Projection of Cash Flows

What is Capital Budgeting?

• Capital Budgeting decisions are the capital expenditure decisions
• These are Long term decisions which are made with the expectation
of future benefits over a period of time
• They involve - huge capital outlay,
• And
• Are irreversible decisions
• CB decisions could be expansion or diversification decisions (Revenue
generating activities) or replacement or modernisation (Cost
reduction activities)
Nature of Investment Decisions
• The investment decisions of a firm are generally known as the
capital budgeting, or capital expenditure decisions.

• A capital expenditure decision may be defined as the firm’s decision

to invest its current funds most efficiently in the long term assets in
anticipation of an expected flow of benefits over a series of years

• Firm’s investment decisions generally include expansion,

acquisition, modernisation, replacement of the long-term assets;
Sale of a division or business (divestment)

• Decisions like the change in the methods of sales distribution, or an

advertisement campaign or a research and development
programme
Features of Investment Decisions
• The exchange of current funds for future benefits.

• The funds are invested in long-term assets.

• The future benefits will occur to the firm over a series

of years.
Importance of Investment Decisions

• Growth

• Risk

• Funding

• Irreversibility

• Complexity
Types of Investment Decisions
• One classification is as follows:
• Expansion of existing business
• Adding of new business
• Replacement and modernisation
• Yet another useful way to classify investments is as
follows:
• Mutually exclusive investments
• Independent investments
• Contingent investments
Investment Evaluation Criteria or
Capital Budgeting Technique
• Three steps are involved in the evaluation of an
investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the
opportunity cost of capital)
3. Application of a decision rule for making the choice
(Capital budgeting Technique)
• E.g. Net Present Value = Present value of Cash Inflows – PV of Cash
outflows

• E.g. Payback Method

CASH FLOWS
Cash Flows (CFs)
• It is not accounting profit

• It is Rupees Received (actual), & Rupees paid (actual) – Not accrued

• Why do we focus on CFs?
• because they easily measure the impact upon the firm’s wealth
• Cash flows occur at different times and these times are easily identifiable. The timing of flows is particularly
important in project analysis
• income statements or profit and loss accounts, may not have a corresponding cash flow effect for the same
period
• Profit / Loss statement do not represent increase or decrease in CFs
• E.g a sale on credit
• We are concerned with ---
• Actual CFs
• Relevant CFs
• Incremental CFs
There is a difference between Accounting
profit and CF analysis
• Non cash transactions: Provision for bad debts, depreciation, writing off
Goodwill - > no cash flow is involved, but is used to compute net profit

• A capital expenditure, though cash payment is not considered as Cost for

the period in which it is incurred, hence is not deducted from the revenue
of that period. This does not has complete effect in the profit, but the Cash
Flow gets reduced.
• Accounting policies, inventory valuation and allocation of indirect costs
(overheads) result in discrepancies in Accounting Profit
• Accounting Profit ignores time value of money, whereas Cash flow analysis
considers time value of money. Financial manager is concerned more with
economic value created by a decision rather than Book value entr. Hence,
he is concerned more with CF analysis
Don’t do Before and After project analysis..
• Relevant CFs
• Are relevant to the project i.e. CFs arising from the project
• Relevant CF is the one which will change (increase or decrease) the firm’s overall CF
as a result of the decision of the project.
• Relevant cash flows thus deal with changes or increments to the firm’s existing cash
flows. These flows are also known as incremental or marginal cash flows
• Project evaluation rests upon incremental CFs. Incremental CFs are CI and
CO traceable to a given project, which disappear if the project disappears
• ICIs can be measured by comparing CFs of firm :
• “With” project, and
• “without project”
• (Don’t do Before and After project analysis)
• For example, suppose a new manufacturing plant uses land that could
otherwise be sold for $500,000.
• The firm owns the land ‘before’ the project and the firm still owns the
land ‘after’ the project. Therefore, if a ‘before versus after’
comparison is used, the cash flow attributed to the manufacturing
project will be zero.
• How should this $500,000 be treated? Should be included in Initial
capital outlay or not?
Concept 1 - Opportunity Cost (OC)
• ‘without’ the project, the firm could generate $500,000 cash if the
land is sold (and some other amount if the land is put to some other
use). ‘
• ‘With’ the project, the firm would not be able to generate this cash
inflow
• Hence, it has opportunity cost.
• Hence, it should be included in the Initial Capital Outlay. It is a Cash
Outflow.
Another Example..
• For example, if a car manufacturing company considers introducing a new
model called, say, Mieko, which is a close substitute for an existing model
called Rieko, then there could be a fall in sales of Rieko due to the new
model Mieko
• A car manufacturing company is planning to launch a new model, Mieko,
which is very similar to existing model called Rieko
• As a result, there would be fall in sales of Raptor by $25 Million
• This negative effect of launching Mieko
• Without Mieko -> future CFs have been higher by 25 Mn.
• Hence, in Mieko project evaluation, 25 Mn should be deducted in CFs
• The rationale for the incorporation of these indirect effects has its base in
the opportunity cost principle
Let’s revisit…..Example – OC
• A proposed project involves the establishment of a production facility.
• This facility will be located within a factory the firm already owns.
• The estimated rental value of the space that the production facility will occupy is $29,000
per year.
• The space has not been rented in the past, but the firm expects to rent it in the future.
• Should $29,000 be included in project evaluation?
• How much will the firm lose “with project”?
• The firm will lose $29,000 ‘with’ the project because that space will be used for the project
• Therefore, the opportunity cost is $29,000 per year in rent forgone and it should be
included as a cash outflow
• Why does this not contradict the principle that we should only consider cash flows?
• This example also illustrates that even when no cash changes hands, there could be an
opportunity cost
• The reason is that opportunity cost of the space measures an extra
cash flow that would be generated (for the firm) ‘without’ the project

• Suppose that this space has not been rented in the past and there is
no intention to rent, sell or use for any other purpose in the future
• Will $29,000 be included in project evaluation?
• In this case, there is no opportunity cost if the resource is used for the
proposed project. Therefore, in this situation, the $29,000 will not be
included as a cash outflow
• (I) Initial Investment/Initial Capital Outlay/capital Expenditure
• Cost of the machinery + any other cost to bring it to the workable condition (e.g
installation cost, transportation cost, any other incidental cost)
• These are the capital CFs
• There could be capital outlay even after the project starts e.g. , upgradation to
equipment, increase in WC investment
• (II) Subsequent CFs
• Till the economic life of the project. These flows are called Operating CFs and
include cash inflows from sales, cash outflows for advertising and marketing,
payments for wages, heating and lighting bills, and purchases of raw materials
• (III) Terminal CFs
• At the end of the project’s economic life
• sale of the project as a going concern, the salvage value of the asset net of tax, and
recovery of any remaining working capital, cost of environmental rehabilitation etc.
• (I) Initial Investment/Initial Capital Outlay/capital Expenditure
• Cost of machinery (Outflow)
• + WC required (Outflow)
• - In case of “Replacement of asset” project – salvage value of the
existing asset (it is reduced from outflow of new asset bought),
adjusted for tax implication (Inflow)
• Sunk cost is Not included
• + Opportunity cost is included (Outflow)
• (II) Subsequent CFs
• Operating CFAT (CF After Tax)

• Sales – Cost – Depreciation = [PBT – Tax] = [PAT + Depreciation] =

CFAT

• Regular maintenance, revenue

• Initial Investment:
• Installation Cost
• WC Requirement
• Salvage value of existing asset in case of replacement decisions
(Sunk costs are not included)
•Terminal Cash Flows
• CF (As in previous year)
• Salvage/scrap value
• WC released
• Sale price of asset (+/-) Tax effect of sale
• Subsequent year CFs
Sales
(-) Cost
--------
PBT
(-) Tax
_____
PAT
(+) Dep
---------
CFAT
Always remember..

Irrelevant CFs Relevant CFs

• Fixed overhead expense • Variable expenses
(existing) • Additional Fixed overhead
• Sunk Costs expenses
• Cost of investment
• Marginal Taxes
• Opportunity Cost
Ques.
• Ques. A project under consideration involves the use of an existing
building to set up a factory to produce shoes. The market value of this
building is $200,000. If the project is undertaken, there will be no
direct cash outflow associated with purchasing the building since the
firm already owns it. In evaluating the proposed shoe-manufacturing
project, should we then assume zero cost for the building?
• Certainly not. The building is not a ‘free’ resource for the project
because if the building was not used for this project it could be used
for some other purpose; for example, it could be sold to generate
cash. Using the existing building for the proposed shoe project thus
has an opportunity cost of $200,000.
Concept 2 - Sunk Cost
• Sunk cost is an amount spent in the past in relation to the project, but
which cannot now be recovered or offset by the current decision
• Sunk costs are past and irreversible.
• They are not contingent upon the decision to accept (or reject) a
proposed project.
• Therefore, they should not be included in the cash flows.
• They are irrelevant Cost
Concept 3 - Overhead Costs
• E.g. overhead costs are utilities (such as electricity, gas and water) and
executive salaries.
• Cost accounting is in part concerned with the appropriate allocation of
various overhead costs to particular production units.
• Overhead expenses occur whether or not a given project is accepted or
rejected; so they would occur ‘with’ or ‘without’ the proposed project
• So, not included in the project evaluation
• But, if overhead expenses are incremental cash flows associated with the
proposed project, then they are considered/ Relevant for project evaluation
Example
• For example, Kedar Ltd currently incurs utility overheads of $500,000 from the operation of its main
office complex, which it allocates to the production departments on the basis of floor space
• Suppose Kedar Ltd is considering extending its factory in order to manufacture a new product
• A new production department will be created which will take up 20% of the available floor space of
the factory
• Firm’s Cost accountant, employing accepted cost accounting principles, would allocate $100,000
(being 20% of a $500,000 utilities cost incurred in the last year) as an expense associated with the
new project
• Should the overheads be allocated to the new production department?
• While it would be tempting to include this overhead expense in the evaluation of the proposed
project, it would be incorrect to do so. Why?
• Will this Overhead cost be incurred without the project?.... The Answer is Yes
• Will this Overhead cost be incurred with the project?........ The Answer is Yes
• Hence, this cost is not an incremental cost to the project; ‘with’ or ‘without’ the project, this utilities
cost is incurred. So, from a project evaluation perspective, this utilities overhead would not be
included in the project analysis
• Situation B) If Cedar Ltd also allocates executive salaries to the production
department, based on the floor space. The firm’s management accountant, using
the same cost accounting principles, would allocate $160,000 (being 20% of the
$800,000 chief executive’s salary) as an expense associated with the new project
• Again, while it would be tempting to include this overhead expense in the
evaluation of the proposed project, it would be incorrect to do so, because this
cost is not an incremental cost to the project; ‘with’ or ‘without’ the project, this
salary is paid
• Situation C) If, however, 25% of the chief executive’s time is spent on the project
causing a decrease in the productivity of the firm’s other activities. Would be it
considered in the project evaluation?
• Yes. It would be considered an opportunity cost of the proposed project and
included in the project analysis
• Situation D) if additional staff (costing $200,000) were recruited to
look after the firm’s existing business (thus preventing possible
adverse effects on the productivity of the firm’s other activities),
would be included in project analysis?
• then the $200,000 would be an increment to the project and should
be included in its evaluation.
Conclusion
• Only the incremental cash flows resulting from changes in overhead
expenses should be included in evaluating a project proposal
• If the expenses are already being incurred, a proportion should not be
allocated to the new project
Next -🡺
• Ques.
• Environmental impact study of the proposed site entailed a cost of
$500,000. Should this be considered in project evaluation?
• R & D expenditure, whether the project is launched or not

• No. These are Sunk Cost

• All the indirect or synergistic effects of a project should be included in
the cash flow calculation
• Synergistic effects can be negative or positive
Concept 3 - Working Capital (WC)
• Working capital is equal to a firm’s current assets minus its current liabilities.
• Current assets: Cash, inventories of raw materials and finished goods, and accounts
receivable (customers’ unpaid bills)
• Current liabilities: accounts payable (the firm’s unpaid bills) and wages payable
• New projects will involve additional investments in working capital
• When a new project starts, it may be necessary to increase the amount of cash
held as a float to accommodate more transactions
• Increases in working capital requirements are considered cash outflows (just like
investment in plant and equipment) even though they do not leave the firm
• e.g. an increase in inventory is considered a cash outflow even though the goods are still in
store, because the firm does not have access to the cash value of that inventory; firm
cannot use that money for other investments
• So, an increase in working capital represents an opportunity cost to the firm
• Disinvestments in working capital produce a cash inflow
WC – capital flow or operational flow for
project evaluation?
• The flows of working capital must be treated as capital flows or
operational flows?
• working capital is allied to sales, you might be tempted to consider such flows
as income or expense flows. But this is not the case.
• working capital represents a pool of funds committed to the project in the
same manner as is the fixed capital
• Please note: the above two points are valid only while doing PROJECT
evaluation
• Hence, the flows of working capital must be treated as capital flows
and not operational flows
Why working capital is required when
project starts?
• When a new project starts, it may be necessary to increase the
amount of cash held as a float to accommodate more transactions.
• Further inventories of raw materials may be required to run the new
production lines smoothly.
• Additional investment in finished goods inventories may be
necessary to handle increased sales.
• When the finished product is sold, customers may be slow to pay,
thus causing an increase in accounts receivable.
• All of these changes require increased working capital investment.
Concept - After tax CFs
• If the project generates tax liabilities, then the tax payable is relevant
to the project, and must be accounted for as a cash outflow
Concept: Treatment of depreciation
• Depreciation is not a cash flow
• It is an allocation of the initial cost of an asset over a number of accounting periods
• Depreciation may be calculated in several different ways:
• The ‘life’ or ‘straight-line’ method allocates an equal amount of the initial cost to each year of the
asset’s life
• The ‘reducing balance’ method allocates a fixed percentage of the asset’s written down value in each
year
• The ‘sum of the year’s digits’ method allocates a reducing proportion of the asset’s cost in each year
• The ‘units of production’ method allocates an amount on the basis of a ratio of the asset’s expected
productive capacity to each year of measured production
• In project evaluation, what is relevant is not the accounting depreciation but the
tax-allowable depreciation
• Hence, our interest in depreciation lies only in its tax effect, i.e. the depreciation tax
shield, or the reduction in taxes attributable to the depreciation allowance
Concept: Tax payable
• Tax payable is a cash outflow
• Tax laws can be changed retrospectively or they can change from time
to time after the project has commenced
• So, the best course to follow in this situation is to ensure that the
project is not dependent upon tax savings or tax shields for its success
Concept: Investment allowance
• Governments often provide special temporary incentives to the
private sector to encourage investments in selected industries
• These incentives normally take the form of a tax benefit where a
given percentage of the cost of investment is assigned as an allowable
deduction for arriving at taxable income
Concept: Treatment of Financing flows
• It is important to distinguish between project cash flows and financing cash flows
• The financing decision concerns the relative proportions of the project’s capital
expenditures to be provided by debt-holders and equity-holders respectively
• The decision about the particular mixture of debt and equity used in financing the
project is a management decision concerning the trade-off between financial risk
and the cost of capital.
• This debt–equity mixture determines how the resultant project cash flows are
divided between debt-holders and equity-owners
• However,
• the investment evaluation decision determines whether the project’s discounted
cash flows exceed the initial capital outlay (investment), and so adds (net present)
value to the firm.
Concept: Interest charges or other financing
costs
• Generally, interest charges or any other financing costs such as dividends or
loan repayments are not deducted in arriving at cash flows, because we are
interested in the cash flow generated by the assets of the project.
• Interest is a return to providers of debt capital. It is an expense against the
income generated to equity-holders, and as such is deducted in the
determination of accounting profit
• It is not included in project cash flow analysis, as the discount rate
employed in the NPV analysis accommodates the required rate of returns
to both equity and debt providers
• Therefore, inclusion of interest charges in cash flow calculations would
result in a double counting of the interest cost
Concept: Tax savings on interest
• Not included in project cash flow analysis
• Interest is tax deductible, and therefore provides a tax shield for any
investment
• This benefit is also accounted for in the discount rate, as the rate
employed in project analysis is an ‘after-tax’ rate
• Accordingly, tax savings on interest expenses are not included in
project cash flow analysis
Within-year timing of CFs
• Normally, cash flows occur at various points of time within a year
• The standard practice in capital budgeting is to assume that capital
expenditures occur at the beginning of the year and all other cash
flows occur at the end of the year
• To maintain consistency for calculation purposes, the points in cash
flow timing are set at the end of each year. Flows which would
normally occur at the start of any year will be timed as occurring at
the end of the immediately preceding year
Impact of Inflation
• To deal with inflation appropriately, the project analysis must recognize
expected inflation in the forecast of future cash flows and use a discount
rate that reflects investors’ expectations of future inflation

• There is differential impact of inflation on various cash flows of the project

• ‘depreciation tax shield’ (or the tax saving from the tax-allowable
depreciation) is totally unaffected by inflation.
• Depreciation tax shields are calculated on the basis of the historical costs of
the assets at the time of their acquisition
• Similarly, a long-term raw-material contract or the purchase of a
commodity in the forward or futures markets may lock in the present
prices, thereby insulating the cash flow from inflationary effects
• Due to the differential impact of inflation on CFs, CFs are usually forecasted
in nominal terms (i.e. including inflationary effects), rather than in real
terms (i.e. excluding inflationary effects)
• Different inflationary trends can be incorporated in Selling prices, labour costs,
material costs etc.
• Remember: If the CFs are in nominal terms, the discount rate/required rate
of return should be in nominal terms, and vice versa
• The required rate of return used for discounting cash flows is normally
derived from observed market rates such as interest rates and returns on
equity., and these observed market rates usually have the expected annual
inflation rates built in and are usually quoted in nominal terms (as opposed
to real terms)
• Discount Rates expressed in nominal terms can, if necessary, be
converted into real terms using the algebraic relationship expressed in
the Fisher effect.
• The Fisher equation is: (1 + n) = (1 + r) ∗(1 + p)
• where:
• n = the annual nominal interest rate (expressed as a decimal value)
• r = the annual real interest rate (expressed as a decimal value)
• p = the expected annual inflation rate
• So, real rate of interest can be derived as:
r = (1 + n) (1 + p) − 1
Gross Profit Vs Net Profit/Net income
Gross Profit Vs Net Profit/Net income –
Another example
• Operating profit measures profitability by subtracting operating
expenses, depreciation, and amortization from gross profit.
• Operating profit is gross profit minus operating costs (except interest
on loans) and minus depreciation.
• Operating income formula = Gross profit - operating expenses -
depreciation and amortization
• Cost of Goods Sold (COGS) includes:
• Raw materials
• Cost of labor
• Machine expenses (items needed to run machines, for example)
• Direct materials
• Wholesale prices
• Overhead costs
• https://www.zoho.com/books/guides/what-is-the-difference-betwee
n-gross-and-net-profit.html
Ques 1. (Asset Expansion)
• A plastic manufacturer has under consideration the proposal of
production of high quality plastic glasses. The necessary equipment
to manufacture the glasses would cost Rs. 1 lakh and would last 5
years. The rate of depreciation is 20% on WDV. There is no other
asset in the block. The expected salvage value is Rs. 10000. The
glasses can be sold at Rs. 4 each.
• Regardless of the level of production, the manufacturer will incur
cash cost of Rs. 25000 each year if the project is undertaken.
• The overhead costs allocated to this new line would be Rs. 5000. The
variable costs are estimated at Rs. 2 per glass. The manufacturer
estimates it will sell about 75000 glasses per year; tax rat is 35%.
• Should the proposed equipment be purchased? Assume 20% cost of capital
and additional working requirements, Rs. 50000. Also assume that the firm
would have sufficient short-term capital gains in year 5.
References – STCG Vs. LTCG
• https://incometaxindia.gov.in/Documents/Left%20Menu/AOP-Incom
e-from-capital-gains.htm

• https://incometaxindia.gov.in/tutorials/14-%20stcg.pdf

• https://www.outlookindia.com/business/how-to-carry-forward-and-s
et-off-a-loss-under-income-from-capital-gain--news-304497/amp
• Initial Investment:
• Installation Cost
• WC Requirement
• Salvage value of existing asset in case of replacement decisions
(Sunk costs are not included)
•Terminal Cash Flows
• CF (As in previous year)
• Salvage/scrap value
• WC released
• Sale price of asset (+/-) Tax effect of sale
• Subsequent year CFs
Sales
(-) Cost
--------
PBT
(-) Tax
_____
PAT
(+) Dep
---------
CFAT
• Block of assets –
• assets of same class in one group – are charged with same rate of
depreciation
• E.g. P/M
• Office building and furniture
• If asset is used for less than 180 days, then only 50% depreciation is charged

• CG/CL arises in 3 situations

• When Sales value> WDV
• Entire block is sold
• In case of 100% depreciable assets
Delta Question
Notes to solve question Delta
• 1. If the asset is used for more than 180 days, depreciation is charged
for the purpose of Income tax computation. If less than 180 days,
complete depreciation is not available on asset
• 2. Capital Gain – ST or LT depends on the type of asset
• 3. Block - meaning (single asset in a block Vs several assets in the
block)
Delta Question – Question 2
• Solve the question in excel with three sheets:
• 1. Assume, no block
• 2. Assume – single asset in the block
• 3. Assume – several assets in the block

• The question has been solved in class by IGNORING the block concept
Some Notes for Delta Question
• Upgrade of equipment is to occur at the end of year 3. Since it is
specifically stated that it is to occur at the end of year 3 (as opposed
to during year 3), it is timed as at the end of year 3. If we were told,
however, that the upgrade is to occur in year 3, then following the
standard practice that capital expenditures are assumed to occur at
the beginning of the year, we would have timed it as at the end of
year 2 so that it is treated as a capital expenditure at the beginning of
year 3.
• Depreciation (non cash expenditure)
• 12.5% is the depreciation rate. This is as per SLM (straight line method). The question does not mention that is reducing
balance method, so it could be assumed SLM
• Hence, depreciation on $1 mn is 125,000 every year

• What is depreciation? – Refresher

• Depreciation is the allocation of cost over the useful life of the asset, and depreciation is not charged just because of the
wear and tear of the asset. (So even if the asset is not used (i.e. no wear and tear), depreciation can be charged as per
Companies Act 2013)
• It is a non-cash expenditure
• https://accountingtool.in/depreciation-as-per-companies-act-2013/
• SLM – another formula to calculate the amount of depreciation
(not rate of depreciation) is: (Cost – Salvage value) / useful life
• Ques (Self exercise): Find out what else can be the non-cash expenditure besides depreciation
• https://www.indeed.com/career-advice/career-development/non-cash-expenses
• https://corporatefinanceinstitute.com/resources/accounting/non-cash-expenses-and-adjustments/
After-tax salvage value is calculated as:
• Book-value = Cost − Tax-allowable accumulated depreciation
= 1,000,000 − (1,000,000 × 0.125 × 8) = 0
• ‘Taxes on sale of assets’ is equal to:
= (Sale proceeds − book-value) × Tax rate
= (16,000 − 0) × 0.3 = $4,800

• Salvage Value is same as Residual value or Scrap Value. Salvage value is the
amount that an asset is estimated to be worth at the end of its useful life.
• In this question, the book value of asset reduces to zero, but is sold at salvage of Rs
16000.
WC at year 8

• You don’t have to deduct the 3000 in year 8 as WC released. 3000 is

the amount released in 8th year as indicated in the question as “level
of WC”. 3000 is the final status at the end of 8th year.
• Note it is zero in question, which indicates that, 3000 has been
released, making WC at level zero…which should be the case at the
end of the project
• So, only consider the initial WC (as part of the Cash outlay), and the
last year’s WC becomes 0 (indicating that 3000 is received)
Further Reading – Can skip
• How to use NPV function?
• https://support.microsoft.com/en-au/office/npv-function-8672cb67-
2576-4d07-b67b-ac28acf2a568
Calculate NPV for Delta Project

• Solve in Excel
Calculate IRR for Delta Project
• IRR is the rate of discount at which NPV = 0
• Highest rate at which the future CFs can be discounted making the project’s
NPV = 0
• Calculated by trial and error approach

• Solve in Excel
Accounting Rate of Return (ARR)
• Uses accounting income data to calculate a ratio which is used as a
decision variable
(Accounting income is different from CF)
• ARR = Annual Average accounting Income / Asset Value
• Example, if an outlay of Rs. 1000 gives return of 200, 500, 700 as
accounting income over three years, then ARR is calculated as:
ARR = [(200+500+700)/3]/ 1000
= 46.6
ARR in Delta Ques.
•Average Net income is PAT for all years divided by 8 years
• i.e., Average PAT = [71,009.69 +75,687.35 +80,365.02 + 1,55,042.69 +1,59,720.36
+3,83,960.03 + 3,91,560.90 + 3,99,162.47 ] / 8
= 1716508.52 / 8
= 2,14,563.56

ARR = Average Income / Asset value

= 2,14,563.56 / -100000
= 21%
• There is no standard way to calculate ARR –
• Another formula is:
• ARR = average annual profit/ average investment
where, Average investment = [Book value at year end 1 + Book
value at end of useful life] / 2
• Time value of money is not taken into consideration in the ratio
• ARR may be characterized as a metric for figuring out how much
money we make on our investments
Payback Period
• It is the period of time over which the accumulated cash flows will be
recovered (in other words, Cash inflows become equal to the initial outlay)
• Example, cash outlay = 1200
Cash inflows in three years respectively= 820, 450, 300
• 820 + 450 = 1270
• 1270 > 1200, so that means the cash outlay has been recovered within two
years. Hence payback period is 2 years
• Decision criteria for accepting the project: If PB period< std PB, then accept
the project. No objective way to know what is the acceptable payback
period
• Delta ques. – find payback period
• NPV is most commonly used, and is supplemented by other methods
for decision making
Q2. Repco Corporation (replacement of
asset)
• Repco Corporation is considering a replacement investment. The machine
currently in use was purchased two years ago (in 1999) for $49,000. Depreciation
for tax purposes is $9,800 per year for five years. The market value of this machine
today (at the beginning of year 2001) is $35,000. The new machine will cost
$123,000 and requires $3,000 for installation. Its economic life is estimated to be
three years and tax-allowable depreciation is $42,000 per year for three years. If
the new machine is acquired, the investment in accounts receivable is expected to
rise by $8,000, the inventory by $25,000 and accounts payable by $13,000. The
annual income before depreciation and taxes is expected to be $65,000 for the
next three years (2001, 2002 and 2003) with the old machine, and $122,000,
$135,000 and $130,000 for the 1st, 2nd and 3rd years, respectively, with the new
machine. The salvage values of the old and new machines three years from today
(end of 2003) is expected to be $3,500 and $4,000, respectively. The income tax
rate is 25%. This income tax applies to operating income as well as to the book
gains or losses on the machinery.
Q2. Repco Corporation (replacement of
asset)
Old asset New asset
Purchased in 1999 = $49000 Cost = 123000; Installation = $3000
Depreciation = $9800 per year for 5 years Depreciation $42000 per year for 3 yrs
Market value in 2001 beginning: $35000 (if sold Economic life = 3 years
today)
Salvage value (end of 2003): $3500 Salvage value (end of 2003)= $4000
Account receivables increase by= $8000
Inventory investment increase by= $25000
Accounts payable increase by = $13000
Annual income before depreciation and taxes: Annual income before depreciation and taxes:
2001: $65000 2001: $122000
2002: $65000 2002: $135000
2003: $65000 2003: $ 130000
Tax rate = 25%
🡺 Project started in beginning of 2001; for
three years
Imp. Notes – Repco
• For replacement projects, we need to include proceeds from both the new asset and the
old asset. The rationale for each of these flows is:
• At the termination of the project the new machine will be sold for its salvage value and a
cash inflow will occur.
• The proceeds from the sale of the old machine are subtracted in arriving at the terminal
cash flow of the proposed replacement investment, because if the replacement project
commenced (at the beginning of year 2001), the old asset would have been sold at that
time. The proceeds from the sale of the old machine at that time were $35,000. This was
treated as a capital outflow in calculating the initial investment value of the proposed
replacement investment project. The $3,500 salvage value of the old machine at the end
of 2003 is included as a terminal cash outflow as it represents an opportunity cost.
• That is, the old machine’s sale proceeds of $3,500 (which would have been a terminal cash
inflow ‘without’ the proposed project) are now lost ‘with’ the proposed project.
Therefore, that amount is attributed as a cash outflow for the proposed replacement
project.
Refer the PPT on Capital Budgeting alongside.

END