"A STUDY ON CAPITAL BUDGETING.

"
Mini Project Report submitted in partial fulfillment of the requirements for
the award of the Degree of
MASTER OF BUSINESS ADMINISTRATION
Of
BANGALORE UNIVERSITY

By
Kumar Swamy T U
Register No. 141GCMD049
Under the guidance of

Dr. RAJESH KUMAR V

Professor

Rashtreeya Sikshana Samithi Trust

R V INSTITUTE OF MANAGEMENT
CA-17, 36th Cross, 26th Main, 4th T Block,
Jayanagar, Bangalore 560 041
20152016

Introduction
A Business organisation has to quite often face the problem of capital investment decisions.
Capital Investment refers to the investment in projects whose results would be available only
after a year. The investments in these projects are quite heavy and is to be made immediately
but the return will be available only after a period of time. These investment decisions,
popularly known as capital Budgeting decisions. It requires comparisons of cost against
benefits over a long period. Such Investments may affect revenues for the time period ranging
from 2 to 20 years or more. In other Words, the system of capital budgeting is employed to
evaluate expenditure decisions which involve Current outlays but are likely to produce
benefits over a period of time longer than one year. These Benefits may be either in the form
of increased revenues or reduction in costs. A capital expenditure is an outlay of cash for a
project that is expected to produce a cash inflow over a period of time exceeding one year.
Examples of projects include investments in property, plant, and equipment, research and
development projects, large advertising campaigns, or any other project that requires a capital
expenditure and generates a future cash flow.
Because capital expenditures can be very large and have a significant impact on the financial
performance of the firm, great importance is placed on project selection. This process is
called capital budgeting.

Fixed assets management

Fixed Asset are those assets which are of a somewhat fixed or permanent nature (a life
expectancy of more than one year) and are used by a business in its normal operations; they
do not include items Offered for sale. Fixed assets management is the most important task
which a management has to face in its day-today situations, and is important for the following
reasons:
i) There is risk involved in fixed assets because of their longer life.
ii) Fixed Asset usually have a relatively High cost.
iii) Fixed Assets create problems of acquisition and replacement. Acquisitions are additions to
fixed assets. The main purpose of acquisitions is to increase existing capability. Replacements
are the assets which take the place of existing assets with comparable capacity. Betterments
and improvements refer to capital expenditure which results in the Physical change or
alteration of an asset. The purchase of fixed assets is of particular significance of business

firms because the amount involved is relatively large and represent commitments for a
relatively long period of time. They are relatively long-lived assets which are acquired for use
in a business and not intended for sale.
iv) There is a greater tendency to make use of machines and invest more and more in fixed
assets. The use of efficient machinery is necessary for economics of scale, particularly in
conditions of increasing competition. Because of technological changes, the investment in
fixed assets is likely to increase, for all assets become outdated and may have to be replaced.
Planning for long-term capital expenditure is the most important function of every business
because substantial amounts are involved and the investment of funds is spread over a
considerable period of time, and returns flow back at varying intervals in unknown amounts.
Capital budgeting on a long-term basis is an essential part of fixed assets management. While
emphasising importance of fixed assets management, Johnson points out that fixed financial
obligations must be met when due, at an average and not in most years but always. The policy
in planning capital expenditure is not only important for a company and its financial
positions, but is also of strategic importance to the total economy.

Meaning of capital budgeting

The term capital budgeting contains two words , capital , the relatively scarce , non-human
resource of production enterprise, and budgeting thus indicating a detailed, quantified
planning which guides future activities of an enterprise towards the achievement of its profit
goals. Capital relates to total funds employed in an enterprise as a whole. The capital fund is
increased by an inward flow of cash and decreased by an outward flow of cash and as such it
is important for an enterprise to plan and arrange cash flows properly. The power of the
financial planning package lies in enabling borrowings to be arranged sufficiently in advance
to reduce the danger of a liquidity crisis also to provide substantiating documents for loan
negotiations. Capital budgeting then consist in planning the deployment of available capital
for the purpose of maximising the long-term profitability (return on investment) of a firm. It
refers to the process by which a firm determines where it should apply its comparatively
limited financial resources.
Capital budgeting may be defined as the decision-making process by which a firm evaluates
the purchase of major fixed assets, including buildings, machinery and equipment. It deals
exclusively with major investment proposals which are essentially long-term projects and is
concerned with the allocation of the firms scarce financial resources among the available

market opportunities. It is a many-sided activity which includes a search for a new and more
profitable investment proposal and the making of an economic analysis to determine the
profit potential of each investment proposal. The term capital expenditure projects is broad
enough to include those projects in which the net assets of a company are acquired by the
issue of the capital stock of the acquiring company. Capital budgeting involve a long-lived
assets affects a forms operation over a period of time (years). They are large, permanent
commitments which influence its long-run flexibility and earning power. It is a process by
which available cash and credit resource are allocated among competitive long-term
investment opportunities so as to promote the greatest profitability of a company over a
period of time. It refers to the total process of generating. Evaluating, selecting and following
up on capital expenditure alternatives.

Significance of capital budgeting

Capital budgeting is Significant for the following reasons:
1. The decision maker loses some of his flexibility, for the results continue over an extended
2.
3.
4.
5.

period of time. He has to make a commitment for the future.

Asset expansion is related to future sales.
The availability of capital assets has to be phased properly.
Asset expansion typically involves the allocation of substantial amounts of funds.
Many firms fail because they have too much or too little capital equipment.

Principles of capital budgeting

Capital expenditure decisions should be taken on the basis of the following factors:
Creative Search for Profitable Opportunities: - The first stage is the conception of the
profits making idea. Profitable investment opportunities should be sought to supplement
existing proposals.
Long-Range Capital Planning: A flexible programme of a companys expected future
development over a long period of time should be prepared.
Short-range Capital Planning: This is for short period. It indicates its sectoral demand for
funds to stimulate alternative proposals before the aggregate demand for funds is finalised.
Measurement of project Work: The economic worth of a project to a company is evaluated
at this stage. The project is ranked with other projects.

Screening and selection: The project is examined on the basis of selection criteria, such as
the supply and cost of capital, expected returns, alternative investment opportunities etc.
Post Mortem: The ex-post routines of a completed investment project should be re-evaluated
in order to verify their exact conformity with exact projections.
Retirement and Disposal: The expiry of the cycle in the life of a project is marked at this
stage. Forms and Procedures: These involve the preparation of reports necessary for any
capital expenditure programme.
Economics of Capital Budgeting:

It includes estimating the rate of return on capital

expenditures. A knowledge theory underlying investment decisions is needed for this

purpose. This broad field of decision-making of capital investment is one of the most
difficult, one of the most recurrent and one of the most controversial of management areas;
and it is also an area where there are tremendous opportunities for basic improvements in
operation and policies. It may be emphasised here that the Use of a model or of any of the
mathematical technique of the operations research does not imply Management by
computers. The mathematical model itself is a tool of management rather than a Replacement
for management.
Authorisation: Since capital expenditure budget does not contain detailed expenditure, it is
essential that before any individual projects relating to capital items are started, the
expenditure should be specially authorised.

Characteristics of capital budgeting:

Capital Expenditure for Long-Period
Forecasting
Planning Asset Capacities
Capital Expenditure for Long-Period:
Capital budgeting entails heavy expenditure. In fact, this is a very important characteristic
which explains the importance of capital budgeting decisions to a firm. Capital is sunk for a
long period. This long-term commitment adds considerably to the risk of capital budgeting
decisions. Capital expenditure is the main link between the present and the future, for it is the
principal means by which an industrial company tries to attain its long-term goals and
objectives. Because of its relationship with long-term profit planning, its disproportionately
heavy impact on short-term profit and its high volume, capital expenditure should be planned

and controlled. Decisions which involve the authorisation of capital expenditure projects are
among the most important for the Boards of Directors and their managerial advisers. Most
capital expenditures schemes call for a permanent commitment of relatively large sums of
money over a number of years. Capital expenditure is Strategic investment of some
magnitude and is of a non-routine nature; it has economic life and its benefits continue over a
series of years. From the standpoint of the stockholder and the consumer, capital expenditure
are the principal bulwark against the seemingly endless progression of wage increase. From
the standpoint of labour, capital expenditure are the basic economic source of future wage
advances, for they embody the creative forward strides of advancing technology. Finally,
capital expenditure, both by their aggregate size and by their cyclical timing, have a great
deal to do with the character of the economy as a whole , and therefore , with the
governments role in maintaining stability.
Forecasting:
As funds are committed over extended periods of time, there is a need for proper
forecasting. A bird in hand is worth two in the bush. There is an element of uncertainty and
risk which may lie in store for the future. All these factors have to be properly evaluated in
the process of forecasting. A proper cost-benefit relationship should also be established.
Planning Asset Capacities:

A firm has to assess the capacities of the assets properly before arriving at its long-term
decisions. Both under-capacities and over-capacities should be avoided. Moreover, the
management should determine the timing and the quality of asset acquisitions. Asset
capacities have to be related to market factors, which may change over a period of time
because of various cyclical fluctuations. A firm should, therefore plan and fix the capacities
of its asset in which long-term investment is going to be sunk. Far-sighted judgement is an
essential pre-requisite of wise decisions bearing on capital expenditures. But such a
judgement, to be sound, should be based on a needs an objective means of measuring the
economic worth of individual investment proposals so that it may choose and select those
which will have the most profound impact on a companys long-run prosperity. The real
worth of an investment proposal may be traced to the credibility of the forecasts of the sales
demand and production capacity which underpin the validity of the assessments and any
miscalculation of these is likely to be of far greater consequences than the relatively marginal
effects of errors caused by the use of a wrong rate of interest in discounting calculations.

Factors Affecting Capital Budgeting:

While making capital budgeting investment decision the following factors or aspects should
be considered.

The amount of investment

Minimum rate of return on investment (k)
Return expected from the investments. (R)
Ranking of the investment proposals and
Based on profitability the raking is evaluated I.e., expected rate of return on
investment.

Types of investment decisions:

There are many ways to classify investments. One classification is as follows:

Expansion of existing business

Expansion of new business
Replacement and modernization

Capital rationing:
Capital rationing means distribution of capital in favor of more acceptable proposals. A firm
determines a certain cut-of-point for selecting accepted proposals. The basic reason for
capital rationing is that funds to be invested over a long period of time must be distributed
most judiciously. The capital rationing problem is one where not all projects with positive
present values (items at the pre-rationing discount rate) can be taken up because of limits on
the funds available for investment. It is also a situation in which some projects, with negative
present or terminal values, may be expected if they generate funds at crucial times. There are
two problems in capital rationing:
Given the cost of capital, which group of investment should be selected? The principle of
accepting all the proposals have a positive present value of the firms cost of capital is
obvious, for a failure to do so would prove critical. Adherence to this principle results in the
present value of a firms net worth being at a maximum al all points of time.

Factors Influencing Capital Budgeting Decisions:

There are many factors, financial as well as non-financial, which influence that Budget
decisions. The crucial factor that influences the capital expenditure decisions is the
profitability of the proposal. There are other factors, which have to be in considerations such
as.
1. Urgency:
Sometimes an investment is to be made due to urgency for the survival of the firm or to avoid
heavy losses. In such circumstances, the proper evaluation of the proposal cannot be made
through profitability tests. The examples of such urgency are breakdown of some plant and
machinery, fire accident etc.
2. Degree of Certainty:
Profitability directly related to risk, higher the profits, Greater is the risk or uncertainty.
Sometimes, a project with some lower profitability may be selected due to constant flow of
income.
3. Intangible Factors:
sometimes a capital expenditure has to be made due to certain emotional and intangible
factors such as safety and welfare of workers, prestigious project, social welfare, goodwill of
the firm, etc.,
4. Legal Factors.
Any investment, which is required by the provisions of the law, is solely influenced by this
factor and although the project may not be profitable yet the investment has to be made.
5. Availability of Funds.
As the capital expenditure generally requires large funds, the availability of funds is an
important factor that influences the capital budgeting decisions. A project, how so ever
profitable, may not be taken for want of funds and a project with a lesser profitability may be
some times preferred due to lesser pay-back period for want of liquidity.
6. Future Earnings

A project may not be profitable as compared to another today but it may promise better future
earnings. In such cases it may be preferred to increase earnings.
7. Obsolescence.
There are certain projects, which have greater risk of obsolescence than others. In case of
projects with high rate of obsolescence, the

project with a lesser payback period may be

preferred other than one this may have higher profitability but still longer pay-back period.
8. Research and Development Projects.
It is necessary for the long-term survival of the business to invest in research and
development project though it may not look to be profitable investment.
9. Cost Consideration.
Cost of the capital project, cost of production, opportunity cost of capital, etc. Are other
considerations involved in the capital budgeting decisions?

Methods of Capital Budgeting

(1) Traditional methods
Payback period
Average rate return method
(2) Discount cash flow method
o Net present value method
o Initial rate return method
o Profitability index method

Risk and uncertainty in capital budgeting:

All the techniques of capital budgeting require the estimation of future cash inflows and cash
outflows. The future cash inflows are estimated based on the following factors.

Expected economic life of the project.

Salvage value of the assets at the end of economic life.
Capacity of the project.
Selling price of the product.
Production cost.
Depreciation rate.
Rate of Taxation

Financial analysis:
Analysis of Ultratech cements limited

Years
2008-

Long

Share

term

holders

funds

Funds

1173.21

982.66

124.49

2289.36

1175.80

3232.23

854.19

4145.56

2789.76

Total

Total

Fixed

Net

Capital

sales

assets

assets

Profit

Employed

5512.4

4437.4

3120.

1007.6

00

2009

2009-

6385.5

5743.7

2010

2010-

7042.8

6213.1

2011

2011-

13205.

14810.

2012

64

64

2012-

18270.

16667.

2013

69

95

4365.

124.49

38

977.02

4716.

1093.2

99
10890

274.04

1404.2

.33
12166

124.49

274.07

2446.1

.13

2812.99

2012.09

The Kesoram Cements limited has Rs. 7683.708 lacks of initial investment and the annual
cash flows for the years 2006 to 2010. Then the payback period is calculated as follows:

1. Payback period method:

CALCULATION OF PAY BACK PERIOD OF Heritage Foods (India) Limited
(Rs. In crorers)
SI .NO
1
2
3

YEAR

2008-2009
2009-2010
2010-2011

CASH INFLOW

CUMULATIVE
CASH FLOWWS

1244.84

1244.84

1300.02

2544.86

1481.32

4026.18

2011-2012

2169.96

6196.14

2013-2014

3348.75

9544.89

The above table shows that, the initial investment RS.2687.87 Cr lies between second and
third years with Rs. 2544.86 and 4026.18 Cr
Difference in cash flows
PBP = Actual (Base) year + ---------------------------------Next year cash flows
1481.32
PBP =

2 + ------------6196.14

2.239 year

Payback period (PBP) = 2.239 year.

Accept-reject criterion:
PBP can be used as a criterion to accept or reject an investment proposal. A proposal whose
actual payback period is more than what is pre-determined by the management.
PBP thus, is useful for the management to accept the investment decision on the Heritage
Foods (India) Limited and also to assist the management to know that the initial investment is
recovered in 1.1884years.
Cash flows of the Ultratech cements Limited are shown in cash flow statement. ARR is
calculated as follows:
Statement showing calculation of ARR
(Rs. In lakes)
YEARS

EARNINGS AFTER TAX (EAT)

2008-2009

1244.84

2009-2010

1300.02

2010-2011

1481.32

2011-2012

2169.96

2012-2013

3348.75

TOTAL

9544.89

Average annual EATS

ARR

= ------------------------------- x 100
Average investment
Total amount

Average Annual EATS = --------------------No.of years

9544.89
= ------------------

= 1908.97

5
Average investment =1908.97
9544.89
ARR = ---------------- X 100

= 50.02 %

1908.97
Average Rate of Return = 50.02 %
ACCEPT-REJECT critters method allows Ultratech cements Limited to fix a minimum
rate of return. Any project expected to give a return below it will be straight away rejected.
The average rate of return is as good as 50.02 % of ultratech cements Limited depicts the
prospects of management efficiency.

CALCULATIONS OF PI:
STEP1: Calculations of cash flows after taxes
STEP2: Calculations of Present values of cash inflows @10%.
STEP3: Application of the formula.
Statement for calculating of benefit cost ratio

YEARS

CFATS

PVIF @ 10%

PVS

2007-2008

1244.84

0.909

1131.55

2008-2009

1300.02

0.826

1073.81

2009-2010

1481.32

0.751

1112.47

2010-2011

2169.96

0.683

1482.08

2011-2012

3348.75

0.620

2076.22

TOTAL:

6876.13

YEARS

CFATS

PVIF @ 10%

PVS

2008-2009

1244.84

0.909

1131.55

2009-2010

1300.02

0.826

1073.81

2010-2011

1481.32

0.751

1112.47

2011-2012

2169.96

0.683

1482.08

2012-2013

3348.75

0.620

2076.22

TOTAL:

6876.13

Present value of cash inflows

Profitability index

-------------------------------------Initial Investment

6876.13
= ------------------

= 2.55

2687.87
Hence PI = 3

Accept-reject criterion:
There is a slight difference between present value index method and profitability index
method. Under profitability index method the present value of cash inflows and cash outflows
are taken as accept-reject decision.
I.e. the accept reject criterion is:
If Profitability Index
Profitability Index

> 1 (ACCEPT).
< 1

(REJECT).

The acceptance of by the management is evaluated through Profitability Index

method of as the PI > 1 (i.e.3years)

Conclusions

 The budgeting exercise in KESORAM also covers the long term capital budgets,
including annual planning and provides long term plan for application of internal
resources and debt servicing translated in to the corporate plan.
The scope of capital budgeting also includes expenditure on plant betterment, and
renovation, balancing equipment, capital additions and commissioning expenses on trial
runs generating units.
To establish a close link between physical progress and monitory outlay and to provide
the basis for plan allocation and budgetary support by the government.
The manual recommends the computation of NPV at a cost of capital / discount rate
specified from time to time.
A single discount rate should not be used for all the capacity budgeting projects.
The analysis of relevant facts and quantifications of anticipated results and benefits, risk
factors if any, must be clearly brought out.
Inducting at least three non -official directors the mechanism of the Search Committee
should restructure the Boards of these PSUs.

Feasibility report of the project is prepared on the cost estimates and the cost of
generation.