6.2: INTERNATIONAL CAPITAL BUDGETING
DECISIONS
6.2.1: REVIEW OF DOMESTIC CAPITAL BUDGETING
When a business makes a capital investment, it incurs a current cash outlay in the
expectation of future benefits. Usually, these benefits extend beyond one year in
the future. Examples include investment in assets, such as equipment, building,
and land as well as the introduction of a new product, a new distribution system,
or a new programme for research and development. An investment proposal
should be judged in relation to whether or not it provides a return equal to, or
greater than that required by investors.
Definition:
Capital budgeting may be defined as the process of identifying, analyzing and
selecting investment projects whose returns are expected to extend beyond one
year.
6.2.1.1 THE CAPITAL BUDGETING PROCESS
Capital budgeting involves the following issues:
• Generating investment project proposals consistent with the firm’s
strategic objectives
• Estimating after tax incremental operating cash flows for the investment
projects
• Evaluating project incremental cash flows
• Selecting projects based on value –maximizing acceptance criterion
• Revaluating implemented projects continually and performing post-audits for
completed projects.
(a) GENERATING INVESTMENT PROJECT PROPOSALS
Investment project proposals can stem from a variety of sources. For the purpose
of analysis, projects may be classified into one of the following categories :
a) New products or expansion of existing projects
, b) Replacement of equipment or buildings
c) Research and development
d) Exploration
e) Safety and/or environmental projects
For a new product, the proposal usually originates in the marketing department.
A proposal to replace a piece of equipment with a more sophisticated model,
however, usually arises from the production area of the firm. In each case,
efficient administrative procedures are needed for channeling investment
requests. All investment requests should be consistent with corporate strategy to
avoid needless analysis of projects incompatible with this strategy.
(b) ESTIMATING AFTER TAX- INCREMENTAL OPERATING CASH
FLOWS
One of the most important tasks in capital budgeting is estimating future cash
flows for a project. In evaluating a capital budget project we are concerned only
with those cash flows that results directly from the project. These cash flows,
called incremental cash flows, represent changes in the firm’s total cash flows
that occur as a direct result of accepting or rejecting the project.
In estimating cash flows, anticipated inflation must be taken into account. Often
there is a tendency to assume erroneously that price levels will remain constant
through out the life of a project. If the required rate of return for a project to be
accepted embodies a premium for inflation (as it usually does), then estimated
cash flows must also reflect inflation.
The illustration below, summarizes the major concerns to keep in mind as we
prepare to actually determine project “after –tax incremental operating cash flows
“. It provides us with a checklist for determining cash-flow estimates.
BASIC CHARACTERISTICS OF THE RELEVANT PROJECT FLOWS
• Incremental (not total) flows
• Cash (not accounting income) flows. Since cash, not accounting income is
central to all decisions of the firm, we express the benefit we expect to
receive from a projection terms of cash flows rather than income flows.
• Operating (not financing) flows. For each investment we used to provide
information on operating as opposed to financing cash flows. Financing
, cash flows such as interest payments, principal payment and cash
dividends are excluded from our cash flows analysis.
• After –tax flows
BASIC PRINCIPLES THAT MUST BE ADHERED TO IN ESTIMATING THE
AFTER TAX INCREMENTAL OPERATING CASH FLOWS:
• Ignore sunk costs-These are uncovered past outlays which, since they
cannot be recovered, should not affect present actions on future decisions.
• Include opportunity costs;-Opportunity cost may be defined as what is lost
by not taking the next-best investment alternative. For instance if we
allocate plant space to a project and this space can be used for something
else, its opportunity cost must be included in the project’s evaluation.
• Include project driven changes in working capital: net of spontaneous
changes in current liabilities.
(c) Calculating the incremental cash flows
It is helpful to place project cash flows into three categories based on timing:
I. Initial cash outlay i.e. the initial net cash investment
II. Interim Incremental net cash flows i.e. those net cash flows occurring
after the initial cash investment but not including the final period’s cash
flows
III. Terminal Year Incremental Net cash flows: - this period’s cash flows are
singled out for special attention because a particular set of cash flows
often occurs at project termination.
Initial cash outflow
In general, the initial cash outflow for a project is determined as illustrated
below. As it will be seen, the cost of the asset is subject to adjustments to reflect
the totality of cash flows associated with its acquisition. These cash flows include
installation costs; changes in net working capital, sale proceeds from the
disposition of any assets replaced and tax adjustments.
Basic Format for determining initial cash out flow
, Cost of New asset
(a) + Capitalized expenditure (e.g. installation costs, shipping expense)*
(b)+(-): Increased (decreased) level of net working capital **
- Net precedes from sale of old asset if the investment is a replacement
decision
+(-) Taxes (tax savings) due to the sale of old asset if the investment is a
replacement decision
= Initial cash outflow
Note: *Asset cost plus capitalization expenditures for the basis upon which tax
depreciation is computed.
** Any change in working capital should be considered “net” of any
spontaneous changes in current liabilities that occur because the
project is implemented.
Interim Incremental Net Cash Flows
After making the initial cash outflow that is necessary to begin implementing a
project, the firm hopes to benefit from the future cash inflows generated by the
project.
Generally, these future cash flows can be determined by the in the following
procedures.
Basic format for determining interim incremental NCF (for a period)
(a) Net increase (decrease) in operating revenue
(b) (+) Any net increase (decrease) in operating expenses, excluding
depreciation
(c) –(+) Net increase (decrease) in tax depreciation charges
(d) = Net changes in income before taxes
(e) –(+) Net increase (decrease) in taxes
(f) =Net change in income after taxes
(g) +(-) Net increase (decrease) in tax depreciation charges
DECISIONS
6.2.1: REVIEW OF DOMESTIC CAPITAL BUDGETING
When a business makes a capital investment, it incurs a current cash outlay in the
expectation of future benefits. Usually, these benefits extend beyond one year in
the future. Examples include investment in assets, such as equipment, building,
and land as well as the introduction of a new product, a new distribution system,
or a new programme for research and development. An investment proposal
should be judged in relation to whether or not it provides a return equal to, or
greater than that required by investors.
Definition:
Capital budgeting may be defined as the process of identifying, analyzing and
selecting investment projects whose returns are expected to extend beyond one
year.
6.2.1.1 THE CAPITAL BUDGETING PROCESS
Capital budgeting involves the following issues:
• Generating investment project proposals consistent with the firm’s
strategic objectives
• Estimating after tax incremental operating cash flows for the investment
projects
• Evaluating project incremental cash flows
• Selecting projects based on value –maximizing acceptance criterion
• Revaluating implemented projects continually and performing post-audits for
completed projects.
(a) GENERATING INVESTMENT PROJECT PROPOSALS
Investment project proposals can stem from a variety of sources. For the purpose
of analysis, projects may be classified into one of the following categories :
a) New products or expansion of existing projects
, b) Replacement of equipment or buildings
c) Research and development
d) Exploration
e) Safety and/or environmental projects
For a new product, the proposal usually originates in the marketing department.
A proposal to replace a piece of equipment with a more sophisticated model,
however, usually arises from the production area of the firm. In each case,
efficient administrative procedures are needed for channeling investment
requests. All investment requests should be consistent with corporate strategy to
avoid needless analysis of projects incompatible with this strategy.
(b) ESTIMATING AFTER TAX- INCREMENTAL OPERATING CASH
FLOWS
One of the most important tasks in capital budgeting is estimating future cash
flows for a project. In evaluating a capital budget project we are concerned only
with those cash flows that results directly from the project. These cash flows,
called incremental cash flows, represent changes in the firm’s total cash flows
that occur as a direct result of accepting or rejecting the project.
In estimating cash flows, anticipated inflation must be taken into account. Often
there is a tendency to assume erroneously that price levels will remain constant
through out the life of a project. If the required rate of return for a project to be
accepted embodies a premium for inflation (as it usually does), then estimated
cash flows must also reflect inflation.
The illustration below, summarizes the major concerns to keep in mind as we
prepare to actually determine project “after –tax incremental operating cash flows
“. It provides us with a checklist for determining cash-flow estimates.
BASIC CHARACTERISTICS OF THE RELEVANT PROJECT FLOWS
• Incremental (not total) flows
• Cash (not accounting income) flows. Since cash, not accounting income is
central to all decisions of the firm, we express the benefit we expect to
receive from a projection terms of cash flows rather than income flows.
• Operating (not financing) flows. For each investment we used to provide
information on operating as opposed to financing cash flows. Financing
, cash flows such as interest payments, principal payment and cash
dividends are excluded from our cash flows analysis.
• After –tax flows
BASIC PRINCIPLES THAT MUST BE ADHERED TO IN ESTIMATING THE
AFTER TAX INCREMENTAL OPERATING CASH FLOWS:
• Ignore sunk costs-These are uncovered past outlays which, since they
cannot be recovered, should not affect present actions on future decisions.
• Include opportunity costs;-Opportunity cost may be defined as what is lost
by not taking the next-best investment alternative. For instance if we
allocate plant space to a project and this space can be used for something
else, its opportunity cost must be included in the project’s evaluation.
• Include project driven changes in working capital: net of spontaneous
changes in current liabilities.
(c) Calculating the incremental cash flows
It is helpful to place project cash flows into three categories based on timing:
I. Initial cash outlay i.e. the initial net cash investment
II. Interim Incremental net cash flows i.e. those net cash flows occurring
after the initial cash investment but not including the final period’s cash
flows
III. Terminal Year Incremental Net cash flows: - this period’s cash flows are
singled out for special attention because a particular set of cash flows
often occurs at project termination.
Initial cash outflow
In general, the initial cash outflow for a project is determined as illustrated
below. As it will be seen, the cost of the asset is subject to adjustments to reflect
the totality of cash flows associated with its acquisition. These cash flows include
installation costs; changes in net working capital, sale proceeds from the
disposition of any assets replaced and tax adjustments.
Basic Format for determining initial cash out flow
, Cost of New asset
(a) + Capitalized expenditure (e.g. installation costs, shipping expense)*
(b)+(-): Increased (decreased) level of net working capital **
- Net precedes from sale of old asset if the investment is a replacement
decision
+(-) Taxes (tax savings) due to the sale of old asset if the investment is a
replacement decision
= Initial cash outflow
Note: *Asset cost plus capitalization expenditures for the basis upon which tax
depreciation is computed.
** Any change in working capital should be considered “net” of any
spontaneous changes in current liabilities that occur because the
project is implemented.
Interim Incremental Net Cash Flows
After making the initial cash outflow that is necessary to begin implementing a
project, the firm hopes to benefit from the future cash inflows generated by the
project.
Generally, these future cash flows can be determined by the in the following
procedures.
Basic format for determining interim incremental NCF (for a period)
(a) Net increase (decrease) in operating revenue
(b) (+) Any net increase (decrease) in operating expenses, excluding
depreciation
(c) –(+) Net increase (decrease) in tax depreciation charges
(d) = Net changes in income before taxes
(e) –(+) Net increase (decrease) in taxes
(f) =Net change in income after taxes
(g) +(-) Net increase (decrease) in tax depreciation charges
