Capital Budgeting

CAPITAL BUDGETING  

The total capital (long-term and short term ) of a company is employed in fixed and current assets of the firm. Fixed assets include those assets which are not meant for sale such as land, building, machinery etc. it is a challenging task before the management to take judicious regarding capital expenditures, i.e., investments in fixed assets to that the amount should not unnecessarily be locked up in capital goods which may have far-reaching effects on the success or failure of an enterprise. A capital asset, once acquired, cannot be disposed of without any substantial loss and if it is acquired on long term credit basis, a continuing liability is incurred over a long period of time, and will affect the financial obligations of the company adversely. It, therefore, requires a long-range planning while taking decision regarding investments in fixed assets. Such process of taking decisions regarding capital expenditure is generally known as capital budgeting. In capital budgeting process, due consideration should b given to the following problems-

(1) Problem of ranking project, i.e., choice of one project over other project.

(2) Problem of capital rationing, i.e., limited budget resources.

(3) Limitations imposed by top management decision on the total volume of investments to be made.

Now-a-days, however, some new analytical techniques are developed for evaluating capital expenditure projects are under study.

Nature of Capital Budgeting

 Nature of capital budgeting can be explained in brief as under

(      a)Capital expenditure plans involve a huge investment in fixed assets.

(b) Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss.

(c) Preparation of capital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects.

It may be asserted here that decision regarding capital investment should be taken very carefully so that the future plans of the company are not affected adversely.

Process of Capital Budgeting

Capital investment decision of the firm have a pervasive influence on the entire spectrum of entrepreneurial activities so the careful consideration should be regarded to all aspects of financial management.

In capital budgeting process, main points to be borne in mind how much money will be needed of implementing immediate plans, how much money is available for its completion and how are the available funds going to be assigned tote various capital projects under consideration. The financial policy and risk policy of the management should be clear in mind before proceeding to the capital budgeting process. The following procedure may be adopted in preparing capital budget :-

(1) Organisation of Investment Proposal. The first step in capital budgeting process is the conception of a profit making idea. The proposals may come from rank and file worker of any department or from any line officer. The department head collects all the investment proposals and reviews them in the light of financial and risk policies of the organisation in order to send them to the capital expenditure planning committee for consideration.

(2) Screening the Proposals. In large organisations, a capital expenditure planning committee is established for the screening of various proposals received by it from the heads of various departments and the line officers of the company. The committee screens the various proposals within the long-range policy-frame work of the organisation. It is to be ascertained by the committee whether the proposals are within the selection criterion of the firm, or they do no lead to department imbalances or they are profitable.

(3) Evaluation of Projects. The next step in capital budgeting process is to evaluate the different proposals in term of the cost of capital, the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation techniques:-

(a) Degree of Urgency Method

(b) Pay-back Method

(c) Return on investment Method

(d) Discounted Cash Flow Method.

(4) Establishing Priorities. After proper screening of the proposals, uneconomic or unprofitable proposals are dropped. The profitable projects or in other words accepted projects are then put in priority. It facilitates their acquisition or construction according to the sources available and avoids unnecessary and costly delays and serious cot-overruns. Generally, priority is fixed in the following order.

(a) Current and incomplete projects are given first priority.

(b) Safety projects ad projects necessary to carry on the legislative requirements.

(c) Projects of maintaining the present efficiency of the firm.

(d) Projects for supplementing the income

(e) Projects for the expansion of new product.

(5) Final Approval. Proposals finally recommended by the committee are sent to the top management along with the detailed report, both o the capital expenditure and of sources of funds to meet them. The management affirms its final seal to proposals taking in view the urgency, profitability of the projects and the available financial resources. Projects are then sent to the budget committee for incorporating them in the capital budget.

(6) Evaluation. Last but not the least important step in the capital budgeting process is an evaluation of the programme after it has been fully implemented. Budget proposals and the net investment in the projects are compared periodically and on the basis of such evaluation, the budget figures may be reviewer and presented in a more realistic way.

Methods of capital budgeting

 Traditional methods

1.      Payback period

2.       Accounting rate of return method

 Discounted cash flow methods

1.      Net present value method

2.       Profitability index method

3.      Internal rate of return

·  1. 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.

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.

·2. 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 cost 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.

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 xxxx Transportation/installation charges xxxx Working capital xxxx Cash outflow xxxx

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

Profitability Index: 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 present value of cash outflow i.e.,original investment.

PI is given by dividing Present value of cash inflow by the present value of cash outflow.

Formulae:

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