CMA USA Part-2 section-E investment decision notes and questions

 Part-2 Section -E

Investment decision notes:

Capital budgeting:

It is a process used to evaluate potential major projects or investments.

It is a process of making long-term investment decisions.

It includes investment in a new plant, a new product line, and purchasing a new machine.


Ø  Stages in capital budgeting:

Step1: identification stage:

During this stage, the company determines which type of capital expenditure needs to be made.

Step2: search stage:

During this stage, the company searches the capital alternative investment that will achieve the organizational objectives.

Step3: information acquisition stage:

The company determined the expected cost and benefits quantitative and qualitative of different capital investments.

Step-4; selection stage:

Based on the financial and non-financial analysis, the company chooses the best project.

Step-5: financial stage:

the company obtains the necessary project funding.

Step-6: implementation and control stage:

The project is implemented and monitored over time.


Ø  Terms uses in capital budgeting:

1.                 Fixed cost
2.      Opportunity cost[relevant]
3.      Sunk cost [historical cost/already paid]
4.      Imputed cost [implicit cost]
5.      Common cost [ not relevant]
6.      Discretionary cost [eg: advertisement]
7.      Avoidable cost
8.      Unavoidable cost
9.      Incremental revenue, incremental cost, incremental cash
10.   Cost of capital: [ it is a weighted average cost of debt and equity]
11.   Differential cash flow: these are cash flows that differ between or among two or more potential alternatives.


Ø  Difference between cash flows and accounting profit:

Cash flows: cash flow is [ cash receipt -cash disbursement or cash payment.


Ø  Accounting profit:

It is a profit determined on the income statement using GAAP.

It is an accrual concept.

Note: estimated cash flows are used to evaluate prospective capital budgeting projects.

Cash flows are a better measure than profit.


Ø  Calculate the relevant cash flows:

1.      Expected cash flows at the beginning of the project [ year zero or time zero]

Year zero cash flow consists of

a.      Initial investment: [outflow]

b.      Initial working capital investment: [outflow]

Working capital is also known as net working capital.

Working capital= current asset – current liability



c.      Cash received from the disposed of the old assets. [inflow]

d.      Amount tax paid [ outflow] or tax benefit [inflow] from the sale of the old assets.


Note: tax basis:

It is the book value of an asset for tax purposes.

Gain or loss on asset= cash received from an asset-tax basis.


2.      Cash Flow during ongoing years:


a.      Additional investment [ outflow] [ no qn]

b.      Additional working capital investment

c.      After-tax operating cash flow [ inflow]

= sale – operating expenses – tax = after tax operating cash flow.


Operating cash inflow  may result from

1.      Increased sales

2.      Decreased operating expenses.


d.      Depreciation tax shield: [ inflow]

Depreciation Is not included in the operating cash flow, because it is not a cash expense.

Depreciation is an accounting expense

Depreciation is not a cash expense but depreciation is a cash deductible expense.

A depreciation tax shield is a reduced income tax.

Depreciation tax shield= depreciation × tax rate.


Ø  MACRS depreciation method for tax purposes:

[ modified accelerated cost recovery system ]

It is a depreciation method required by US tax law.

[Example in my youtube channel]

For capital budgeting purposes we depreciate 100% cost of the asset.

We do not need to subtract salvage value.


Ø  Strength line depreciation method for tax purposes:

This method results in equal depreciation each year.

Historical cost ÷ useful life = depreciation year.

Ø  Cash Flow at the disposal or completion of the project:

1.      Depreciation tax shield

2.      After-tax operating cash flow

3.      Cash received from the disposal of equipment [ inflow]

4.      Tax benefit [ inflow] or tax payment [ outflow].

5.      Recovery of working capital [ inflow]

Note: MACRS method is similar to the 200% double decline balance method.





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