The word Capital refers to be the total investment of a company of firm in money,
tangible and intangible assets. Whereas budgeting defined by the Rowland and
William it may be said to be the art of building budgets. Budgets are a blue print
of a plan and action expressed in quantities and manners.
Capital expenditure:
It refers to an outlay of funds that is expected to produce benefits over a period of time
exceeding one year.
The examples of capital expenditure:
1. Purchase of fixed assets such as land and building, plant and machinery, good
will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration to
the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.
The overall objective of capital budgeting is to maximize the profitability. If a firm
concentrates return on investment, this objective can be achieved either by
increasing the revenues or reducing the costs. The increasing revenues can be
achieved by expansion or the size of operations by adding a new product line.
Reducing costs mean representing obsolete return on assets.
Prof.P.Sreelakshmi,
(3) Immediate need for the project: Capital budgeting is also influenced by the immediate
need for the project.
(4) Earnings of the project: The earnings from the project also would affect capital budgeting.
Generally, if the earnings of a project are quite good, naturally such projects are preferred. On
the other hand, if the earnings of a project are very low, then it may be rejected.
(5) Capital return or payback:
budgeting. If a project helps a firm to get back its investment as early as possible, it will be
considered worthwhile. On the other hand, if the payback or capital return of a project is such
that it will hot help the firm to get back its investments quickly, it may not be undertaken.
(6) Working capital needs of the project: The working capital needs of a project also will
influence capital budgeting. If a project involves more additional working capital, it may not be
chosen for implementation. On the other hand, if a project, does not involve more additional
working capital, the project may be selected for implementation.
(7) Accounting practices of a firm: Standard accounting practices have an impact of the
profitability of a project. Different accounting practices give different results as regards the
earnings or the profitability of a concern. So, accounting practices also have to be taken into
account in the process of capital budgeting.
Steps involved in capital budgeting process:
Capital budgeting is a many-sided activity involving generation of investment proposals,
estimation of costs and benefits expected form such proposals and evaluation and selection of
investment proposals based on acceptance criteria and funds available to finance them.
Capital budgeting involves the following process or steps.
(1) Project generation: Project generation refers to the generation of investment proposals or
projects. The investment proposals may fall into one of the following categories.
Proposal to add new product to the product line
Proposal to expand production capacity in existing product lines.
Proposals to reduce the costs of the output of the existing products without altering the
scale of production.
Investment proposals can originate at any level within a firm. It may come from the top
management, middle management or bottom management. It may come even form workers.
Prof.P.Sreelakshmi,
It should be noted that, for sound capital budgeting, there should be generation of enough
investment proposals so that there could be better selection of profitable proposals. Further,
there should be continuous flow of investment proposals. Again, there should be a systematic
procedure for generation of investment proposals.
(2) Project evaluation: project evaluation refers to the evaluation of the different investment
proposals in terms of their capital costs and expected return.
Project evaluation involves two steps, namely
While evaluating the various investment proposals, the following points must be noted:
The costs and benefits of various proposals should be estimated in terms of cash flows.
While estimating the cash flows, particularly the cash inflows of different proposals, the
risk associated with the proposals or projects should be properly taken into consideration.
While estimating the costs and benefits of proposals or projects, the time value of money
should be taken into consideration.
For the objective evaluation, the evaluation of the projects should be done by a group of
experts who are impartial so that there could be objective evaluation of the projects.
Proper care should be taken while deciding upon the selection criteria. The selection
criteria should be consistent with the concerns objective of maximizing its market value.
(3) Project selection: Project selection refers to the selection or choosing of the most profitable
or desirable proposals among the various investment proposals.
The work of project selection is generally, done by the top management. But the top
management to the middle management may sometimes, delegate this work. While delegating
the work of selection of desirable proposal to the middle management, the top management may
lay down the selection criteria and may also hold the middle and lower level management
accountable for the result.
(4) Project execution: Project execution refers to the implementation of the selected projects or
proposals with adequate allocation funds.
(5) Follow up of the project or proposals: Follow up of the projects refers to the periodical
assessment of the results of the projects that have been implemented by comparing the actual
results of the projects with the estimated results.
Prof.P.Sreelakshmi,
Independent proposals: These are the proposals, which do not compete with one
another in such a way that acceptance, or selection of one project does not come
in the way of acceptance or selection of another project. As these are independent
projects, the firm may straightaway accept or reject a proposal on the basis of
accept or reject criterion.
(2)
Mutually exclusive proposals: These are the proposals, which compete with one
another in such a way that the acceptance or selection of one project excludes the
acceptance or selection of other proposals. That means, in the case of these
proposals, only one or some of the proposals may be accepted and other projects
have to be rejected.
(3)
Capital rationing decision: In a situation where the firm has unlimited funds, all
independent investment proposals yielding return greater than some predetermined level are accepted. However, this situation does not prevail in most of
the business firms in actual practice. They have a fixed capital budget. A large
number of investment proposals compete for these limited funds. Therefore, the
firm must ration them. The firm allocates funds to projects in a manner that it
maximizes long-run returns. Thus, capital rationing refers to a situation in which
a firm has more acceptable investments than it can finance. It is concerned with
the selection of a group of investment proposals out of many investment proposals
acceptable under the accept-reject decision. Capital rationing employs ranking of
the acceptable investment projects.
Prof.P.Sreelakshmi,
By matching the available resources and projects it can be invested. The funds
available are always living funds. There are many considerations taken for
investment decision process such as environment and economic conditions.
The methods of evaluations are classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Post Pay-back Methods
(iii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method
Pay-back Period
Pay-back period is the time required to recover the initial investment in a project.
The basic element of this method is to calculate the recovery time, by yearwise
accumulation of cash inflows (inclusive of depreciation) until the cash inflows equal
the amount of the original investment. The time taken to recover such original
investment is the payback period for the project.
The shorter the payback period, the more desirable a project.
Merits :
(1) No assumptions about future interest rates.
(2) In case of uncertainty in future, this method is most appropriate.
(3) A company is compelled to invest in projects with shortest payback period, if
capital
is a constraint.
(4) It is an indication for th prospective investors specifying the payback period of
their
investments.
(5) Ranking projects as per their payback period may be useful to firms undergoing liquidity
constraints.
Demerits : (1) Cash generation beyond payback period is ignored.
(2) The timing of returns and the cost of capital is not considered.
(3) The traditional payback method does not consider the salvage value of an investment.
Prof.P.Sreelakshmi,
Prof.P.Sreelakshmi,
Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties in the
calculation of the project.
Accept/Reject criteria
If the actual accounting rate of return is more than the predetermined required rate of return, the
project would be accepted. If not it would be rejected.
Net Present Value
Net present value method is one of the modern methods for evaluating the project proposals.
In this method cash inflows are considered with the time value of the money. Net present
value describes as the summation of the present value of cash inflow and present value of
cash outflow. Net present value is the difference between the total present value of future
cash inflows and the total present value of future cash outflows.
Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
Prof.P.Sreelakshmi,
Cash inflow
Investment initial
Merits
1. It consider the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the internal rate of
return.
Accept/Reject criteria
If the present value of the sum total of the compounded reinvested cash flows is greater than the
present value of the outflows, the proposed project is accepted. If not it would be rejected.
Profitability Index:
Prof.P.Sreelakshmi,
It is also called as Benefit-cost Ratio or Desirability factor is the trelationship between the
present value of cash inflows and the present value of cash outflows.
PI = PV of cash inflows
Initial cash outlay.
The proposal is accepted if the profitability index is more than one and is rejected in case
PI<1.One with higher PI is ranked higher than the other with lower PI.
Prof.P.Sreelakshmi,
3. X ltd is producing articles mostly by manual labour and is considering to replace it by new
m/c. Thee ore two alternative models M and N of te new machine. Prepare a statement of
profitability showing the pay back period from the following information.
Machine M
Machine N
Estimated life of machine
4 years
5 years
Cost of machine
Rs.90,000
Rs.1,80,000
Estimated savings in scrap
5,000
8,000
Estimated savings in dirct
60,000
80,000
wages
Additional cost of maintenance
8,000
10,000
Additional cost of supervision
12,000
18,000
4. Compute i) pay back period, ii) poat pay back profitability and iii) post pay back
profitability index:
a) Initial outlay
Rs.50,000
Rs. 10,000
8 years
Rs.50,000
Rs.15,000
Rs.5,000
8 years
Rs. 8,000
Prof.P.Sreelakshmi,
Investments
Expected Life (no salvage value)
Projected Net Income (after interest, depreciation and taxes)
1
2,000
2
1,500
3
1,500
4
1,000
5
If the rate of return is 12% which project should be undertaken?
Prof.P.Sreelakshmi,
Project B
Rs. 30,000
5 years
3,000
3,000
2,000
1,000
1,000
9. X Ltd is considering the purchase of a machine. Two machines are available E and F. The cost
of each mchine is Rs.60,000. Each machine has an expected life of 5 years. Net profits before
tax and after depreciation during the expected life of the machines are :
year
Machine E
Machine F
1
15,000
5,000
2
20,000
15,000
3
25,000
20,000
4
15,000
30,000
5
10,000
20,000
Total
85,000
90,000
Following ARR, ascertain which of the alternatives will be more profitable. The average rate of
tax may be taken at 50%.
Net Present Value:
11.
Prof.P.Sreelakshmi,
12.
13. Calculate the NPV of two projects and suggest which one should be accepted @ 10%
discount rate.
Projext X
Project Y
Initial investment
Rs.20,000
Rs.30,000
Estimated life
5 years
5 years
Scrap value
Rs.1,000
Rs.20,000
The profits before depreciation and after taxes (cash flows) are as follows:
Year
1
2
3
4
5
Project x Rs.
5,000
10,000
10,000
3,000
2,000
Project y Rs. 20,000
10,000
5,000
3,000
2,000
14.
15.
Prof.P.Sreelakshmi,
PI:
16. The initial cash outlay of a project is rs.50,000 and it generates cash inflows of Rs.20,000
15,000 , 25,000 and 10,000 in four years. Using PV index method, appraise profitability of the
proposed investment assuming 10% rate of discount.
17.
IRR:
18.
Prof.P.Sreelakshmi,
19.
20.
Prof.P.Sreelakshmi,