Part-2 Section -E
Investment decision notes:
Ø
Capital budgeting:
It is a process used to evaluate potential major projects or
investments.
It is a process of making long-term investment decisions.
It includes investment in a new plant, a new product line, and
purchasing a new machine.
Ø Stages in capital budgeting:
Step1: identification stage:
During this stage, the company determines which type of capital
expenditure needs to be made.
Step2: search stage:
During this stage, the company searches the capital alternative investment
that will achieve the organizational objectives.
Step3: information acquisition stage:
The company determined the expected cost and benefits
quantitative and qualitative of different capital investments.
Step-4; selection stage:
Based on the financial and non-financial analysis, the company
chooses the best project.
Step-5: financial stage:
the company obtains the necessary project funding.
Step-6: implementation and control stage:
The project is implemented and monitored over time.
Ø Terms uses in capital budgeting:
1. Fixed cost
2.
Opportunity cost[relevant]
3.
Sunk cost [historical cost/already paid]
4.
Imputed cost [implicit cost]
5.
Common cost [ not relevant]
6.
Discretionary cost [eg: advertisement]
7.
Avoidable cost
8.
Unavoidable cost
9.
Incremental revenue, incremental cost,
incremental cash
10.
Cost of capital: [ it is a weighted average cost
of debt and equity]
11.
Differential cash flow: these are cash flows that
differ between or among two or more potential alternatives.
Ø Difference between cash flows and accounting profit:
Cash flows: cash flow is [ cash receipt -cash disbursement or cash payment.
Ø Accounting profit:
It is a profit determined on the income statement using
GAAP.
It is an accrual concept.
Note: estimated cash flows are used to evaluate prospective
capital budgeting projects.
Cash flows are a better measure than profit.
Ø Calculate the relevant cash flows:
1.
Expected cash flows at the beginning of the
project [ year zero or time zero]
Year zero cash flow consists of
a.
Initial investment: [outflow]
b.
Initial working capital investment: [outflow]
Working capital is also known as net working capital.
Working capital= current asset – current liability
c.
Cash received from the disposed of the old assets.
[inflow]
d.
Amount tax paid [ outflow] or tax benefit
[inflow] from the sale of the old assets.
Note: tax basis:
It is the book value of an asset for tax purposes.
Gain or loss on asset= cash received from an asset-tax basis.
2. Cash Flow during ongoing years:
a.
Additional investment [ outflow] [ no qn]
b.
Additional working capital investment
c.
After-tax operating cash flow [ inflow]
= sale – operating expenses – tax = after tax operating cash flow.
Operating cash inflow may result from
1.
Increased sales
2.
Decreased operating expenses.
d.
Depreciation tax shield: [ inflow]
Depreciation Is not included in the operating cash flow, because
it is not a cash expense.
Depreciation is an accounting expense
Depreciation is not a cash expense but depreciation is a cash deductible expense.
A depreciation tax shield is a reduced income tax.
Depreciation tax shield= depreciation × tax rate.
Ø MACRS depreciation method for tax purposes:
[ modified accelerated cost
recovery system ]
It is a depreciation method
required by US tax law.
[Example in my youtube channel]
For capital budgeting purposes we depreciate 100% cost of the asset.
We do not need to subtract salvage value.
Ø Strength line depreciation method for tax purposes:
This method results in equal depreciation each year.
Historical cost ÷ useful life = depreciation year.
1.
Depreciation tax shield
2.
After-tax operating
3.
Cash received from the disposal of equipment [
inflow]
4.
Tax benefit [ inflow] or tax payment [ outflow].
5.
Recovery of working capital [ inflow]
Note: MACRS method is similar to the 200% double decline balance
method.