Data necessary to take capital expenditure decisions
The following data are to be collected in order to take the decision of capital expenditure.
1. Initial Investment: It is otherwise called as original investment. The term original investment refers to the cost of implementing the proposal or project into practice. If the new proposal is acquiring new fixed assets, the cost of new fixed assets, the tax paid for acquiring such fixed asset, the installation charges and all other direct expenses incurred to acquire are added in total.
If there is any investment allowances available for acquiring fixed assets from the government which can be deducted from the total and if old assets are sold and such sale proceeds are used for acquiring new fixed assets, which is also to be deducted from the total.
A format for calculating the Initial Investment or Original Investment is given below.
2. Cash Inflows: The term cash inflows refers to the amount available in the hands of the company after paying taxes for and from the current year revenue but before depreciation. If there is any salvage value of the fixed asset, such salvage value is also treated as cash inflows. Cash inflows is uniform or uneven throughout the life of the proposal.
3. Treatment of Depreciation: Depreciation is a book entry. Therefore, depreciation amount is included in the cash inflows. Generally, depreciation is deducted from the earned profit for the purpose of calculation of net tax payable and the depreciation is added back with the amount of profit after tax. In this way, the profit after tax but before depreciation is calculated.
Cash Inflows = Operating Income — Tax + Depreciation
4. Treatment of Salvage Value: Salvage value is the realized amount of the asset which can be realized at the end of the economic life of the amount. If only one project is being considered for implementation, the salvage value is added along with cash inflow of the last year.
Sometimes, the existing asset may be sold and the realized amount is considered for total cash outlay of the ensuring project. If removal costs are incurred to replace the asset, it should be deducted from the scrap value of old machine or asset and then net salvage value should be deducted from the initial cash outlay of new project.
5. Balancing Charge: Balancing charge is the recovered depreciation on the sale of old assets. It is taxable as ordinary business income up to the original cost of the asset. It should be treated as inflow of cash and tax payable on it should be treated as outflow of cash.
6. Investment Allowance: Investment allowance is given by the either state government or central government to increase employment opportunity through project implementation. It is the form of financial incentive to motivate the businessman to replace their old assets. It is calculated at the rate of 25% on original cost of the project. It is deducted from the taxable profits. It is treated as cash inflow in the first year and it should be deducted from the initial cash outflow on new asset.
7. Working Capital: Whenever a proposal is accepted for implementation, there is a need of additional working capital. An additional amount is required to meet wage and other bills, additional inventory, work in progress, finished goods and receivables. The amount of additional working capital so required should be included in initial cash outflow of the project and at the end of the year, the same additional working capital should be included in the cash inflow of that year.
8. Type of the Project: The type of project may be independent, dependent or mutually exclusive. Independent project means a project compete with one another in such a way that the acceptance of one does not eliminate the other from further consideration. Dependent project means a selection of one project depends on the acceptance of some other proposals.
Mutually exclusive projects are competing with each other in all aspects. If the firms has unlimited funds, all the independent proposals and dependent proposals are accepted for implementation. In the case of mutually exclusive projects, only profitable projects are accepted and all other projects are rejected.
9. Capital Rationing: Most of the firms have only limited funds. But, many projects are competing for these limited funds. In this case, the firm has ration its projects and allocate the funds to the projects in a manner that maximizes the long run returns. Such allocation of financial resources to different competing projects is capital rationing.