CHAPTER NO.

:- 4 CAPITAL BUDGETING
When in long run a firm shift from a smaller to a larger plant size then what the firm will have to do to made such shift, changeover to a bigger plant size requires investment in new capacity. Even keeping to the same plant size over time, requires replacement of worn-out plant. All these require investment of resources. Investment is defined as the acquisition of durable productive facilities in the expectation of a future gain. It normally consists of physical capital like plant, equipment, building, machinery etc. it may also include non- physical capital like training of personnel etc. Investment or capital expenditure usually involves a large sum of money (although the amount need not be huge) incurred at a point of time where as benefit are realized at different point of time in future but it is very natural, investment decision becomes vital to almost organization. So how well this activity is planned and implemented. The value of investment lies on potential profit. If a firm acquires a capital asset which gives less revenue than its cost the business will definitely suffer setback. Hence a correct estimation of the worth of investment is essential before the investment is undertaken.

Capital Budgeting Decision:

Project which keep on generating return for a long period (i.e. more than a year) are known as capital project. e.g. - factory building, transport vehicles, new plant. The capital budgeting process can be classified into three broad categories:1. Investment selection 2. Financing investment 3. Allocation of funds among project

1) Investment selection :It involves decision regarding both the amount of investment in the planning period and selection of project.

It consist of Expansion of firm production facilities (to meet growing demand for the product of the company) Replacement decision : (Replacing damaged or obsolete plant and machinery by more efficient one. New improved product decision (to bring new or changed product in the market, certain investment are needed like expenditure on R & D, market research, advertisement etc. Make or buy decision :To produce the product or to purchase it from vendor (supplier) Lease or buy decision :A firm may decide to lease equipment rather than invest sizeable funds for buying equipment.

2) Financing investment :There are certain norms against which the benefits are to be judged from the long term investment. E.g.:- minimum rate of return, required rate of return. Sources of capital to the firm are presumed to be: a) External sources (the capital market) b) Internal sources (retained earning) Each specific sources of capital has its own cost, which becomes a component part of overall cost of capital to the firm. 3) Allocation of fund among project :-

Factors influencing investment decision;

a) Technological change: - new technology which is relatively more efficient, takes place of old technology. However in taking decision of this type, the mgmt has to consider the cost of new equipment, salvage value of replaced equipment.

b) Competitors strategy:- many a times a investment taken to maintain the competitive strength of the firm. If the competitors are installing new equipment to expand output or to improve quality of their product the firm under consideration will have no alternative but to follow suit(go with).

c) Demand forecasting:- the long run forecast of demand is one of the determinant of investment decision. If it is found that there is market potential for the product in the long run, the dynamic firm will have to take decision for capital expansion.

d) Types of management:- whether capital investment would be encouraged or not depend to a large extent on the view point of the management. If mgmt is modern & progressive then innovation is encouraged.

e) Fiscal policy:- various tax policies of the government have favorable or unfavorable influence on capital investment. E.g. excise duties, method of allowing depreciation.

f) Cash flow:- every firm makes a cash flow budget. Its analysis influence capital investment decision. With its help the firms plans funds for acquiring the capital asset.

g) Return expected from the investment:- in most of the cases, investment decision are made in anticipation of increased return in future. While evaluating investment proposal, it is therefore essential for the firm to estimate future return or benefit accruing from the investment.

Steps in capital project evaluation:In order to evaluate a project we need to have three kind of information: 1. List of investment proposals (developing investment proposals) 2. Estimate cash flow of each of these proposals. 3. Knowledge about the various criteria used for project evaluation.

1) Developing investment proposal: The capital budgeting process begins with the generation of capital investment proposals. A firm growth and development depend upon a constant flow of new investment ideas. Many investment opportunities reveals themselves in ordinary course of business (e.g. need to replace worn-out machinery) Various corporate strategies are made by the business acquisition to achieve competitive edge over it competitors project. Which are not compatible with corporate strategy are rejected and those that are essential to implement, the strategy are accepted. It must be noted that the strategy is not static - as time passes and circumstances changes, new strategies involve.

Thus the first step is screening process is to assemble a list of proposed new investment, together with the data necessary to evaluate them. This data include: a) Estimating investment requirement of the project. b) Forecasting cash inflow of the project. c) The mgmt attitude towards risk. d) Time value of money.

2) Estimating cash inflow:-

In capital expenditure proposal analysis the most important and difficult step is to estimate cash flow associated with the project.

Cash flow is of two kinds: Cash outflows (Associated with building and equipment the new production facility) Cash inflow The annual cash inflows the project will generate after it goes into operation.

A large no. of variables are involved in the cash flow forecast and many individual and departments participate is developing them.

Guidelines for estimation of cash flows:a) Cash flow must be constructed on incremental basis. ( only the difference of cash flow due to acceptance of the project are relevant for inclusion in investment analysis). b) Indirect cash flow must be taken. e.g. the impact of a new product on the sales revenue of the existing product. c) Cash flow should be constructed on an after tax basis (because that represents net Flow from the point of view of the firm).

3) Evaluation of project:Capital project have a finite life over which the project yield a stream(flow) of annual receipt. A fundamental concept that must be understood while taking as out stream of annual receipt is the notion of time

value of money.

The investment in projects occurs only in initial years of the project. The net return from the project comes in stream of annual receipt.So net return from the project can be scientifically calculated only when the cash inflow and outflow are expressed in terms of common denominator. I.e. when the stream of annual cash flows is disconnected to find the present value.

Evaluation of project

Traditional method

Time adjusted method

ARR

P B Period

NPV

PI

IRR

1) Return on investment or , average rate of return (ARR) :-

ARR

Average profit Average investment

* 100

Where, Average profit is = total profit during the life of the project Number of years

2) Pay back period: Pay back period means period required to get back initial investment. Less the pay back period better the project.

Modern techniques of investment:

1) Net present value: This method is based on the economic reasoning of discounting future cash flow to make comparable. NPV is calculated by discounting all future flows to present and subtracting. The present value of all cash out flow from the present value of all inflows. If NPV of project is positive, this indicates that project add more to revenue than it adds to cost. Therefore accepted.

NPV (+) = accepted

If NPV of project is negative the project should be rejected.

NPV (-) = rejected If NPV is zero than by any other evaluation method to evaluate the project. NPV =

nt=1

Rt

Co

(1 + r )t
t = time period ( 0 to n year) Rt = cash inflow in period t Co = initial investment or cash outflow R = discount rate (cost of capital) N = last period of project 1) TIME VALUE OF MONEY: - Time value of money means that value of a unit of money is different in different time periods. The concept of time value of money refers to fact that the money received today is different in its worth from the money receivable at some other time in future. In other words, the same principal can be stated as that the money receivable in future is less valuable than the money received today. The main reason for the time preference of money is to found in the reinvestment opportunities for funds which are received early. The funds so invested will earn a rate of return; this would not be possible if the fund is received at a later time. Example: Suppose a firm is selling a machine for RS. 20,000 .The buyer offers to pay Rs.20, 000 either now or after one year. The seller firm naturally accepts the first choice. i.e. to receive Rs. 20000 now. In this case firm reinvest the amount in fixed deposit account for one year and get return 2000 @10%. So in first case co. net income is 22,000 where as in second option co. income is 20,000. In this case interest amount is time value of money. So we can say that T.V.M. for the money is its rate of return which the firm can earn by reinvesting its present money. This rate of return can also be expressed as a required rate of return to make equal the worth of money of two different time periods.