Dear All,
A short note on Replacement Decisions - Capital Budgeting. Please do see my other post - i have given a plan for SFM for the month of June for students to follow and prepare for the exams on a systematic basis. Yuo could formulate your own plan based on your pace of learning but its important to have consistent studying and learning experience.
Capital budgeting is a process of identifying, selecting and analyzing investment projects whose cash flows are expected to be over more than a year period of time.
As a process in capital budgeting we go through three stages
a. Abandonment
b. Purchase
c. Replacement decisions.
While replacing an Asset we have to consider if the New Asset or Existing asset has positive NPV. the one with higher NPV is selected. This can be true when we have the same equal period to get a decision, when the period of lives of assets are not equal - in terms of useful life. In such cases we consider using Equated method - Annual beneift or annual cost.
Incremental cash flows method can only be used if life of new Asset and Existing asset are equal.The one with Higher NPV is choosen
Keypoints to consider in Incremental Cash flow method
Initial Cash outflow > Net cash investment ( Cost of Machine Less Net sale value of Old machine ( Cash inflow due to sale of asset - Tax outflow on Profit on sale of Asset))
Incremental cash flow from the asset Less cash flow savings from old asset (Incremental Revenue or Savings in Cost from New asset - Depreciation) to arrive at Profit before Tax. Apply Tax at rate provided to get PAT. PAT + Depreciation(Non cash item) is the Cash flow After Tax
Terminal /end Incremental cash flows . Salvage value of asset disposed - Opportunity cost of Old asset salvage value net of tax.
Discount the above at After Tax cost of Capital to arrive at NPV
Principles for Replacement Decisions
> Ignore Sunk cost
> Include Opportunity cost . Like in example we discussed today that if the Old Asset has been used till the end of terminal period and if we have an Opportunity to salvage it at the end of period, that must be considered for Terminal cash flows
> Include any working capital requirement for the project
> Effects of Inflation ( we will discuss this further)
Students could follow Authors - Pattabhiraman, Sridhar or Padhukas based on thier preference - and solve the exercise revision problems applying the concept. Solve practice manuals & RTP's .
Studetns get benefitted if they participate in the forum asking for doubts and clarifications and my intent is to provide concepts for every topic in the coming months for Financial reporting, Financial management & Income tax.
Studens in Bangalore could attend my classes - batch size less than 10 by contacting tejas @ tejas.co.in or write to me for any doubts or clarifications. Happy learning.
Regards,
Satish.
CAclubindia
