1. What is importance of capital budgeting?

Explain the basic steps involved in

evaluating capital budgeting proposals.
OR
Explain the right procedure for a capital budgeting decision.

The process of long term planning , developing of resources, making

investment decision in capital expenditure to get profit which is expected to
receive or generate over period of a year or more than a year, is referred as
Capital Budgeting.
Importance of Capital Budgeting
1. Involvement of Heavy funds
Capital budgeting decisions involve large capital outlays. In such cases, the
firm should carefully plan its investment programs. Incorrect decision can
damage the survival of the firm.
2. Long-term Influence
They have a major impact on the firms in the future and will be felt by the
firm over a longer period. As a result it has a considerable influence on the
growth of the firm.
3. Capital budgeting decisions are Irreversible
It is difficult to reverse capital investment decisions because it is very difficult
to find a market for the capital asset.
4. Financial risk
The investment in the project is for long term purpose that will increase the
risk as huge amount of funds are taken for long term.
5. Most Difficult in Making
These decisions require an assessment of future events which are uncertain. It
is really a difficult task to estimate that probable future events, benefits and
costs accurately.
6. Important at National level
Individual decisions also matter for investment as it provides economic
growth, economic activity and employment at national level.
The steps/processes involved in capital budgeting
Ascertainment of project
Project Selection
Project analysis
Determine priorties
Project approval
Project Implementation
Project Performance Review
A. Ascertainment of project
Identifying the project for investment is the first step in capital budgeting.
From various projects, the project needs to be ascertained by department
officer or head for analysis and the suitable project is selected according to
corporate strategies and submitted to the capital expenditure planning
 committee for large organization or else to concerned head for long term
investment decisions.
B. Project Selection
Different projects are checked thoroughly by capital expenditure planning
committee and selection is based on the corporate strategy.
C. Project Analysis
In this step profitability of different projects is analysed. It may be
classified into independent project, dependent project and mutually exclusive
project. The methods by which profitability of project cab be ascertained are
Pay Back Period (PBP), Rate Of Return (ROR), Net Present Value (NPV),
Interval Rate of Return (IRR) etc.
D. Determine Priorities
Giving priorities help’s the firm or an individual to work smoothly. By
analyzing the project one can know the profitability urgency and risk involved
and can accordingly select the project. Ranking different projects is required
for the firm.
E. Project Approval
After meeting all the requirements stated in above step the project is
approved and included in capital expenditure budget. Then, the amount from
which fixed assets are purchased in budget period is estimated.
F. Project Implementation
Implementing the project is an important aspect for capital expenditure
committee as they have to consider the profitability of the project with time
and cost limit. To overcome delays in work network techniques such as PERT
and CPM are useful for managing the project.
G. Project Performance Review
The final step is to check whether all the above steps ar running smoothly
or not and if any problem occurred, it can be rectified with corrective actions.
The project expenditure needs to be compared with post completion expense
of the investment process, the actual return generating from investment
everything needs to be properly viewed. Finally the performance can be
known.

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2. What are the components of working capital? Explain each of them.

The amount required for taking decisions relating to fulfill the purpose of
short term investment in the business such as purchasing of raw material, wages
to be paid and other activities for maintaining or running day to day transactions.
To carry out operation, the funds used are known as “working capital”.
The two components of working capital are current assets and current
liabilities. Current assets keep changing from time to time and have high degree
of liquidity. They are cash balance, bank balance, raw material, work in progress,
finished goods, account receivables and debtors. current liabilities provide finance
depending upon the respective operating cycle. They are creditors, expenses
accrual, bills payable etc. The following are current assets.
Cash and bank Balance
These assets are required for maintaining ordinary course of business.
Cash and bank balance is important for any firm as they provide liquidity to the
firm. So, minimum balance has to be maintained.
Raw material
In any firm sufficient stock of raw materials is needed to carry out
operation smoothly.
Raw material stock = cost (or) Average of materials in stock.
Work-in-progress
Every firm works in continous process which has many levels. The
process of procuring of raw materials , paying wages and expenses to maintain the
production is taken as work in progress.
Work-in-progress = Cost of materials + Wages + Overhead of work-in-progress.
Finished Goods
These goods include the raw material which is to be put in process to
make a finished product. Finished goods require time to be sold. So, the process
of putting raw material, labor etc into production and for maintaining goods in
warehouse before the stage of sales requires working capital. And finished goods
are then valued on the basis of cost involved.
Finished goods = cost of materials + wages + overhead of finished goods.
Debtors
The basic criterion of this is to be increase in sales. Debtors are the
persons to whom the organization or firm sell goods on credit. Total cost price
depends on the working capital used in relation to debt.
Creditors
This is an important type of liability. They are the giver. Creditors are one
from whom an organization or firm purchase goods on credit. The credit is
allowed on the basis of period.
Expenses or Accruals
The valuation of expenses and wages are considered for processing the
goods. Generally it is paid at the end of the month or specified duration, which
generate working capital to the firm.
Bills Payable
Bills payable are the bills of exchange for which money is paid within a
short period of time.

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3. What do you understand by working capital cycle and what is its importance?
Working Capital cycle or Operating cycle
The time duration required for acquiring the raw material till the final
products or goods are made to generate sales or to realize cash. This process is
referred as operating cycle or working capital cycle. Operating cycle may differ
from one firm to other.
In case of “Manufacturing firms” , the operating cycle is the length of time
necessary to complete the following cycle events.
a. Conversion of cash into raw materials.
b. Conversion of raw materials into work-in-process or semi finished goods.
c. Conversion of semi furnished goods into finished goods.
d. Conversion of finished goods into debtors or accounts receivables.
e. Conversion of debtors into cash.

The operating cycle for “Trading firm” require continuous flow of activities
a. Converting cash into inventories.
b. Converting inventories into accounts receivables.
c. Converting accounts receivables into cash.

The operating cycle of “Financial firms” includes the time taken for
a. Converting cash into debtors.
b. Converting debtors into cash.

Importance of working capital cycle or operating cycle

Operating cycle is a central concept for making decisions. It deals in
continuous flow or process. Operating cycle represents a systematic flow of
activities, which can convert raw materials into finished products. This is a
dynamic technique and refers working capital cycle in a realistic way.
The continuous flow of activities makes proper utilization of resources. It
gives clear idea of time period and investment required to improve the
profitability of a business. Production function is very essential, as based on it,
necessary changes can be implemented in the cycle.

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4. Write short notes on the following

Cumulative preference shares
Customer advances
Equity shares
Fixed capital

a. Cumulative Preference shares

 In case of cumulative preference shares, the dividend unpaid if any in the
previous years gets accumulated until it is paid. In noncumulative preference
shares, no such facility is available.

b. Customer Advances
The goods manufacturer may request his customer to make a part payment in
advance. These are unusual and pertain to cases special orders or big orders.
This part payment made to the manufacturer for the products ordered, is
referred to as customer advance. The products ordered will be delivered to the
customer on the agreed date.

c. Equity Shares
1. These are the primary risk bearers.
2. They provide risk capital, their risk is unlimited.
3. They can earn higher rates of return during prosperity and in
combination with preference and loan capital.
4. They have right to control over the company.
5. They will be treated as the actual owners of the company.
6. They elect the directors and managing director in a democratic way to
run the business.
7. Each share will have one vote as right.

Merits
1. It is source of permanent capital without any commitment of fixed return.
2. The return on capital depends upon profitability only.
3. Higher rate of return is possible in comparison to borrowed funds.
4. Assets are not required to be secured against such shareholders.

Limitations
1. There is a risk of fluctuating returns due to changes in profitability.
2. The value of the shares also varies in share markets depending on business
conditions.

d. Fixed Capital
Capital required to purchase assets that is land, building, furniture etc which
are intended to generate revenues for the business are called fixed capital.
Fixed capital can also be taken as fixed assets. It is divided into three types.
They are, tangible fixed assets, intangible fixed assets and financial fixed
assets.
Assets which can be touched and seen are taken as tangible fixed assets.
Eg: furniture, buildings etc. Assets which have value to business, but cannot
be touched or seen are taken as intangible fixed assets. Eg copy rights,
goodwill, patents etc. And assets which can be invested in other companies in
the form of shares, foreign currency deposits, government bonds are taken as
financial fixed assets.
Determinants of Fixed capital
 - Characteristics of Business
- Business Size
- Type of Business
- Method of production
- Working capital

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5. What factors determine the working capital requirements of a company?

OR
Explain the factors influencing the requirements of working capital.
OR
Explain the factors affecting the requirements of working capital.

Determinants/Factors of Working Capital

The factors which influence working capital of a firm are as follows.
1. At Initial Stage
A firm requires funds for promotion and formation of business. Careful
planning is needed for launching the project otherwise it affect firm’s
financial position.
2. Characteristic of Business
Usually, the working capital of firm depends on the nature of business.
Requirement of funds differs from one firm to other. Like trading firms and
financial firms need relatively huge amount of investment while public utility
requires small amount of working capital.
3. Operating Scale
Business operation depends on the size of the firm and have a direct influence
on scale. If the size is large the amount of working capital will be more and
sometimes small firm also requires huge working capital.
4. Procedure for Manufacturing
The mechanism or procedure of manufacturing business rely on the length of
manufacturing period and process. Longer procedure require more working
capital and shorter the procedure, lesser the working capital.
5. Seasonal Fluctuation
In busy seasons large amount of working capital is required, because there
will be high demand in that season and they need to maintain big inventories.
In slack season, less working capital is required because of low demand in that
season.
6. Credit Policy
Basically a firm has two types of credit policies. One to deal with debtors and
other with creditors. The sales and purchase of goods depend on the terms and
conditions of policies. Working capital is very much influenced by the credit
policy of the business.
7. Operating Cycle
Operating cycle refers to the time taken to convert raw materials into cash, If
the time taken for completing an operation is more, than the working capital
required will also be more and vice-versa.
8. Expansion and Growth in Business
Expansion of business refers to addition in existing firm where as growth
means increase in scale or size of operation. The phenomena of expansion and
growth are different. Working capital is necessary for both growth and
expansion of business or firm.
9. Velocity of TurnOver
Firms which can sell their goods or products quickly, require less amount of
working capital. And the firms with intensive nature require more amount of
working capital.
10. Availability of raw material
Easy availability of raw material helps the firm to carry out its operation
smoothly as time required in loading will be less and working capital needs
will be reduced.
11. Inflation
During the period of rising price level, the business firms have to maintain a
large amount of working capital.
12. Efficiency in operation
To attain or obtain high level of efficiency in operation the following
strategies need to be followed that is cost reduction and cost control,
improvement in layout, control on stock inventory, utilizing the available
time, evolving appropriate policies for taxation, reserves, dividends and
profits.

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6. What are the major sources of short term finance?

Sources of short term finance

Short term finance refers to the finance that is obtained or available for a
period of less than one year. There are many sources from which short term
finance can be obtained. They are as listed below.
1. CP- Commercial paper
CP is a new instrument introduced recently into Indian money market system.
Reliance Industries of Dhiru Bhai Ambani was the first company to issue
commercial paper in India. CPs are usually issued both in public and private
sector companies, in large denominations. The companies that issue CPs
should be highly reputed with high credit worth.
2. Trade Credit
 Trade credit refers to a short term credit opportunity to the debtors as provided
pay back the credit after they sell all the stock. Sometimes, this happens
legally by signing a bill called ‘Bills Payable’.
3. Bank OD (Over Draft)
This is a facility provided by a banker to overcome the temporary shortage of
funds. In this the customer can draw the amount more than what is is present
in his/her account but should pay an interest on day-to-day.
4. Internal funds
These are the funds generated by the organization itself in the form of secret
reserves, provisions for depreciation and taxation, retained profits, etc , in
order to meet the urgent requirements.
5. Collecting the advance from customers can also be done to overcome working
capital requirements.
6. Gathering short term deposits from the customers, sister companies and
outsiders.
7. Debt and Credit Factoring
Debt Factoring refers to an agreement with a factor(third person) wherein the
trader agrees to sell its accounts receivable or debtors at discount to the
specialized dealers called factors. In credit factoring, the trader agrees to sell

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7) What are the merits and limitations of Pay Back period? How does Discounting
approach overcome the limitations of Pay Back period?
A:- Merits of Pay Back period:-
(a) Calculation of pay back period is easy and understandable by all. It does not
involve any complicated formulae.
(b) It depends on the earlier cash flows which are more likely to be accurate than
that of the later cash flows
(c) It reduces the risk (The more the risk, the more the loss in the investment).
(d) It is a reliable technique for project appraisal (specially in the business where
changes takes place such as change in technology, change in customer’s tastes and
preferences).

Limitations of Pay Back Period:-

(a) This method ignores the earnings after the pay back period.
(b) It ignores the total life of the project and also the total profitability of the investment.
(c) This method does not consider the timing of cash flows. The cash flows are given
equal weightage irrespective of their timings.
(d) This method chooses the cash inflows due to which the liquidity is over emphasized.
(e) The factors such as cost of capital and cost of proposal are ignored.

Discounting Method vs Pay Back Method:

1. Discounting method uses the future cash flows reduced to their present value.
2. This method considers the time value of money.
3. This method considers the whole earnings of the proposal and the cost of the project.
4. This method is a modern method of investment appraisal.
5. Under this method NPV and IRR are adopted and the decision to choose or reject a
proposal is based on their discounted cash flows.