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All about Capital Budgeting Principles & Decisions

Capital Budgeting, or investment appraisal, is the planning process used to determine whether an organization’s long term investment such as machinery, products  etc. are worth funding of cash through the firm’s capitalization structure.

Capital budgeting, is budgeting for capital expenditure. In the context of financial management, it refers to “making a large outlay of money today in anticipation of benefits [cash inflows] which would flow across the life of the investments”.

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Principles in Capital Budgeting

Principle 1: Cash flow principle.

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Capital budgeting is always concerned with cash flows and not with profits.

Methods of calculating cash flows are:

  1. Direct method
  2. Indirect method.

The direct method arrives at cash flow by knocking out the cash paid during the year from cash received during the year.

In indirect method we compute cash flow from Profit and Loss account by adding back depreciation and non cash charges from Profit After Tax. To this we adjust working capital changes.

Reason for adding back depreciation and non cash charges:

Depreciation and non cash charges because they do not involve in outflow of cash. Initially they are  deducted because they effect the tax payments. As long as depreciation becomes tax deductible expense or as long as company has taxable profit, depreciation becomes relevant.

Adjustment to working capital changes:

Working capital is the excess of current asset over current liabilities, an increase in working capital should be deducted from profits and reduction in working capital should be added back to profits to arrive at correct flows.

  Increase Decrease
Debtors Overstate Understate
Creditors Understate Overstate
Stock Overstate Understate

Principle 2: After tax principle

The Cash flows must be expressed after tax. Logic is that tax is an outflow.

Principle 3: Incremental principle

Incremental cash flow refers to the firms future cash flow with project and those without a project.

While calculating incremental principle remember:

  1. Include opportunity cost.
  2. Forget sunk cost
  3. Average could be wrong
  4. Remember working capital
  5. Consider side effects.

Principle 4: Inflation adjustment principle.

Prices do not stay stagnant; they change. We could either consider inflation or ignore it. If cash flow include inflation then discount rate should also include. If cash flow exclude inflation, then discount rate should also exclude it.

Steps in capital budgeting decision

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Step 1: Identify the intial investments

This consists of:

  1. Intial Capital expenditure
  2. Intial Investment in Working Capital.

Step 2: Identify operation cash flows

This consists of:

  1. Operational cash flows.
  2. Increase/ Decrease in working capital.
  3. Additional investments in capital assets.

Step 3: Identify terminal cash flows

This consists of:

  1. Net sale value of assets
  2. Re-capture from working capital.

Step 4: Prepare analysis statements

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  1. Consolidate cash flows from step 1 to 3.
  2. Compute Net Present Value.
  3. If the Net present value (NPV) is positive the  project should be accepted.

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About Author: Sindhu

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