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EduPristine>Blog>CFA® Program-I Tutorial: Understanding Capital Budgeting

CFA® Program-I Tutorial: Understanding Capital Budgeting

May 16, 2013

Are you interested in Finance??

Do you really want to make a future in the field of finance??

If your answer is a Yes, this one is for you!!!!

Take my words; you cannot become a good financial analyst if you have any doubt on the topic Capital Budgeting. You need to have proper command on this topic. And just in case you are planning to write CFA® Exam, this would definitely give you an edge over your peers.

What is this Capital Budgeting?? Is it really helpful?? (Yes, of course!!! :P)

The key things to remember for Capital Budgeting are:

1. The incremental cash flows are used for evaluating a project and not accounting Net Income.

Suppose you are considering undertaking a new project. To complete the project, you would need funding, and more importantly fundamental understanding of “Capital Budgeting”.

Capital Budgeting says that the incremental cash flows are to be used for evaluation and not accounting Net Income. So if during the first year, you received $4mn (all in cash) in revenues and spent $500,000 cash on expenses, the incremental cash flow is $3.5mn. This $3.5mn is the relevant figure that would be used for evaluation and not the accounting income that you would get from the Income statement.

2. Financing costs are not considered as part of net cash flows.

I myself have made this blunder!!! The interest expense is not considered as a part of net cash flows. The cost of capital accounts for financing costs. So, even if you paid $100,000 on the loan that you took, DO NOT subtract this amount from your cash flows. The cost of capital accounts for financing costs. That means net cash flow is the algebraic sum of all cash flows except the financing costs.

Remember this one!!!

We have excluded taxes from our analysis. How would the approach change if we included taxes as well??

3. Cash flows are considered on after-tax basis.

As the heading suggests Cash flows are considered on after-tax basis. Suppose we take some of your Income Statement data from the last financial year:

Revenues:

$4mn (Received in cash)

Rental and crew expense:

$1.5mn (Paid in cash)

Promotion expense:

$500,000 (To be paid)

Interest expense:

$100,000 (Paid in cash)

Using 40% tax rate, you can easily apply your accounting fundamentals and get PAT equal to $1.14mn.

(Hint: $1.9mn*0.6 = $1.14mn). You would be tempted to use this $1.14 as your net cash flow. But you should not. This is not the relevant cash flow for the year. Remember Point 1!!!!

The million dollar question is what is the relevant cash flow for the year??

The answer is: $4mn – $1.5mn – Taxes paid (Hint: Taxes paid is equal to $1.9*0.4 = $0.76mn)

= $1.74mn

4. Cash flows are based on opportunity costs.

Cash flows are based on opportunity costs. If you are using a property during the project, account for the forgone rental income as well. Suppose, if not used, your property would generate a yearly income of $12000 per year. Now, this $12,000 should be subtracted from your net cash flows every year.

5. The concept is used to evaluate projects that have cash flows spread over a period usually longer than a year.

The concept of capital budgeting is really helpful in evaluating projects that have cash flows spread over years. It gives you the dollar value that the project would add to the wealth.

Look out for our next article to experience more fun!!!

You cannot understand budgeting unless you work it out yourself.

If you still have any queries on the topic, please feel free to contact us at lokesh@eneev.com

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