Page 164 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 13. Treat inflation inconsistently: If the discount rate is stated in nominal terms, then
consistency requires that cash flows be estimated in nominal terms, taking account of
trends in selling price, labour and material costs, etc. This calls for more than simply
applying a single assumed inflation rate to all components of cash flow. Tax shields on
depreciation do not increase with inflation. They are constant in nominal terms because
tax law in India allows only the original cost of assets to be depreciated.
14. Effect on other projects: Cash flow effects of the project under consideration. If it is not
economically independent on other existing projects of the firm it must be taken into
consideration.

Example: If the company is considering the production of a new product that competes
with the existing products in the firms product line, it is likely that as a result of the
new proposal, the cash flows related to the old product will be effected.
15. Tax effect from investment tax credit: An investment tax credit is a tax benefit allowed to
business purchasing capital assets. The firm may claim a specified percentage of new
capital investments as credit against income tax in the current year. This is in line with
investment allowance provided in the Income Tax Act, 1961 earlier.
Conversion of Incremental Accounting Profit to Cash Inflow for Project Evaluation:
Year wise Incremental
Cash Inflow = Year Wise Incremental Accounting Profit of any project (whether it
be for new product or replacement of old Machinery with new
machinery etc.) after tax, but, before interest + Depreciation + all
other non-cash expenses.
– Non-cash revenue i.e., profit on sale of asset after the end of the
project.

Self Assessment

Fill in the blanks:
3. A capital budgeting decision is a ………………process.
4. It is important to include all ……………..effects on the remainder of the business.

9.3 Methods of Analyze Capital Budgeting Decisions

9.3.1 Traditional Techniques of Evaluation

Payback Period

Sometimes called the payout method i.e., a computationally simple project evaluation approach
that has been used for many years. The procedure is to determine how long it takes a project to
return the cost of the original investment.

Example: A project costing 20 lakhs yields annually a profit of 3 lakhs after depreciation
@12.5% (straight line method) but before tax 50%. In this case cash inflow = Profit after tax +
Depreciation = 3,00,000 – Tax 1,50,000 + Depre. 2,00,000 = 4,00,000 p.a.

1,60,000 – 10,000 Cost of the project 20,00,000
Payback period = = = 5 years.
15 Annual cash inflow 4,00,000

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