1. Investment in long term assets is referred as capital expenditure Firm decision to invest its current funds efficiently in long term assets in anticipation of expected flow of benefits over a series of years

2. Importance of capital budgeting decisions Growth More risky Huge investments Irreversibility Effect on other projects Difficult decision

3. Kinds of capital budgeting Accept-reject decisions Mutually exclusive investments Capital rationing decisions Contingent investment

4. Estimating cash flows- the investment outlays and cash inflows after the project is commissioned is most important and difficult

5. Proforma of cash inflows after taxes (CFAT) Sales Revenue –Less : variable cost Contribution –Less Fixed costs EBDT (Earnings before depreciation and tax) –Less Depreciation EBT (Earnings Before Tax) –Less taxes PAT (Profit after tax) –Add depreciation CFAT (cash flow after tax)

6. Elements of cash flow stream Initial investment- It is the after tax cash outlay on capital expenditure and net working capital when the project is set up Operating cash inflows- After tax cash inflows resulting from the operations of the project during its economic life Terminal cash inflow - After tax cash flow resulting from the liquidation of the project at the end of its economic life

7. Time horizon for analysis Physical life of the plant Technological life of the plant Product market life of the plant Investment planning Horizon of the firm

8. Basic principles of cash flow estimation

9. Separation Principle Two sides of project –Investment or (asset ) type –Financing While defining the cash flows on investment side. Financing costs should not be considered because they will be reflected in the cost of capital figure against which the rate of return figure will be evaluated

10. Incremental Principle Project cash flows for year t = (cash flow for the firm with the project for year t) – (cash flow for the firm without the project for year t)

11. Incremental Principle Consider all incidental effects-product cannibalisation Ignore sunk costs Include opportunity costs Allocation of overhead costs Estimate working capital ( current assets, loans and advances)- current liabilities and provisions

12. Post tax principle Cash flows should be measured on an after tax basis Effect of non cash charges Depreciation rates (Written down value method) –Buildings = 5% –Plant & Machinery = 25% –Computers = 60% –Vehicles on Hire = 40% –Pollution control equipments = 100%

13. Consistency Principle Cash flows and discount rates applied to these cash flows must be consistent with respect to investor group and inflation  Cash flow to investors = PBIT + Depreciation – capital expenditure – change in working capital  Cash flow to equity shareholders = PAT+ Depreciation – preference dividend – capital expenditure – change in working capital – repayment of debt + proceeds from debt issues – redemption of preference capital + proceeds from preference issue

14. Generally in capital budgeting criteria of cash flow to investors is considered

15. Various points of view Long term funds = equity & long term debt Current liability = short term debt & spontaneous current liability (trade credit & provisions) Explicit cost = long term funds & short term debt Total Resources = Long term funds & current Liabilities Fixed Assets = supported by long term funds Current Assets = partly supported by long term funds and current liability Portion of current assets that is supported by long term funds = working capital margin

16. Viewing a project from other perspective Equity Long term funds Explicit cost funds (investor claims) Total funds

17. Biases in cash flow estimation

18. Overstatement of Profitability Observers believe that profitability is overstated because initial investment is underestimated and operating cash inflows are exaggerated. –Intentional –Lack of experience –Myopic euphoria –Capital rationing

19. Understatement of Profitability Terminal benefits of a project are likely to be under estimated because salvage values are underestimated, intangible benefits are ignored and value of future options is looked