Advanced Capital Budgeting

MODULE 1
/15
SYLLABUS
Cash
Flow Measurement: dependence

and independence of cash flows in
evaluating projects, Measures of risk
and returns, Inflation in capital
budgeting, Real vs. nominal discount
rates, Bias in cash flow estimates, Total
risk for multiple investment. Measuring
cash flow for acquisition. Use of Excel
for estimating cash flows & decision
making.
2
MBA & PGDM-Advanced Capital Budgeting
CAPITAL
CAPITAL BUDGETING
BUDGETING AND
AND
ESTIMATING
ESTIMATING CASH
CASH FLOWS
FLOWS
The Capital Budgeting Process

Generating Investment Project
Proposals
Estimating Project After-Tax
Incremental Operating Cash Flows
WHAT
WHAT IS
IS CAPITAL
CAPITAL
BUDGETING?
BUDGETING?
The
process of identifying, analyzing,

and selecting investment projects
whose returns (cash flows) are
expected to extend beyond one year.
THE
THE CAPITAL
CAPITAL
BUDGETING
BUDGETING PROCESS
PROCESS
Generate investment proposals

consistent with the firms strategic
objectives.
Estimate after-tax incremental
operating cash flows for the
investment projects.
Evaluate project incremental cash
flows.
THE
THE CAPITAL
CAPITAL
BUDGETING
BUDGETING PROCESS
PROCESS
Select projects based on a valuemaximizing acceptance criterion.

Reevaluate implemented investment
projects continually and perform
postaudits for completed projects.
CLASSIFICATION OF
INVESTMENT PROJECT
PROPOSALS
1. New products or expansion of
existing products
2. Replacement of existing equipment
or buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution
related)
SCREENING
PROPOSALS
AND DECISION MAKING
1.
2.
3.
4.
Section Chiefs
Advancement
Plant Managers
to
the
next
VP for Operations
level depends
Capital Expenditures
on cost
Committee
and strategic
5. President
importance.
6. Board of Directors
ESTIMATING AFTERTAX INCREMENTAL

CASH FLOWS
Basic characteristics of
relevant project flows
Cash (not accounting income) flows
Operating (not financing) flows
After-tax flows
Incremental flows
ESTIMATING AFTERTAX INCREMENTAL

CASH FLOWS
Principles that must be
adhered to in the estimation
Ignore sunk costs
Include opportunity costs
Include project-driven changes in
working capital net of
spontaneous changes in current
liabilities
Include
effects of inflation
Sound
investment decisions should be

based on the net present value (NPV) rule.
Problems
to be resolved in applying the
NPV rule
What should be discounted? In theory,
the answer is: We should always
discount cash flows.
What rate should be used to discount
cash flows? In principle, the opportunity
cost of capital should be used as the
discountMBA
rate.
& PGDM-Advanced Capital Budgeting
CASH FLOWS VERSUS

PROFIT
Cash
flow is not the same thing as profit,

at least, for two reasons.
First, profit, as measured by an accountant, is

based on accrual concept.
Second,
for computing profit, expenditures are

arbitrarily divided into revenue and capital
expenditures.
CF (REV EXP DEP) DEP CAPEX
CF Profit DEP CAPEX
12
INCREMENTAL CASH FLOWS

Every
investment involves a comparison of

alternatives:
When
the incremental cash flows for an

investment are calculated by comparing with a
hypothetical zero-cash-flow project, we call
them absolute cash flows.
The incremental cash flows found out by
comparison between two real alternatives can
be called relative cash flows.
The
principle of incremental cash flows

assumes greater
importance in the case of
replacement decisions.
EXAMPLE
Suppose a firm is considering replacing an
equipment at book value of Rs. 5000 and market
value of Rs. 3000. New equipment will require an
initial cash outlay of Rs 10,000, and is estimated to
generate cash flows of Rs 8,000, Rs 7,000 and Rs
4,500 for the next 3 years.
The book value of old machine is a sunk cost.
Market value is opportunity cost.
Thus, on an incremental basis the net cash outflow
of new equipment is: Rs 10,000 Rs 3,000 = Rs
7,000.
Also, The differences of the cash flows of new
equipment over
the cash flows of old equipment
are incremental cash flows.
COMPONENTS OF CASH
FLOWS
Initial Investment
Net Cash Flows
Depreciation and Taxes

Net Working Capital
Change in accounts receivable

Change in inventory
Change in accounts payable
Free Cash Flows
Terminal Cash Flows
Salvage Value
Salvage value of the new asset

Salvage value of the existing asset now
Salvage value of the existing asset at the end of its normal
Tax effect of salvage value
Release of Net Working Capital
INITIAL INVESTMENT
Initial
investment is the net cash outlay in

the period in which an asset is purchased.
A major element of the initial investment
is gross outlay or original value (OV) of the
asset, which comprises of its cost
(including accessories and spare parts)
and freight and installation charges.
Original value is included in the existing
block of assets for computing annual
depreciation.
EXAMPLE OF INITIAL INVESTMENT
Wattle Extract Project: Initial

Investment
NET CASH FLOWS
Consist of annual cash flows occurring from the

operation of an investment, but it is also be
affected by changes in net working capital and
capital expenditures during the life of the
investment.
Net cash flow = Revenues - Expenses - Taxes
NCF = REV - EXP - TAX
The computation of the after-tax cash flows

requires a careful treatment of non-cash expense
items such as depreciation.
Depreciation, calculated as per the income tax
rules influences cash flows indirectly by way of
MBA
& PGDM-Advanced
Capital Budgeting
depreciation
tax
shield.
CALCULATION OF DEPRECIATION FOR

TAX PURPOSES
Two most popular methods of charging
depreciation are:
straight-line
Diminishing balance or written-down value
(WDV) methods.
For reporting to the shareholders, companies in
India could charge depreciation either on the
straight-line or the written-down value basis.
No choice of depreciation method and rates for
the tax purposes is available to companies in
India.
Depreciation is computed on the written down
value of the block of assets and rates are
specified.
NET WORKING CAPITAL
It
is the difference between change in

current assets (e.g., receivable and
inventory) and change in current liabilities
(e.g., accounts payable) to profit.
Increase in net working capital should be
subtracted from and decrease added to
after-tax operating profit.
NCF = EBIT (1 - T ) + DEP - NWC
FREE CASH FLOWS

It
is the cash flow available to service both

lenders and shareholders, who have
provided, respectively, debt and equity,
funds to finance the firms investments.
It is this cash flow, which should be
discounted to find out an investments
NPV.
TERMINAL CASH FLOW: SALVAGE

VALUE
Salvage
value is a terminal cash flow.

Salvage value may be defined as the
market price of an investment at the time
of its sale.
No immediate tax liability (or tax savings)
arises on the sale of an asset because the
value of the asset sold is adjusted in the
depreciable base of assets.
EFFECTS OF SALVAGE VALUE
Salvage value of the new asset:

It will
increase cash inflow in the terminal (last) period
of the new investment.
Salvage value of the existing asset now: It

will reduce the initial cash outlay of the new
asset.
Salvage value of the existing asset at the

end of its normal life: It will reduce the cash
flow of the new investment of in the period in
which the existing asset is sold.
RELEASE OF NET WORKING

CAPITAL
Besides
salvage value, terminal cost flows

will also include the release of net working
capital.
It is reasonable to assume that funds
initially tied up in net working capital at
the time the investment was undertaken
would be released in the last year when
the investment is terminated.
CALCULATION OF DEPRECIATION FOR

TAX PURPOSES
Two most popular methods of charging depreciation

are:
1.
2.
Straight-line and diminishing balance

Written-down value (WDV) methods
.In
India, depreciation is allowed as deduction every

year on the written-down value basis in respect of
fixed assets as per the rates prescribed in the
Income Tax rules.
.Depreciation is computed on the written down value
of the block of assets.
DEPRECIATION BASE
In the case of block of assets, the written down
value is calculated as follows:
The aggregate of the written down value of all
assets in the block at the beginning of the year
Plus the actual cost of any asset in the block
acquired during the year
Minus the proceeds from the sale of any asset in
the block during the year
Thus, in a replacement decision, the depreciation
base of a new asset will be equal to: Cost of new
equipment + Written down value of old
equipment Salvage value of old equipment
CASH FLOW ESTIMATES FOR NEW

PRODUCTS
It
depends on forecasts of sales and

operating expenses.
Sales forecasts require information on the
quantity of sales and the price of the
product.
Anticipation of the competitors reactions.
SALVAGE VALUE AND TAX EFFECTS

As
per the current tax rules in India, the

after-tax salvage value should be
calculated as follows:
Book value > Salvage value:
After-tax salvage value = Salvage value
+ PV of depreciation tax shield on (BV
SV)
Salvage value > Book value:
After-tax salvage value = Salvage value
- PV of depreciation tax shield lost on
(SV BV)
TERMINAL VALUE FOR A NEW

BUSINESS
The terminal value included the salvage value of

the asset and the release of the working capital.
Managers make assumption of horizon period

because detailed calculations for a long period
become quite intricate. The financial analysis of
such projects should incorporate an estimate of the
value of cash flows after the horizon period without
involving detailed calculations.
A simple method of estimating the terminal value

at the end of the horizon period is to employ the
following formula, which
is a variation of the
NCFn 1 g NCFn 1
dividend growth
TVnmodel
kg
k g
TERMINAL VALUE OF NEW BUSINESS /

NEW PRODUCTS
New businesses have the potential of generating
revenues and cash flows much
beyond the
assumed period of analysis, which is referred to
as horizon period.
A simple method of estimating the terminal value
at the end of the horizon period is:
TVn =
NCFn ( 1 + g )
k- g
NCFn+1
k- g
where NCFn+1 is the projects net cash flow one

year after the horizon period, k is the opportunity
cost of capital (discount rate) and g is the expected
growth in the projects net cash flows.
CASH FLOW ESTIMATES FOR

REPLACEMENT DECISIONS
The
initial investment of the new machine

will be reduced by the cash proceeds from
the sale of the existing machine.
The annual cash flows are found on
incremental basis.
The
incremental cash proceeds from
salvage value is considered.
15
SYLLABUS
Cash Flow Measurement:
Dependence and independence of
cash flows in evaluating projects,
Measures of risk and returns,
Inflation in capital budgeting, Real
vs. nominal discount rates, Bias in
cash flow estimates, Total risk for
multiple investment. Measuring
cash flow for acquisition. Use of
Excel for estimating cash flows &
decision making.
32
INFLATION AND CAPITAL

BUDGETING
Inflation is the increase in the

general level of prices for all
goods and services in an
economy
NOMINAL VS. REAL
Nominal values are the actual

amount of money making up
cash flows
Real values reflect the
purchasing power of the cash
flows
Real values are found by
adjusting the nominal values for
the rate of inflation
INFLATION
EFFECTS TWO ASPECTS OF

CAPITAL BUDGETING
PROJECTED
CASH FLOWS
DISCOUNT RATE
IF
PROJECTED CASH FLOWS ARE IN REAL

TERMS (WITHOUT INFLATION
CONSIDERED) THE DISCOUNT RATE
USED SHOULD BE A REAL RATE.
IF
PROJECTED CASH FLOWS ARE IN

NOMINAL TERMS (WITH INFLATION
CONSIDERED) THE DISCOUNT RATE
USED SHOULD BE A NOMINAL RATE.
BOTH
THE PAYMENT SERIES AND THE

DISCOUNT RATE MUST BE SPECIFIED
EITHER IN NOMINAL VALUES OR IN REAL
VALUES, BUT NOT IN BOTH VALUES
CONCURRENTLY.
/15
The
opportunity cost of capital of a

firm or project is generally market
determined and is based on expected
future return.
It is, there fore usually expressed in
nominal terms and reflects the
expected rate of inflation.
The opportunity cost of capital is or
the discount rate is a combination of
the real rate and expected inflation
rate.
This effect is called Fishers effect
38
/15
Nominal discount rate (k)=

(1+K) (1+)- 1
K= real discount rate
= inflation rate
39
/15
EXAMPLE:
ye 0
1
2
3
4
ar
Cas 300 300 300 300
h
1000 0
0
0
0
flo 0
The
w firms opportunity cost of capital,
which is market determined expressed
in nominal terms is 14%. Rate of
inflation is 7%
40
IS IT BETTER TO USE REAL OR NOMINAL VALUES?

Using
nominal values is more common.

Market interest rates are nominal values
that already contain a premium for
anticipated inflation.
Income tax obligations are based on
nominal values.
Therefore, it is usually easier to use
nominal values.
However, if a nominal discount rate is
used, projected cash flows should reflect
anticipated inflation.
15
SYLLABUS
Cash Flow Measurement:
Dependence and independence of
cash flows in evaluating projects,
Measures of risk and returns,
Inflation in capital budgeting, Real
vs. nominal discount rates, Bias in
cash flow estimates, Total risk for
multiple investment. Measuring
cash flow for acquisition. Use of
Excel for estimating cash flows &
decision making.
42
RETURN ON A SINGLE ASSET

Total
return = Dividend + Capital gain

Rate of return Dividend yield Capital gain yield
DIV1 P1 P0 DIV1 P1 P0
R1
P0
P0
P0
DEFINING
DEFINING RETURN
RETURN
Income received on an investment plus any
change in market price, usually expressed as
a percent of the beginning market price of
the investment.
Dt + (Pt - Pt-1 )
R=
Pt-1
RETURN
RETURN EXAMPLE
EXAMPLE
The stock price for Stock A was Rs.10 per
share 1 year ago. The stock is currently
trading at Rs.9.50 per share and
shareholders just received a Rs.1
dividend. What return was earned over
the past year?
RETURN
RETURN EXAMPLE
EXAMPLE
The stock price for Stock A was Rs.10 per
share 1 year ago. The stock is currently
trading at Rs.9.50 per share and
shareholders just received a Rs.1
dividend. What return was earned over
the past year?
Rs.1.00 + (Rs.9.50 - Rs.10.00)

R=
Rs.10.00
= 5%
DEFINING
DEFINING RISK
RISK
The variability of returns from
those that are expected.
What rate of return do you expect on
your investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a
share of stock?
EXPECTED RATE OF RETURN

=
(Probability of Return) (Possible

Return)
ri= return for the I th possible

income
Pi =
probability associated with ri
n= number of possible income
HOW
HOW TO
TO DETERMINE
DETERMINE THE
THE
EXPECTED
EXPECTED RETURN
RETURN AND
AND
STANDARD
STANDARD DEVIATION
DEVIATION
Stock BW
R i Pi
(Ri)(Pi)
-.15
-.03
.09
.21
.33
Sum
.10
.20
.40
.20
.10
1.00
-.015
-.006
.036
.042
.033
.090
The
expected
return, R,
for Stock
BW is .09
or 9%
/15
DETERMINING STANDARD DEVIATION (RISK MEASURE)
Standard Deviation, , is a statistical

measure of the variability of a
distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
50
HOW
HOW TO
TO DETERMINE
DETERMINE THE
THE
EXPECTED
EXPECTED RETURN
RETURN AND
AND
STANDARD
STANDARD DEVIATION
DEVIATION
Stock BW
R i Pi
(Ri)(Pi)
-.15
.10
-.03
.20
.09
.40
.21
.20
.33
.10
Sum
1.00
(Ri - R )2(Pi)
-.015
.00576
-.006
.00288
.036
.00000
.042
.00288
.033
.00576
.090
.01728
DETERMINING
DETERMINING STANDARD
STANDARD
DEVIATION
DEVIATION (RISK
(RISK MEASURE)
MEASURE)
(
r
R
)
(
P
)
i
i
i=1
=
=
.01728
.1315 or 13.15%
COEFFICIENT OF VARIATION
It
is a measure of relative dispersion

used in comparing the risk of assets
with differing expected return.
/15
COEFFICIENT OF VARIATION OF
BW
=.1315 / .09
= 1.46
54
DISCRETE VS. CONTINUOUS

DISTRIBUTIONS
Discrete
Continuous
0.035
0.03
0.025
0.02
0.015
0.01
0.005
67%
58%
49%
40%
31%
22%
13%
4%
-5%
-14%
-23%
-32%
-41%
-50%
RISK
RISK ATTITUDES
ATTITUDES
Certainty Equivalent (CE) is the amount of
cash someone would require with certainty
at a point in time to make the individual
indifferent between that certain amount and
an amount expected to be received with risk
at the same point in time.
RISK
RISK ATTITUDES
ATTITUDES
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
TOTAL
TOTAL RISK
RISK =
= SYSTEMATIC
SYSTEMATIC
RISK
RISK +
+ UNSYSTEMATIC
UNSYSTEMATIC RISK
RISK
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return
on stocks or portfolios associated with
changes in return on the market as a
whole.
Unsystematic Risk is the variability of
return on stocks or portfolios not
explained by general market movements.
MBA & PGDM-Advanced
Capital Budgeting
It is avoidable
through diversification.
STD DEV OF PORTFOLIO RETURN
TOTAL
TOTAL RISK
RISK =
= SYSTEMATIC
SYSTEMATIC
RISK
RISK +
+ UNSYSTEMATIC
UNSYSTEMATIC RISK
RISK
Factors such as changes in nations
economy, tax reform by the Congress,
or a change in the world situation.
Unsystematic risk
Total
Risk
Systematic risk
NUMBER OF SECURITIES IN THE PORTFOLIO

STD DEV OF PORTFOLIO RETURN
TOTAL
TOTAL RISK
RISK =
= SYSTEMATIC
SYSTEMATIC
RISK
RISK +
+ UNSYSTEMATIC
UNSYSTEMATIC RISK
RISK
Factors unique to a particular company
or industry. For example, the death of a
key executive or loss of a governmental
defense contract.
Unsystematic risk
Total
Risk
Systematic risk
NUMBER OF SECURITIES IN THE PORTFOLIO

CAPITAL
CAPITAL ASSET
ASSET
PRICING
PRICING MODEL
MODEL (CAPM)
(CAPM)
CAPM is a model that describes the
relationship between risk and expected
(required) return; in this model, a securitys
expected (required) return is the risk-free rate
plus a premium based on the systematic risk
of the security.
CAPM
CAPM ASSUMPTIONS
ASSUMPTIONS
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index
similar as a proxy).
or
WHAT
WHAT IS
IS BETA?
BETA?
An index of systematic risk.
It measures the sensitivity of a stocks
returns to changes in returns on the market
portfolio.
The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio.
CHARACTERISTIC
CHARACTERISTIC LINES
LINES
DIFFERENT
DIFFERENT BETAS
BETAS
EXCESS RETURN
ON STOCK
AND
AND
Beta > 1
(aggressive)
Beta = 1
Each characteristic
line has a
different slope.
Beta < 1
(defensive)
EXCESS RETURN
ON MARKET PORTFOLIO
SECURITY
SECURITY MARKET
MARKET LINE
LINE
Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock
j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures
systematic risk of stock j),
MBA & PGDM-Advanced
RM is the expected
returnCapital
forBudgeting
the market
SECURITY
SECURITY MARKET
MARKET LINE
LINE
Required Return
Rj = Rf + j(RM - Rf)
Risk
Premium
RM
Rf
Risk-free
Return
M = 1.0
Systematic
Risk (Beta)Capital Budgeting
MBA & PGDM-Advanced
SECURITY
SECURITY MARKET
MARKET LINE
LINE
Obtaining
Can use historical data if past best represents

the expectations of the future
Can also utilize services like Value Line,
Ibbotson Associates, etc.
Adjusted
Betas
Beta
Betas have a tendency to revert to the mean of

1.0
Can utilize combination of recent beta and
mean
2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate

DETERMINATION
DETERMINATION OF
OF THE
THE
REQUIRED
REQUIRED RATE
RATE OF
OF RETURN
RETURN
Lisa Miller at Basket Wonders is

attempting to determine the rate of
return required by their stock investors.
Lisa is using a 6% Rf and a long-term
market expected rate of return of 10%.
A stock analyst following the firm has
calculated that the firm beta is 1.2.
What is the required rate of return on
MBA & of
PGDM-Advanced
Budgeting
the stock
BasketCapital
Wonders?
BWS
BWS REQUIRED
REQUIRED RATE
RATE
OF
OF RETURN
RETURN
RBW = Rf + j(RM - Rf)

RBW = 6% + 1.2(10% - 6%)
RBW = 10.8%
The required rate of return exceeds the
market rate of return as BWs beta exceeds
the market beta (1.0).
DETERMINATION
DETERMINATION OF
OF THE
THE
INTRINSIC
INTRINSIC VALUE
VALUE OF
OF BW
BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next
period will be Rs.0.50 and that BW will
grow at a constant rate of 5.8%. The
stock is currently selling for Rs.15.
What is the intrinsic value of the

stock? Is the stock over or
MBAunderpriced?
& PGDM-Advanced Capital Budgeting
DETERMINATION
DETERMINATION OF
OF THE
THE
INTRINSIC
INTRINSIC VALUE
VALUE OF
OF BW
BW
Intrinsic
Value
Rs.0.50
=
10.8% - 5.8%
= Rs.10
The stock is OVERVALUED as

the market price (Rs.15)
exceeds the intrinsic value
(Rs.10). Capital Budgeting
MBA & PGDM-Advanced
SECURITY
SECURITY MARKET
MARKET LINE
LINE
Required Return
Stock X (Underpriced)
Direction of
Movement
Rf
Direction of
Movement
Stock Y (Overpriced)
Systematic Risk (Beta)
DETERMINATION
DETERMINATION OF
OF THE
THE
REQUIRED
REQUIRED RATE
RATE OF
OF RETURN
RETURN
Small-firm Effect
Price / Earnings Effect
January Effect
These anomalies have
presented serious challenges to
the CAPM theory.
RISK AND CAPITAL BUDGETING
RISK
PERTAINS TO THE POSSIBILITY THAT

THE PROJECTED CASH FLOWS WILL BE
LESS THAN ESTIMATED.
METHODS OF ACCOUNTING FOR RISK IN CAPITAL BUDGETING ARE
ADJUSTING
THE DISCOUNT RATE TO

REFLECT A RISK PREMIUM.
CONVERTING
THE PAYMENT SERIES TO

CERTAINTY EQUIVALENTS.
PROBABILITY
ANALYSIS.
ADJUSTING THE DISCOUNT

RATE
DISCOUNT
RATE COMPONENTS
INCLUDE:
TIME
PREFERENCE
INFLATION EXPECTATIONS
RISK PREMIUM
THE
RISK PREMIUM IS THE COST OF RISK

BEARING.
INCREASING
THE DISCOUNT RATE ADDS

A COST FOR TAKING RISK BY REQUIRING
A HIGHER RATE OF RETURN FOR RISK
BEARING.
/15
Risk
adjusted discount rate =

Risk free rate
+Risk premium
k=kf + kr
under CAPM, the risk premium is the
difference between the market rate of
return and the risk free rate multiplied
by the beta of the project
78

Advanced Capital Budgeting

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Advanced Capital Budgeting

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MODULE 1

Flow Measurement: dependence

The Capital Budgeting Process

MBA & PGDM-Advanced Capital Budgeting

process of identifying, analyzing,

MBA & PGDM-Advanced Capital Budgeting

Generate investment proposals

Select projects based on a valuemaximizing acceptance criterion.

MBA & PGDM-Advanced Capital Budgeting

ESTIMATING AFTERTAX INCREMENTAL

MBA & PGDM-Advanced Capital Budgeting

ESTIMATING AFTERTAX INCREMENTAL

investment decisions should be

to be resolved in applying the

CASH FLOWS VERSUS

flow is not the same thing as profit,

First, profit, as measured by an accountant, is

for computing profit, expenditures are

MBA & PGDM-Advanced Capital Budgeting

INCREMENTAL CASH FLOWS

investment involves a comparison of

the incremental cash flows for an

principle of incremental cash flows

Depreciation and Taxes

Change in accounts receivable

Free Cash Flows

Terminal Cash Flows

Salvage value of the new asset

Release of Net Working Capital

MBA & PGDM-Advanced Capital Budgeting

investment is the net cash outlay in

EXAMPLE OF INITIAL INVESTMENT

Wattle Extract Project: Initial

MBA & PGDM-Advanced Capital Budgeting

NET CASH FLOWS

Consist of annual cash flows occurring from the

The computation of the after-tax cash flows

CALCULATION OF DEPRECIATION FOR

MBA & PGDM-Advanced Capital Budgeting

NET WORKING CAPITAL

is the difference between change in

MBA & PGDM-Advanced Capital Budgeting

FREE CASH FLOWS

is the cash flow available to service both

MBA & PGDM-Advanced Capital Budgeting

TERMINAL CASH FLOW: SALVAGE

value is a terminal cash flow.

MBA & PGDM-Advanced Capital Budgeting

EFFECTS OF SALVAGE VALUE

Salvage value of the new asset:

Salvage value of the existing asset now: It

Salvage value of the existing asset at the

RELEASE OF NET WORKING

salvage value, terminal cost flows

MBA & PGDM-Advanced Capital Budgeting

CALCULATION OF DEPRECIATION FOR

Two most popular methods of charging depreciation

Straight-line and diminishing balance

India, depreciation is allowed as deduction every

MBA & PGDM-Advanced Capital Budgeting

CASH FLOW ESTIMATES FOR NEW

depends on forecasts of sales and

MBA & PGDM-Advanced Capital Budgeting

SALVAGE VALUE AND TAX EFFECTS