KINDS OF CAPITAL BUDGETING DECISIONS Capital budgeting decisions have to be taken by identifying certain background features.

The decisions depend on the (I) Type of firm/company for which decisions have to be taken and for (II) different situations. These are classified as follows: I. Type of Firm/Company: Capital budgeting decisions depend on the nature of a firm. A firm may be a new firm or an existing firm. New firm: A new firm would be interested in purchasing new assets for the use of the company. When it is at the start up stage there would be a large requirement for the purchase of new equipment and begin new projects. The financial manager will have to analyze and evaluate the requirement of purchases for long-term use. He must use capital budgeting techniques for taking the right decision. When it is an existing company it would require capital budgeting decisions in the following cases existing firm will require capital budgeting decisions in three different situations: (i) Expansion of the market share In this case capital budgeting decisions have to be analyzed to find out the future costs and benefits. The purchase of new assets should be made only when the benefits exceeds the costs. The utility of the asset should be for a long-term period of time. Replacing and modernizing plant and machinery A replacement decision is to be taken when the asset has completed its lifetime productivity and a new one is required to increase the efficiency of the plant. Some times the economic life of the machine is not completed but technological modernization is important to bring about reduction in cost and improvement in efficiency. Diversifying into new products Capital budgeting decisions have to be taken with the intention of increasing the revenue of the company. It is important to make cash flow analysis to look into the usefulness of the product. Time value of money and incremental analysis would help in establishing the need for diversification and capital budgeting decisions thereof.

(ii)

(iii)

The kinds of capital budgeting decisions to be taken in the case of a new firm and an existing firm may be summarized as: Capital budgeting decision for new asset in a new firm Decision to purchase new asset in an existing firm for expansion Decision to purchase new asset for replacement and modernization Decision to purchase new asset for diversification to bring about an increase in revenue of the firm.

II.

Capital budgeting decisions in different situations Capital budgeting decisions are classified on the basis of whether it is a new firm or an existing firm. It takes decisions from the point of view of different situations like taking a decision on a single independent proposal, mutually exclusive project, contingent decision and capital rationing projects.

Single Independent Proposal: Each project should be evaluated on its own merit when there are single independent proposals. This means that the proposal has to be of some merit to be either accepted or rejected. It is often called accept reject decision. Such projects are analyzed and evaluated by taking into .consideration their costs and benefits by making cash flows, using time value techniques and also applying capital budgeting techniques. These projects do not affect any other proposals. Many proposals may be evaluated without bias on their own competitive strength to find out their usefulness for the company. Mutually Exclusive: If one investment is undertaken - other similar ones will have to be rejected, as they are all of the same type. The best suited should be selected. When two proposals are equally competitive and useful for the work of the company, only one of them is selected. This means that when there are two alternatives, the company should be able to select only one and reject the other. For example if one machine has to be purchased and the company evaluates two proposals of equal costs. Machine 'A' is manufactured in Germany and machine 'B' is manufactured in Korea. Having similar costs and similar features, the Indian company will have to decide which is better suited to its environment m India. If it decides on machine 'A' then machine 'B' will be rejected. Contingent Decisions: Dependent or Contingent decision means that to fit a requirement of a company there has to be a change in installation of other machines to fit with the new machine. If a project begins for e.g. shoe project with showroom, leather treatment, shoe uppers etc. all of it is treated like one investment. Thus the new shoe project cannot begin working unless other conditions are also fulfilled. Capital Rationing Decisions: When a firm has a very large investment and it has a limited amount of lands at its disposal, then a firm may either take up one project at a time. It may decide to do all the projects together but to extend the budget in such a manner that it is able to cover the minimum costs of all the projects that it wants to cover. In no case can it exceed its budget. Such decisions are called capital rationing. Capital budgeting decisions are assumed to be taken by firms, which do not have the pressure of capital rationing. Projects are selected and when they are completed, new projects are under taken with enough resources to work to make the projects successful.

ACCOUNTING PROFIT Accounting profits also measures costs and benefits of a proposal. It is a good estimate for judging profits but it does not satisfy all the requirements of capital budgeting proposals. Accounting profit is described to show the distinction between cash flows, analysis and accounting profit to provide the reasons for favouring the use of cash flow analysis and not accounting profit. Profit based on Accrual Method: Accounting profit recognizes the inflow of cash immediately when there is a promise of receiving a cash flow. It also takes the effect of future expenditures. In capital-budgeting it is useful to consider the cash flow approach of receipts and payments, which have actually been incurred. Since accounting profits are based on both actual and accruals the procedure and the approach is different. Adjustment through Different Techniques: Accounting profits can be adjusted through the techniques: of different inventory valuation methods, depreciation methods and amortization of expenses. The profits become different when different methodologies are used. Time Value of Money: Accounting profit does not have any discounting rate through which the time value of money can be measured. This does not provide a good economic value to judge the efficiency of a new project. It does not measure or compare two mutually exclusive proposals or funds received it different periods of time because it does not use discounting techniques. Consider Cash and Non-cash Items: The accounting profit is a good measure for finding out the profitability of a firm. In terms of estimating the value or benefits of a proposal it does not give a true measure as it considers non-cash items like depreciation, writing off past losses, inventory valuation.

Distinctions between the Cash Flow Analysis and Accounting Profit Cash Flow Analysis (i) It considers time value of money through a required discounting rate of return. (ii) Cash flow measures economic value through actual cash inflows and outflows. (iii) Cash flows consider only cash items. It does not consider items like depreciation thus creating economic value of the assets. (iv) Cash flows have a uniform method of calculation. They follow the same methodology in valuing an asset. (v) Cash flows evaluate projects through incremental analysis. They consider the costs, which are attributable to new investment opportunities. Accounting Profit (i) It ignores time value of money as it does not have any common required rate of return or cost of capital. (ii) Accounting profit considers book entries value of an asset. (iii) Accounting profit considers noncash items like depreciation for evaluating the worth of an asset. Accounting profit uses different techniques of inventory valuation, depreciation, amortization of expenses. Accounting profit considers the profits of a firm in one complete unit and not as a separate new entity. Thus the economic value can not be measured correctly.

(iv)

(v)

DETERMINATION OF CASH FLOWS OF A PROJECT

A. CASH OUTFLOWS IN CASE OF EXPANSION OR MODERNIZATION

SITUATION

PARTICULARS

AMOUNT (Rs)

The cost of the new project Add: Installation Expenses

Xxxx Xxxx

Xxxxxxx

Add/Less: Working Capital Requirements

Xxxx

Xxxxxxx

Less: Tax benefits due to investment allowance

Xxxx

CASH OUTFLOWS

Xxxxxxxxxxx

B. CASH OUTFLOWS IN CASE OF REPLACEMENT SITUATION

PARTICULARS

AMOUNT (Rs)

The cost of the new project Add: Installation Expenses

Xxxx Xxxx

Xxxxxxx Add/Less: Working Capital Requirements Xxxx

Xxxxxxx Less: Tax benefits due to investment allowance Xxxx

Xxxxxxx

Less: Sale proceeds of the existing project

Xxxx

Xxxxxxx Add/Less: Taxes Paid or Saved on the sale of the asset Xxxx

CASH OUTFLOWS

Xxxxxxxxxxx

II. CALCULATION OF CASH INFLOWS:

A. CASH INFLOWS IN CASE OF A NEW PROJECT

PARTICULARS

AMOUNT (Rs)

Cash Sales Less: Cash Operating Cost CASH INFLOW BEFORE TAX Less: Depreciation

Xxxx Xxxx

Xxxxxxx Xxxx

TAXABLE INCOME Less: Taxes

Xxxxxxx Xxxx

EARNINGS AFTER TAX Add: Depreciation

Xxxxxxx Xxxx

CASH INFLOWS AFTER TAX Add: 1. Salvage Value in the nth year 2. Recovery of Working Capital in the nth year

Xxxxxxx Xxxx Xxxx

CASH INFLOWS (CFAT)

Xxxxxxxxxxx

B. CASH INFLOWS IN CASE OF REPLACEMENT SITUATION

PARTICULARS

AMOUNT (Rs)

Cash Inflows before tax of new asset Less: Cash Inflows after tax of the old asset

Xxxx Xxxx

Xxxxxxx Less: Taxes Xxxx

INCREMENTAL CASH INFLOWS AFTER TAXES (CFAT) Depreciation of the new asset Less: Depreciation of the old asset

Xxxxxxx ------ (I)

Xxxx Xxxx

EXCESS DEPRECIATION

Xxxxxxx

Tax Savings on excess depreciation Total Incremental CFAT {(I) (II)} Add/Less: Working Capital Recovery/Requirement in the nth year

Xxxxxxx ------- (II) Xxxxxxx Xxxx

CASH INFLOWS (CFAT)

Xxxxxxxxxxx