CAPITAL BUDGETING.docx - CAPITAL BUDGETING (ADVANCED)...

This preview shows page 1 - 3 out of 8 pages.

CAPITAL BUDGETING (ADVANCED)Further considerations incapital budgetinga. Sunk costs: A sunk cost is a cost that has already been incurred and will thereforenot affect the acceptance or rejection of a project. Since sunk costs are notincremental costs, they are irrelevant in capital budgeting.b. Opportunity costs: This refers to the best alternative sacrifice made. b. In capitalbudgeting the opportunity cost should be considered as an incremental cost.c. Transfers of revenues: Transfers of revenues are not incremental benefits c. andshould not be considered in capital budgeting.d. Changes in working capital: Working capital refers to current assets minus currentliabilities. Working capital changes are treated as an investment in the initialstage and as a cash inflow at the end of the project’s life. Any additional workingcapital incurred in between the projects life should be treated as a cash outflowto the extent incurred.Incorporatingtaxation incapital budgetingWhen taxation is incorporated in capital budgeting it brings about tax shield benefit.This benefit should be treated as a cash inflow when tax is paid. The followinggeneral format is then used to calculate cash flows;Additional revenues`xxx)Less additional expenses(xxx)Profit before interest and tax (PBDT) xxxLess Depreciation(xxx)Profit before taxxxxLess tax(xxx)Profit after taxxxxAdd depreciationxxxCashflowxxxAlso cash flow = PBDT (1-T) + Depreciation x TaxationIllustrationAruma Ltd. evaluating an investment project which requires the importation of a new machine at a cost ofSh2,700,000. The machine has a useful life of six years.Additional information:The following additional costs would be incurred in relation to the machine:ShFreight225,000Installation and pre-production375,000Import duty900,000The machine is expected to increase the company’s annual cash flows (before tax) as shown below:Year12345Increase incash flow (Sh)1,760,0001,360,0001,050,000900,000840,000750,000The machine is to be fully depreciated over its useful life using the straight line method.The corporate rate of tax is 30% while the cost of capital is 12%The maximum acceptable payback period to the company for all capital projects is four years.6
Installation375Import duty900Total cost4,2004,200,000/6 Annual Depreciation/useful life = Sh700,000DTSB = 700,000 X0.3 = 210,000Determination of cash flowYear 1Year 2Year3Year 4Year 5Year 6Profit before tax1,760,0001,360,0001,050,000900,000840,000750,000Less tax @ 30%528000408,000315,000270,000252,000225,000Profit after tax1,232,000952,000735,000630,000588,000525,000Add DTSBbenefit210,000210,000210,000210,000210,000210,000Cashflow1,442,0001162,000945,000840,000798,000735,000yearcashflowSh000Cumulative cash flow11442144221162260439453549484043895798518767355922Payback period= year before full recovery +(cash balance to payback/cash received the following year)Payback= 3+(651/840)= 3.775 yrsNPV= PV of cash inflows – initial outlayyearCashflowDiscountfactorsPresentvalue114420.89291288211620.797292639450.711867348400.635553457980.567445367350.5066372Total PV4246Initial outlay(4200)NPV46Since NPVis greater than zero, accept the project.

Upload your study docs or become a

Course Hero member to access this document

Upload your study docs or become a

Course Hero member to access this document

End of preview. Want to read all 8 pages?

Upload your study docs or become a

Course Hero member to access this document

Term
Winter
Professor
DR. Onyango

Newly Uploaded Documents

Show More

Newly Uploaded Documents

Show More

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture