FINANCIAL MANAGEMENT

(FIN401)

Lecture 5:
Capital Budgeting

Capital Budgeting
(Strategic Asset Allocation)
9-11-2020

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What is CAPITAL BUDGETING?
• It involves:
• GENERATING INVESTMENT PROPOSALS
• ESTIMATING AFTER-TAX INCREMENTAL CASH FLOWS
FOR THE PROPOSED PROJECT.

Capital Budgeting
• EVALUATING PROJECT INCREMENTAL CASH
FLOWS (Inflows & Outflows) using evaluation
techniques like IRR & NPV methods.
• SELECTING PROJECTS BASED ON SOME RATE OF
RETURN CRITERION.
• RE-EVALUATING IMPLEMENTED PROJECTS.
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Capital Budgeting
The process of analyzing, and selecting
investment projects whose returns
(cash flows) are expected to extend
beyond one year.

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Why thorough evaluation is done before
making investment in long-term
projects?
• Capital Projects affect long-term
profitability of firms.

• Purchasing fixed assets requires huge

investment.

• Capital decisions are not easily reversed. 4

Types of Capital projects include…

New & Expansion Projects:

New products or expansion of existing products

Replacement Projects:
Replacement of existing equipment or buildings

Regulatory Projects:
Projects to control pollution or provide safety of
employees
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Types of Capital projects include…

Independent Projects:
The decision to accept/reject one project
does not affect the decision to
accept/reject another project.

Mutually Exclusive Projects:

The decision to accept/reject one project
affects the decision to reject/accept
another project.
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Some important points to remember!!!
• Projects are evaluated on stand-alone basis.
• Evaluation is based on incremental operating cash flows.
• Only the relevant cash flows are included in analysis.
• Cash flows are computed on after-tax basis.
• Sunk costs are ignored in the analysis.
• Opportunity costs are included in the analysis.
• Project-driven changes in working capital are considered.
• Financing costs are not included in cash flows.
• Effects of inflation are included.

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Why financing costs should be ignored
in the calculation of cash flows?
• Financing costs are ignored from the calculations
of operating cash flows. Financing costs are
reflected in the required rate of return from an
investment project, so cash flows are not

Capital Budgeting
adjusted for these costs

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Sunk costs & opportunity costs
• Capital budgeting decisions are based on current and future
incremental cash flows and not any past cash flows.
Therefore, in calculating net initial investment outlay, analysts
need to ignore the sunk costs but include opportunity costs in
their analysis.

Capital Budgeting
• Any cost incurred in the past before selecting and
implementing a project is a sunk cost hence should not be
added to project cost.
• Any financial benefit you forego for the sake of the project is
opportunity cost which should added into the cost of the
project.
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Cost of BF2 Summer course?
• A student (Mr. Rauf) got enrolled in BF2 Spring 21 by paying Rs.
35,000 and failed the course.
• The student was also doing a part-time (6:30 pm to 9 pm) job
at a monthly salary of Rs. 50,000.
• Now he got enrolled in BF2 Summer 21 by paying another Rs

Capital Budgeting
35,000 and is attending physical classes along-with Rao and
Zaid. He had to leave the part-time job to attend Summer
classes.
• Rauf calculates that the Summer course has costed him:
Fees paid earlier in Spring 21 Rs. 35,000
Fees paid for Summer 21 Rs. 35,000
Total …………………………………. Rs. 70,000 10
Do you agree?
Correct cost of BF2 Summer for Rauf

Fees paid for BF2 Summer 21 …........................ Rs. 35,000

Salary fore-gone (lost) by joining Summer 21 ….Rs. 50,000 (opportunity cost)
TOTAL COST ………………………………. Rs 85,000

Capital Budgeting
Another way of looking at it is that Rauf would have been richer by
Rs.85,000 if he had not joined BF2 Summer.

Fees for Spring 21 is Sunk Cost (Rs 35,000) as it was paid even before
Rauf thought of joining the Summer course. So this Fee has nothing to do
with the cost of BF2 Summer. This amount is not recoverable/refundable.

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 Practice problem
• Green Metro, Inc. is a company interested in public transportation projects in developing
countries. The company recently completed a traffic modelling study of a South Asian city at a cost
of $10 million, which unveiled some attractive investment areas for the company to consider.
• One option is to invest in a dedicated bus corridor along the main artery of the city. It requires
initial investment of $260 million and would result in net cash flows of $20 million for next 20
years.
• The company is also a supplier of sophisticated e-ticketing equipment to other transport
companies, which cost $20 million per dedicated bus corridor and can be easily sold for $30
million due to acute shortage in the market.
• Following is the calculation of net initial investment. Do you agree?

Capital Budgeting
Civil works $150 million

Buses $40 million

initial investment oy:
Following is the calculation of net
E-ticketing equipment $20 million

Design costs $40 million

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Traffic modelling study $10 million

Initial investment outlay TOTAL $260 million

Solution
• Two adjustments need to be made to the calculation of net
investment outlay.
• The e-ticketing equipment cost should be included at its sale price
of $30 million instead of its cost of $20 million. This is because
though the company will spend $20 million on in-house

Capital Budgeting
production of the system, it could sell this system at $30 million
earning a profit of $10 m. Using an e-ticketing system in its own
project would result in $10 million less profit elsewhere so this
$10 million (opportunity cost) should be added in the net
initial investment.
• Traffic modelling study cost ($10 m) should not be included in the
net investment outlay because it is a sunk cost. The study was
conducted before taking any investment decision and it doesn’t 13
affect any future cash flows of the project.
Capital evaluation involves…

1. Estimating the cash flows (inflows and outflows) during

project’s useful life.
i. Initial Investment
ii. Operating Cash flows
iii. Terminal Cash flows

2. Estimating the cost of capital (WACC) to be used as

discount rate.

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Initial Cash Investment (t=0)
(outflows) includes the following…
– Cost of new assets (-)
– Capitalized expenditures (-)
– Increased Net Working Capital (-)
Only for replacement projects:
+ Net proceeds from sale of old asset (+)
–/+ Taxes (tax savings) on gain/loss on the sale of old
asset

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Calculation of operating cash flows(when accounting
depreciation is different from depreciation for
tax purposes)
Correct tax can be calculated when we deduct depreciation
expense allowed by tax rules.

Capital Budgeting
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Operating Cash flows (t=1 to n) for
replacement projects…

Operating cash flows from new asset

Less: Operating cash flows from old asset
=Incremental operating cash flows

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Terminal Cash Flows (t=n) include
the following…
+/– Salvage value (disposal costs) of new asset
–/+ Taxes (tax savings) on gain/loss on sale or disposal of
new assets
+ Release/ recovery of net working capital

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Format to determine terminal
year incremental net cash flow
(when accounting depreciation is different from tax depreciation)

Capital Budgeting
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References
• Fundamentals of Corporate Finance. Stephen A. Ross,
Randolph W. Westerfield & Bradford D. Jordan, 8th edition.
Chapter 10.

• Fundamentals of Corporate Finance, Brealey Myers Marcus,

Stock Valuation Models

4th edition

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