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15. CAPITAL BUDGETING

15.1 INTRODUCTION

Capital Budgeting is perhaps one of the most important branches of Managerial

Economics. According to Charles T Hormgrem “Capital Budgeting is a long term
planning for making and financing proposed capital outlays.” According to
Eugene F Brigham “Capital Budgeting is in essence, an application of the classic
proposition from the economic theory of the firm, namely, a firm should operate
at a point where marginal revenue is just equal to its marginal cost. When this rule
is applied to the capital budgeting decision marginal revenue is taken to be the
percentage rate of return on investments and marginal cost is the firms’
percentage cost of capital.”

Capital budgeting decisions are essentially long-term investment decisions. They

have to be taken very carefully because once these decisions are taken and
implemented they become very expensive if they are to be reversed. The time factor
involved in financial planning is of fairly distant future and the capital expenditure
can be recovered only over a fairly long period of time. Due to this time element,
capital budgeting decisions are subject to greater degree of risks and uncertainty.
The long term investment decisions therefore, must be based on sound budgeting
procedures. The nature of budgeting problem revolves round three basic questions.

i) How much money will be needed for expenditure in the coming period?
ii) How much money will be available at what cost?
iii) How should the available money be distributed amongst various projects?

The first question deals with demand for capital. As the aim of capital
expenditure is to make profits, this problem involves a survey of profitable
opportunities of investments on the basis of their yields.
The second question concerns the supply of capital. The supply side has three
aspects.
a) How much can we raise internally from depreciation and retained earnings?
b) How much can be procured from outside agencies?
c) What shall be the cost of capital?
The third question relates to rationing of funds. How much should be spent in
all and where?
These questions are analyzed by referring to the demand for capital, supply of
capital and the cost of capital.

15.2 DEMAND FOR CAPITAL

The demand schedule for capital refers to the arrangement of the various
proposed projects in a descending order according to their estimated rates of
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return together with required amounts of capital needed by the respective

projects.

Before analyzing the investments, the management must understand the nature
of opportunities. Some investments are complimentary i.e. making one investment
implies that another investment will be necessary. Some investments are mutually
exclusive i.e. acceptance of one, implies rejection of others and some investments are
independent. It is therefore necessary to identify the various opportunities of
investments. Alternative investments can be ranked according to their relative
profitability. It is also important to distinguish between cost reducing investment
and revenue increasing investment. According to W.W. Haynes “any investment
decision is profitable if it adds more to revenue than to cost or if it reduces cost
more than the revenue.” An important element in the analysis of demand for capital
is the productivity of proposed capital outlay. The yield must be calculated in terms
of individual projects. It is the expected productivity of marginal unit of capital i.e.
the key factor in the appraisal of allocating capital funds and not the profitability of
the old and sunk investment based on the estimates of the historical costs. The past is
useful only as a guide to the future i.e. the future profit which is more relevant and
influences demand for capital; besides the capital yield should be calculated over the
whole lifetime of the asset. Undoubtedly all the future ventures of capital investment
involve risks.

INVESTMENT WORTH OR PROFITABILITY OF A PROJECT

One of the most significant aspects of capital budgeting is the measurement of

investment worth.

For appraising the profitability of a project following criteria have been proposed:

A] The Payback Period Method

B] The Discounted Present Value Method
C] Internal Rate of Return Method

A] The Payback Period Method:

A Payback Period = Initial Investment Outlay

Annual Cash Flow

For example If initial investment outlay is Rs 1, 00, 000/- and cash inflow per year
is Rs 25, 000/- then payback period is 1, 00, 000 = 4 years
25, 000
From among the several projects the one which has the shortest Payback Period
may be selected.
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Merits

1. Simple and easy to calculate.

2. It takes care of liquidity problem of the firm.
3. Favours less risky projects.

Demerits

1. It ignores profitability.
2. It ignores changes in cash flows over a long period.
3. It disregards time value of money i.e. simply adds up annuities without proper
discounting.
4. It ignores cash inflow after the payback.

B] The Discounted Present Value Method (DPV)

DPV = RI + R2 + - - - - - - Rn
2
1+i (1+i ) (1+i)n

i) Project cost is given.

ii) Market rate of interest is given.
iii) RI ,R2 are known.

Find the DPV.

Compare it with the cost.
Investment is worthwhile if DPV > Cost.

Illustration:

Assume that a machine has a life of 2 years, each year it yields Rs 1210. The
present cost of the machine is Rs 2000 and the current rate of interest is 10%. Is the
investment worthwhile?
Applying the formula DPV = RI + R2
1+i (1+i )2

= 1210 + 1210
(1+.1) (1+.1) 2

= 1210 + 1210
1.1 (1.1) 2

= 1210 + 1210
11 121
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10 100

= 1210 x 10 + 1210 x 100

11 121

= 1100 + 1000

DPV = 2100

The Discounted Present Value (DPV) of the machine is expected to be Rs 2100.

Considering the current rate of interest and also assuming that RI, R2 remain the same;
whereas the actual cost of the machine is Rs 2000. Therefore DPV>C and hence the
investment in the machine is worthwhile.

C] Internal Rate of Return Method

C = RI + R 2 + - - - - - - Rn
1+e (1+e )2 (1+e)n

C: Cost is given.
RI ,R2 is the expected return each year.
e is the marginal efficiency of capital. To be obtained i.e. e = ?

Compare e with I (market rate of interest) where value of i is given.

As long as e > i, investment is worthwhile.

A well managed firm is always very careful with its capital budgeting.

15.3 SUPPLY OF CAPITAL AND COST OF CAPITAL

So far we have considered various concepts and principles underlying demand for
capital funds. We now turn to supply of capital. There are fundamentally two
sources of supply of capital:
i) Internal
ii) External

The internal sources of supply of capital are a) depreciation charges, and b)

retained earnings. The capital expenditure of many firms is confined purely to the
amount that can be secured internally. Therefore amount that can be expected from
accumulated depreciation and from retained earnings comprises the most significant
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part of capital budgeting. The retained earnings as a source of supply of capital

makes the plough back policy an integral part of capital budgeting.

The external sources of capital are issue of shares and debentures and inter- firm
borrowings. The external sources which depend on issue of shares, debentures and
inter firm borrowings are very volatile and depend upon the overall atmosphere in
the capital market, the company’s reputation, its financial backing and the integrity
of its management. Whenever the firm decides to acquire external source of finance
its project, it has to think many a times about the cost of capital. The cost of capital
is the rate which must be paid to obtain funds for operating the enterprise. As the
supply of capital comes from several sources, each source has to be analyzed
carefully because every source has a different cost component.

There are innumerable difficulties that arise while measuring the cost of capital
and hence the determination of company’s cost of capital is subject to various
margins of error. The computed values can be at the most regarded as fair
approximations of the cost. The cost approximation includes the computation of the
cost of debt capital, as well as cost of preference share capital, the cost of equity
capital, the cost of retained earnings, the cost of depreciation funds etc. The capital
costs are determined by a number of forces that exert their influence on capital
markets. The Government itself is the single most important determinant of the
interest rate structure through resorting to various policy measures by exercising
control over reserve requirements, rediscounting facilities selective controls and
open market operations. The Government influences the cost of capital. Similarly the
investor’s psychology, their confidence and business outlook also affect the yields on
security issues. Estimating the cost of capital requires the knowledge of market value
of securities and cost of floatation.

To conclude, the cost of capital is a complex subject although determining the

firm’s cost of capital is an essential part of capital budgeting process. Firms raise
funds in many forms including long-term and short-terms debts, stock, retained
earnings and lease financing. Each source of funds has a cost and these costs are the
basic inputs in the cost of capital determination.

15.4 POST AUDIT

Post Audit is necessary in any treatment of capital budgeting. The Post Audit
involves:
i) A comparison of actual results to those predicted in the investment proposal.
ii) An explanation of observed differences.

The Post Audit serves many purposes such as improving of the forecasts as well as
improving of the operations.
The Post Audit is a complex process. We must recognize that every element of
cash flow forecast is subject to uncertainty. Secondly, projects sometimes fail to meet
expectations for reasons beyond control of operating executives. It is also difficult to
separate the operating results of one investment from those of a larger system.
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Because of these difficulties some firms do not give adequate importance to Post
Audit. However, experience shows that the best run and most successful
organizations are those that put greatest stress on the Post Audit’s and therefore Post
Audit is one of the most important elements in a good system of capital budgeting.

15.5 PROJECT PLANNING

Capital budgeting presupposes Project Planning. In fact, project planning is the

most practical branch of Managerial Economics. A project refers to a scheme of
investing resources; project planning is essentially a long term planning of
proposed capital outlays. It relates to long term investment decisions.

Features of Project Planning

1. Determining the financial outlays.

2. It has time, technical and financial dimensions.
3. It is a long term phenomenon
4. It is non-repetitive & non-routine exercise.
5. It envisages a flow of yield in future.

In fact, Project Planning is also very often referred to as Capital Budgeting.

Stages of Project Planning

i.) Identification of investment opportunities through a search for new

investment proposals.
ii.) Assembling of resources.
iii.) Optimizing the use of resources.
iv.) Estimating the yield.
v.) Selection of the project on the basis of investment worth and economic
feasibility.
vi.) Decision taking.
vii.) Implementation.
viii.) Mid-term appraisal.
ix.) Performance reviews.
x.) Further areas:
a) Expansion of existing product.
b) Expansion of existing markets.
c) Innovation.
d) Environmental investments.
e) Replacement for maintenance.
f) Replacement for cost reduction.
These matters which underlie project planning will have to be taken into
consideration in capital budgeting for further developments in distant future.
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SUGGESTED READINGS

1. Joel Dean Managerial Economics

2. Pappas and Hirschey Fundamentals of Managerial Economics
3. Peterson and Lewis Managerial Economics
4. Haynes, Mote and Paul Managerial Economics

QUESTIONS

1. What do you understand by Capital Budgeting?

2. “Capital Budgeting decisions are subject to risks and uncertainty.” Why?

3.“It is necessary to identify the various opportunities of investments.” Explain.

4. “One of the most significant aspects of Capital Budgeting is the measurement of

investment worth.” What methods are normally used in deciding the profitability
of
a project?

5. Explain briefly the following:

i) The Payback Period Method

ii) The Discounted Present Value Method
iii) Internal Rate of Return Method

6. Explain the Internal and External sources of Supply of Capital.

7. “Each source of Supply of Capital has different cost component.” Explain the cost
component of the various sources of Supply of Capital.

8. ‘Post Audit is necessary in any treatment of Capital Budgeting.’ Do you agree?

Why?

9. ‘Capital Budgeting presupposes Project Planning.’ Outline the features and

stages of Project Planning.

10. Visit a few firms to study their methods of Capital Budgeting. Do they all have
similar Capital Budgeting structures. Do you notice any differences? If so, why?