Our Prime Focus for capital budgeting decisions:
Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets. In some situations, the process may entail in acquiring assets that are completely new to the firm. In other situations, it may mean replacing an existing obsolete asset to maintain efficiency.
We at Reinaldo on the start of our business should consider following both Cash flow as well as the accounting profits as both are equally important as the Cash flow statement in financial accounting shows the movement of cash in the business, And it also segregates the cash activities into operating, financial and investing activities. The most important function of the Cash flow is to monitor the activities of inflow and outflow from the business. Cash flow statement also helps to analyze the short-term viability of the company, i.e., the company's capacity to pay of it debts and outstanding amounts.
Where as accounting profits have a lot of things, which includes things such as Gross profits, Operating profit, Net profit. Profits are important to be know for the business if it is earning or not, or if it is advisable to run the business according the investment made in the business.
Capital budgeting is important to know if the investment made by the company in the new machine is viable in the long term or not. The capital budget can be determined be many methods such as: -
▪ Net present value
▪ Profitability index
▪ Internal rate of return
All these methods follow the incremental cash flow method, which is not an advisable method to follow instead the break-even period or the time needed to realize the invested amount.
It would be advised that in order to have a more appropriate and a clear view on the return equal emphasis should be paid on both, cash flow as well as the accounting profits.
It is also advised the company should pay attention on the incremental profit rather than the incremental cash flow as the incremental cash flow is the excess cash flow introduced in the system on acceptance of a new project which is not an important criteria to determine weather to start the business or not, what is more important is the incremental profit which is the estimated profit received on the increased investment which is important for the company to determine the viability of the project. There are many ways to inject cash flow in the business if it falls short of, but there is not a way to introduce profit unless the business earns it.
We, should also pay emphasis on the total profits rather than the total free cash flow as the total cash flow determines the financial surplus in the system which is to be distributed among the shareholders and the investors, as we have no investors, the company will retain all the earning. Thus, we should pay much more emphasis on the total profit determining the final return of the project and the investment.
The company has an estimated tenure of 5 years. Also, the working capital requirement decreases eventually thereby leading to cash outflows.
Being a comparatively short-term venture the emphasis should be on accounting profits. However any major deviations in the cash flows should not be overlooked.
Affect of Depreciation on Free Cash Flow:
Free cash flow is the cash flow available for distribution among all the security holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on, and depreciation is the fall in value of a fixed asset over the period of time due to the usage and the wear and tear.
In Accounting terms the deprecation is a non-cash expense, thus it does not have any effect on the cash flow, but in terms of finance, depreciation is considered to be to a loss of value of the asset, i.e. the machinery and land and building, which are the investment made by the business. Thus it has an affect on the FREE CASH FLOW.
Net Income
+ Depreciation/Amortization
- Changes in Working Capital
- Capital expenditure
= Free Cash Flow
Thus, the net amount available to the stakeholders and the tax payable by the organisation is only after duly making a provision for the depreciation on assets at the required rate thereby affecting the cash flows.
Affect Of Sunk Cost on the determination of Cash Flow:
In decision-making, sunk costs are the past costs that have already been incurred and cannot be recovered. Sunk Cost depends on the future course of action, sunk cost may change according to action taken, i.e. it may either increase or decrease according to the decision made.
But in making a decision for the prospective business we only consider the future cost not the cost which have been made in the past, and same is with the cash flow statement, it tells us about the regular activities of the business which are in terms of cash, and not assumed cost as sunk cost.
Thus, Sunk Cost does not have an affect on the determination of cash flow and it should also not have an affect on the decision of starting of the business as sunk cost can change based on the change in decisions.
Projects Initial Outlay:
Projects initial outlay is also called the net investment, it is the total cost incurred by a company to enter into a project or a business.
Projects Initial Outlay:
Equipment cost (certain) = $ 79,00,000
+
Capitalized expenditures:
Shipping &
Installation cost = $ 1,00,000
+
Working Capital Requirements:
Initial Working Capital =$ 1,00,000
Project's initial outlay = $ 81,00,000
Differential Cash Flows over the Projects Life
The “ Differential Cash Flow ” allows you to add and subtract projects ability to generate the incremental cash flow. It is the company ability to generate surplus cash in the system during the life of the business.
The differential cash flows involve the incremental after-tax cash flows resulting from the acceptance of the project.
Added revenue offset by increased expenses
Add: Labor and material savings
Add: Tax savings from depreciation
Note: Below is the Differential Cash flow statement of Reinaldo Products For the prospective new venture, for its assumed life of 5 years.
CASH FLOW STATEMENT
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Quantity
70,000
1,20,000
1,40,000
80,000
60,000
Selling Price
$300
$300
$300
$300
$260
Sales
$21,000,000
$36,000,000
$42,000,000
$24,000,000
$15,600,000
Variable cost
($12,600,000)
($21,600,000)
($25,200,000)
($14,400,000)
($10,800,000)
Fixed Cost
($200,000)
($200,000)
($200,000)
($200,000)
($200,000)
EBDIT
$8,200,000
$14,200,000
$16,600,000
$9,400,000
$4,600,000
Less Deprication
($1,600,000)
($1,600,000)
($1,600,000)
($1,600,000)
($1,600,000)
EBIT
$6,600,000
$12,600,000
$15,000,000
$7,800,000
$3,000,000
Taxes (34%)
($2,244,000)
($4,284,000)
($5,100,000)
($2,652,000)
($1,020,000)
Add Deprication
$1,600,000
$1,600,000
$1,600,000
$1,600,000
$1,600,000
Operating CF
$5,956,000
$9,916,000
$11,500,000
$6,748,000
$3,580,000
WC (10% sales)
($2,100,000)
($3,600,000)
($4,200,000)
($2,400,000)
($1,560,000)
Incremental WC
($100,000)
($2,000,000)
($1,500,000)
($600,000)
$1,800,000
$2,400,000
Capital Invest
($8,000,000)
Terminal Cash flow
15,60,000
Free Cash flow
-81,00,000
$3,956,000
$8,416,000
$10,900,000
$8,548,000
$5,980,000
PVIF 15%
0.86965
0.75635
0.65785
0.5722
0.49775
NPV
-81,00,000
34,40,335.40
63,65,441.60
71,70,565
48,91,165.60
29,76,545
NPV Total
16,744,052.6
WC needed
WC ₀
WC₁-WC₀
WC₂-WC₁
WC₃-WC₂
WC₄-WC₃
WC₅-WC₄-WC₅
Initial WC/Incremental WC
$100,000
($2,000,000)
($1,500,000)
($600,000)
$1,800,000
$2,400,000
Terminal Cash Flows:
Terminal cash flow is the last cash flow of the business i.e., the cash flow on the termination of the business. It includes the net cash generated from the sale of the assets, tax effects from the termination of the asset and the release of net working capital i.e
After-tax salvage value of the project
+Cash outlays associated with the project's termination
+Recapture of working-capital investments
In this case there is no salvage value and the entire asset value has been depreciated in 5 years. Therefore only the recapture of working capital investment i.e. $ 15,60,000 constitute the terminal cash flow.
Note: Working for the terminal cash flow shown in RED in the above Cash flow Statement.
Cash Flow Diagram
Cash flow diagram is the diagrammatic representations of the free cash flows over the life of the project or a business.
Net Present Value (NPV)
NPV in simple words for us will compare the value of our investment made today against the value of the same in the future, taking inflation and returns into account. If our NPV of a prospective project is positive, we should accept it, but, if the NPV is negative, the project should be rejected because then the cash flows are also expected to be negative.
NPV is indicators of how much will the new investments add to our firm. NPV includes all cash flows including initial cash flows such as the cost of purchasing an asset.
The NPV will depend on the rate of return on our Investment Idea, is 15% according to our expectations. This rate of return should be higher than the expected rate of return for an alternate source such as bank or the stock market.
The Net present value is calculated on the free cash flow derived from the cash flow statement, and the PVIF of the 15% is taken from the PVIF table.
Free Cash flow
-81,00,000
$3,956,000
$8,416,000
$10,900,000
$8,548,000
$5,980,000
PVIF 15%
0.86965
0.75635
0.65785
0.5722
0.49775
NPV
-81,00,000
34,40,335.40
63,65,441.60
71,70,565
48,91,165.60
29,76,545
NPV Total
16,744,052.6
From the above table and the calculated NPV, which is 16,744,052.6 and which is a lot more than the initial investment of 81,00,000, which is a positive sign for the starting of a new project.
Internal rate of Return (IRR)
In the capital budgeting we use the IRR in order to calculate the profitability of our investment. It is also called Rate Of Return. It is the Rate of return that an investment can return annually. Our investment will only be considered to be acceptable if the rate of return is higher than the acceptable rate of return.
IRR is the Growth rate that our investment is expected to provide, but it is not necessary that the actual return at the end of the project is same as the IRR. Higher the IRR higher is the recommendation to enter into the project, but however, if the IRR is not more than the general market rate of return then it is suggested to retail the investment in the market rather than the new business.
My opinion on the acceptance of the project:
After making the expected cash flow and doing all calculation and analysis as shown in the above pages, I have come to a conclusion that our decision of accepting or not accepting the project should be based on the following:
* Net present value(NPV).
* Profitability Index.
* Internal Rate of Return(IRR).
The NPV is positive ($16,744,052.6, as shown in the working) which is a good sign for the investment.
Also the profitability Index is positive i.e. (16,744,052.6/81,00,000) = 2.0671 so, according to the golden rule if the profitability index is >1 then the project should be accepted.
Calculation for the alternative projects:
NPV
PI
IRR
Project A
23182
1.12
23.07%
Project B
300000
1.25
37.5%
Capital Rationing includes:
The restriction of new investment by a company and a restriction on an organization's ability to invest capital funds, caused by an internal budget ceiling being imposed by management (soft capital rationing), or by external limitations being applied to the company, as when additional borrowed funds cannot be obtained (hard capital rationing).
Where enough cash is available that is there is no capital restrictions either both the projects should be accepted as both projects have a positive NPV or even if one project has to be selected the choice must be made between positive NPV projects. Therefore both must be accepted in case of no capital rationing.
However, PI is more useful than NPV as it expressed the value as a proportion of initial outlay funds required. Therefore, where funds are scarce PI should be taken as the measure. Therefore project B must be accepted in case of capital rationing.
Refrences:
* www.wikepedia.com
* www.investopedia.com
