BA, Msc AF, PMP AIDAN LUVANDA Capital budgeting refers to the decision to invest in long term assets or projects. These assets or projects are expected to be used or benefit the company over a long period of time. - Identify the possible opportunities available.
- Screen them to reduce the number of alternatives to the most feasible alternatives.
- Estimate cash flows (inflows and outflows) for the feasible alternatives. Inflows are benefits while outflows are expenditure on the project.
- Evaluate and appraise to determine the feasibility of the project.
- Select and implement the most feasible alternative.
DETERMINATION OF CASH FLOWS Determination of cash flows of a business is very important in making successful finance decisions. It involves the estimations of costs and benefits anticipated to be accrued in the investment and requires the help of different departments e.g. accounting, marketing, production etc. Which come together to forecast potential sales and costs of the investment. Cash flows can either be inflows or outflows. They can also be categorized basing on when they were realized i.e. initial cash outlays, intermediate cash flows and terminal cash flows (salvage value). CONSIDERATION IN CASH FLOWS DETERMINATION - Benefits from the investment should be on cash flows basis and not accounting profit basis.
- Benefits should be incremental and after tax.
- Consider changes in working capital
- Depreciation: refers to gradual loss in value of an asset due to wear and tear. Whereas depreciation is deducted from net revenues in order to determine net earnings, it does not involve an actual movement of cash like other expenses. Depreciation also acts as a shield against taxes. The bigger the depreciation figure, the lower the level of earnings available for taxation. Hence, depreciation is regarded as a boost to inflow, which should be added back to the cash inflow after tax. Depreciation expense is added back because it does not involve actual cash flow much as is a tax deductible expenses
- Salvage value which is the value at which an asset can be sold when the firm ceases to use it. It must be adjusted for tax to get net salvage value.
- NSV=SV (1 - t)
- Where SV=salvage value
- t=tax rate
- Sunk costs (cost of past investments that cannot be recovered) have no relevance to the new investment and they should be ignored.
- Opportunity cost i.e. the expected benefits which the company would have derived from those resources if they were not committed to the proposed project e.g. if a building was to be rented out at a certain amount but a company decides to use the building for a project, the money that would otherwise been received as rental income is an opportunity cost and should be incorporate in the initial cost of the project.
- The opportunity cost of other resources can also be computed in the same manner e.g. if the resource can be sold its opportunity cost is equal to the amount of price of that resource which the company misses by putting it in the alternative use.
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