Now the “Cash Flow” and the interest rate related “Discount Factor” are the most important concept of capital budgeting process. Here in this section we will explain this in details.
1. All the capital budgeting decisions are taken based on the incremental cash flows, not based on the income from the project. To do this all the hidden cost should be considered and depreciation or amortization has to be added to the income to get the actual incremental cash flow as they are non-cash expenses and do not incur any cash outflow.
2. Here the word “Incremental” is also very important as only the incremental cash flow has to be considered for any kind of capital budgeting decision. Let us see this with an example.
Suppose one company has one plant with old machines which gives revenue of 1000USD per month with running expenses as 900 USD. So the profit from the plant is 100 USD per month.
Now the company wants to replace the old machines with the new and efficient one so that it can produce more output with less power consumed.
While evaluating the capital budget, it has found that after replacing the old machines with the new ones, the monthly revenue will be 1200 USD due to higher output and monthly expense will be 85o USD due to lower power consumption. So the monthly profit will be 350 USD.
Total cost to replace the old machines with the new ones will be 10000 USD and new machines can be used for next 5 year with full efficiency.
The profit will increase by (350-100) = 250 USD. This will be the incremental cash flow or the increase in cash inflow if the old machines will be replaced by the new ones.
This incremental cash flow (250 USD) will be considered while evaluating the project, not the monthly income (350 USD).
This example explains the rationale behind using the incremental cash flow instead of income.
3. Opportunity cost has to be considered while calculating the cash flow for capital budgeting process.Opportunitycost denotes the loss incurred or value of the opportunity lost by undertaking another project.
Suppose a company has a land of value 1 million USD and it is planning to set up a factory on that land.
Now if the company builds the plant on that land, then it won’t be able to sell the land to anyone or use it for another purpose, which makes the land to lose its market value.
The cost of the land will be the opportunity cost if the factory is built on that.
So while evaluating the cash flow from the new factory the cost of the land should be considered as a cost and should be included in the capital budgeting calculation.
4. Tax payment causes tax outflow for the company, so project specific tax has to be considered while calculating the incremental cash flow of the project. In this case tax percentage is very important. Let us see with an example
For the previous incremental cash flow example let us consider the tax rate as 30%.
For the plant with old machines the profit was 100 USD, so tax will be 30 USD. Cash inflow 70 USD.
For the new plant with new machines, the profit is 350 USD and tax 105 USD. So the total cash inflow is 245 USD.
Here the incremental cash inflow will be (245 – 70) = 175 USD, which is significantly lower below the previous incremental cash flow.
So we can see how the tax consideration can change the cash inflow significantly and drive the final decision.
5. Cost of capital is another important factor while evaluating the capital budgeting process as it specifies the cost of the capital borrowed from the market. All the new projects require capital investment and most of the cases the requirement is fulfilled by borrowing money from the market at some particular cost. If the cost increase, it impacts significantly in the decision making process. Cost of capital is mainly calculated from the working average cost of capital and debt holding of the company. This will be explained in detail later on.
6. Timing is the most important aspect while evaluating a new capital project as more delay reduces the present value of the cash flow. Here it is explained in detail
Some money having now worth more value than the same amount of money in future because of interest rate. If you have 100 USD now, it is more valued than 100 USD after one year. The main reason is that if you have that money you can invest in some risk free government bonds or Treasury bill and earn interest on the same. If the interest rate is 10% then, after 1 year, the total value will be 110 USD, which is more than 100 USD at that time.
Due to the same reason, we use discount factor for any future cash flow to get the present value of the same amount. If the interest rate is “I” then the discount factor would be 1/(1+I) for one year and 1/((1+I)^n) for nth year as the present value will be reduced more because of more delay.
If the expected cash inflow will be 100 USD after 10 years and interest rate or cost of capital is 10% then the present value of the expected cash inflow will be (100/((1+0.10)^10)) = 38.55 USD. It shows how the interest factor reduces the value significantly.
All the details explained above are equally important and have to be considered while evaluating any capital budgeting decision. The methods of evaluation will be explained now.