Capital Budgeting & Estimating Cash Flows ? Meaning & Significance 1. Fixed assets account for sizeable proportion of firm’s 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 among different departments within a firm.
? Types of proposals 1. Expansion 2. Replacement 3. Strategic 4. Safety and/or environmental
? 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 estimation 1. Separation principle ? Investment side ? Financing side 2. Incremental principle ? Consider all incidental effects ? Ignore sunk costs ? Include opportunity costs
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 Action 1 Incurs Incurs Defer tax losses losses savings 2 Incurs Makes Take tax losses profits savings in the year of loss 3 Makes Incurs Defer taxes profits losses until the firm makes profit 4 Makes Makes Consider
1.
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 capital Cash Flow Discount rate Cash Flow to all WACC investors
Cash Flow to Cost of equity 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
doc_269267020.doc
? Types of proposals 1. Expansion 2. Replacement 3. Strategic 4. Safety and/or environmental
? 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 estimation 1. Separation principle ? Investment side ? Financing side 2. Incremental principle ? Consider all incidental effects ? Ignore sunk costs ? Include opportunity costs
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 Action 1 Incurs Incurs Defer tax losses losses savings 2 Incurs Makes Take tax losses profits savings in the year of loss 3 Makes Incurs Defer taxes profits losses until the firm makes profit 4 Makes Makes Consider
1.
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 capital Cash Flow Discount rate Cash Flow to all WACC investors
Cash Flow to Cost of equity 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
doc_269267020.doc