Capital Budgeting

Meaning of capital budgeting Significance Capital budgeting process Investment criteria Methods of capital budgeting

Meaning
The process through which different projects are evaluated is known as capital budgeting Capital budgeting is defined as the firms formal process for the acquisition and investment of capital. It involves firms decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets. Capital budgeting is long term planning for making and financing proposed capital outlays- Charles T Horngreen.

 Capital budgeting consists in planning development of available capital for the purpose of maximising the long term profitability of the concern Lynch The main features of capital budgeting are a. potentially large anticipated benefits b. a relatively high degree of risk c. relatively long time period between the initial outlay and the anticipated return. - Oster Young

Significance of capital budgeting The success and failure of business mainly depends on how the available resources are being utilised. Main tool of financial management All types of capital budgeting decisions are exposed to risk and uncertainty. They are irreversible in nature. Capital rationing gives sufficient scope for the financial manager to evaluate different proposals and only viable project must be taken up for investments. Capital budgeting offers effective control on cost of capital expenditure projects. It helps the management to avoid over investment and under investments.

Capital budgeting process involves the following 1. Project generation: Generating the proposals for investment is the first step. The investment proposal may fall into one of the following categories: Proposals to add new product to the product line, proposals to expand production capacity in existing lines proposals to reduce the costs of the output of the existing products without altering the scale of operation. Sales campaining, trade fairs people in the industry, R and D institutes, conferences and seminars will offer wide variety of innovations on capital assets for investment.

2. Project Evaluation: it involves two steps Estimation of benefits and costs: the benefits and costs are measured in terms of cash flows. The estimation of the cash inflows and cash outflows mainly depends on future uncertainities. The risk associated with each project must be carefully analysed and sufficeint provision must be made for covering the different types of risks. Selection of an appropriate criteria to judge the desirability of the project: It must be consistent with the firms objective of maximising its market value. The technique of time value of money may come as a handy tool in evaluation such proposals.

3. Project Selection: No standard administrative procedure can be laid down for approving the investment proposal. The screening and selection procedures are different from firm to firm. 4. Project Evaluation: Once the proposal for capital expenditure is finalised, it is the duty of the finance manager to explore the different alternatives available for acquiring the funds. He has to prepare capital budget. Sufficient care must be taken to reduce the average cost of funds. He has to prepare periodical reports and must seek prior permission from the top management. Systematic procedure should be developed to review the performance of projects during their lifetime and after completion.

The follow up, comparison of actual performance with original estimates not only ensures better forecasting but also helps in sharpening the techniques for improving future forecasts.

Factors influencing capital budgeting

Availability of funds Structure of capital Taxation policy Government policy Lending policies of financial institutions Immediate need of the project Earnings Capital return Economical value of the project Working capital Accounting practice Trend of earnings

Methods of capital budgeting

Traditional methods Payback period Accounting rate of return method

Discounted cash flow methods Net present value method Profitability index method Internal rate of return

Pay back period method It refers to the period in which the project will generate the necessary cash to recover the initial investment. It does not take the effect of time value of money. It emphasizes more on annual cash inflows, economic life of the project and original investment. The selection of the project is based on the earning capacity of a project. It involves simple calcuation, selection or rejection of the project can be made easily, results obtained is more reliable, best method for evaluating high risk projects.

Cons It is based on principle of rule of thumb, Does not recognize importance of time value of money, Does not consider profitability of economic life of project, Does not recognize pattern of cash flows, Does not reflect all the relevant dimensions of profitability.

Accounting Rate of Return method

IT considers the earnings of the project of the economic life. This method is based on conventional accounting concepts. The rate of return is expressed as percentage of the earnings of the investment in a particular project. This method has been introduced to overcome the disadvantage of pay back period. The profits under this method is calculated as profit after depreciation and tax of the entire life of the project. This method of ARR is not commonly accepted in assessing the profitability of capital expenditure. Because the method does to consider the heavy cash inflow during the project period as the earnings with be averaged. The cash flow advantage derived by adopting different kinds of depreciation is also not considered in this method.

Accept or Reject Criterion: Under the method, all project, having Accounting Rate of return higher than the minimum rate establishment by management will be considered and those having ARR less than the pre-determined rate. This method ranks a Project as number one, if it has highest ARR, and lowest rank is assigned to the project with the lowest ARR. Merits It is very simple to understand and use. This method takes into account saving over the entire economic life of the project. Therefore, it provides a better means of comparison of project than the pay back period. This method through the concept of "net earnings" ensures a compensation of expected profitability of the projects and It can readily be calculated by using the accounting data.

Demerits 1. It ignores time value of money. 2. It does not consider the length of life of the projects. 3. It is not consistent with the firm's objective of maximizing the market value of shares. 4. It ignores the fact that the profits earned can be reinvested. -

Discounted cash flow method Time adjusted technique is an improvement over pay back method and ARR. An investment is essentially out flow of funds aiming at fair percentage of return in future. The presence of time as a factor in investment is fundamental for the purpose of evaluating investment. Time is a crucial factor, because, the real value of money fluctuates over a period of time. A rupee received today has more value than a rupee received tomorrow. In evaluating investment projects it is important to consider the timing of returns on investment. Discounted cash flow technique takes into account both the interest factor and the return after the payback 'period.

Discounted cash flow technique involves the following steps: Calculation of cash inflow and out flows over the entire life of the asset. Discounting the cash flows by a discount factor Aggregating the discounted cash inflows and comparing the total so obtained with the discounted out flows.

Net present value method It recognises the impact of time value of money. It is considered as the best method of evaluating the capital investment proposal. It is widely used in practice. The cash inflow to be received at different period of time will be discounted at a particular discount rate. The present values of the cash inflow are compared with the original investment. The difference between the two will be used for accept or reject criteria. If the different yields (+) positive value , the proposal is selected for invesment. If the difference shows (-) negative values, it will be rejected.

Pros: It recognizes the time value of money. It considers the cash inflow of the entire project. It estimates the present value of their cash inflows by using a discount rate equal to the cost of capital. It is consistent with the objective of maximizing the welfare of owners. Cons: It is very difficult to find and understand the concept of cost of capital It may not give reliable answers when dealing with alternative projects under the conditions of unequal lives of project.

Internal Rate of Return

It is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows. It is the rate at which the net present value of the investment is zero. It is the rate of discount which reduces the NPV of an investment to zero. It is called internal rate because it depends mainly on the outlay and proceeds associated with the project and not on any rate determined outside the investment.

Merits of IRR method It consider the time value of money Calculation of casot of capital is not a prerequisite for adopting IRR IRR attempts to find the maximum rate of interest at which funds invested in the project could be repaid out of the cash inflows arising from the project. It is not in conflict with the concept of maximising the welfare of the equity shareholders. It considers cash inflows throughout the life of the project.

Cons Computation of IRR is tedious and difficult to understand Both NPV and IRR assume that the cash inflows can be reinvested at the discounting rate in the new projects. However, reinvestment of funds at the cut off rate is more appropriate than at the IRR. IT may give results inconsistent with NPV method. This is especially true in case of mutually exclusive project.

Step 1:Calculation of cash outflow

Cost of project/asset Transportation/installation charges Working capital Cash outflow xxxx xxxx xxxx xxxx

Step 2: Calculation of cash inflow Sales Less: Cash expenses PBDT Less: Depreciation PBT less: Tax PAT Add: Depreciation Cash inflow p.a

xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx

Note: Depreciation = St.Line method PBDT Tax is Cash inflow ( if the tax amount is given) PATBD = Cash inflow Cash inflow- Scrap and working capital must be added.

Step 3: Apply the different techniques Pay back period= No. of years + Amt to recover/ total cash of next years. ARR = Average Profits after tax/ Net investment x 100 NPV= PV of cash inflows PV of cash outflows Profitability index = PV of cash inflows/ PV of cash outflows IRR : Pay back factor: Cash outflow/ Avg cash inflow p.a. Find IRR range PV of Cash inflows for IRR range and then calculate IRR

Thank You