive Projects: Projects that compete with one another, Projects that compete with one another,
so that the acceptance of one eliminates so that the acceptance of one eliminates from further consideration all other from further consideration all other projects that serve a similar function projects that serve a similar function
Unlimited Funds vs. Capital Unlimited Funds vs. Capital RationingRationing
Unlimited Funds:Unlimited Funds: The financial situation in which a firm is The financial situation in which a firm is
able to accept all independent projects able to accept all independent projects that provide an acceptable returnthat provide an acceptable return
Capital Rationing:Capital Rationing: The financial situation in which a firm has The financial situation in which a firm has
only a fixed amount of funds available for only a fixed amount of funds available for capital expenditures, and numerous capital expenditures, and numerous projects compete for this fundprojects compete for this fund
Accept-Reject vs. Ranking ApproachesAccept-Reject vs. Ranking Approaches
Accept-Reject Approach:Accept-Reject Approach: The evaluation of capital expenditure The evaluation of capital expenditure
proposals to determine whether they meet proposals to determine whether they meet the firm’s minimum acceptance criterion.the firm’s minimum acceptance criterion.
Ranking Approach:Ranking Approach: The ranking of capital expenditure projects The ranking of capital expenditure projects
on the basis of some pre-determined on the basis of some pre-determined measure, such as the rate of return.measure, such as the rate of return.
Conventional vs. Non-conventional Conventional vs. Non-conventional cash flow patternscash flow patterns
Conventional cash Flow Patterns:Conventional cash Flow Patterns: A conventional cash flow pattern A conventional cash flow pattern
consists of an initial outflow followed consists of an initial outflow followed only by a series of inflowsonly by a series of inflows
Non-conventional cash flow patterns:Non-conventional cash flow patterns: An initial outflow followed by a series An initial outflow followed by a series
of inflows and outflowsof inflows and outflows
Relevant Cash FlowsRelevant Cash Flows
The incremental cash outflow The incremental cash outflow (investment) and resulting (investment) and resulting subsequent inflows associated with a subsequent inflows associated with a proposed capital expenditureproposed capital expenditure
Incremental cash FlowsIncremental cash Flows
The additional cash outflows or The additional cash outflows or inflows which are expected to result inflows which are expected to result from a proposed capital expenditurefrom a proposed capital expenditure
Major cash flow componentsMajor cash flow components
Initial investmentInitial investment Operating cash inflowsOperating cash inflows Terminal cash inflowsTerminal cash inflows
Major cash flow componentsMajor cash flow components
Initial Investment:Initial Investment: The relevant cash outflow for a The relevant cash outflow for a
proposed project at time zeroproposed project at time zero Operational Cash Inflows:Operational Cash Inflows: The incremental after-tax cash The incremental after-tax cash
inflows resulting from inflows resulting from implementation of a project during implementation of a project during its lifeits life
Major cash flow componentsMajor cash flow components
Terminal Cash flow:Terminal Cash flow: The after-tax non-operating cash flow The after-tax non-operating cash flow
occurring in the final year of a occurring in the final year of a project. It is usually attributable to project. It is usually attributable to liquidation of the projectliquidation of the project
Expansion vs. Replacement Cash Expansion vs. Replacement Cash flowsflows
Cash Flows for Expansion decisions:Cash Flows for Expansion decisions: Initial InvestmentInitial Investment Operating cash inflowOperating cash inflow Terminal cash inflowTerminal cash inflow Cash Flows for Replacement decisions:Cash Flows for Replacement decisions: ComplicatedComplicated Incremental outflows and inflows of cash Incremental outflows and inflows of cash
need to be identifiedneed to be identified
Replacement Cash flowsReplacement Cash flows
Initial Investment:Initial Investment: Initial investment required to acquire Initial investment required to acquire
new asset – After tax cash inflows new asset – After tax cash inflows from liquidation of old assetfrom liquidation of old asset
Operating Cash Inflows:Operating Cash Inflows: Operating cash inflows from new Operating cash inflows from new
asset – Operating cash inflows from asset – Operating cash inflows from the old assetthe old asset
Replacement Cash flowsReplacement Cash flows
Terminal cash flow:Terminal cash flow: After tax cash flow from termination After tax cash flow from termination
of new asset – After tax cash flow of new asset – After tax cash flow from the termination of old assetfrom the termination of old asset
Cash Flow estimatesCash Flow estimates
Tax effectTax effect Effect on other projectsEffect on other projects Effect of indirect expensesEffect of indirect expenses Effect of depreciationEffect of depreciation
Sunk Cost vs. Opportunity CostSunk Cost vs. Opportunity Cost
Sunk cost:Sunk cost: What is spent and cannot be taken What is spent and cannot be taken
backback Opportunity cost:Opportunity cost: Alternative benefits missed on Alternative benefits missed on
account of a choice/ decisionaccount of a choice/ decision