2011 Assignment Enrolment Number

Annamalai University Director of Distance Education MBA xxxxxxxxxxxxxxxxxx 1st year

Assignment Topic 1.2 Management Economics

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Q 2. How to prepare a Capital Budget for yarn industry? - Explain Before we prepare a capital budget for yarn industry, let us discuss about capital budgeting and necessity of capital budgeting. Introducing to Capital Budgeting Capital budgeting involves and integrates the various elements of the firm, marketing, finance, accounting, production engineering and purchase departments. The effectiveness of the process of capital budgeting is dependent on inputs from all major departments of the firm. The estimates for a project are got from the various departments and they are drawn together in the form of project evaluation. Top management sets the standards of acceptability and ultimately makes the decision and the money spent on accept or reject the project. Capital budgeting is concerned with planning and control of capital expenditure. It describes planning systematic program for investing money on fixed assets. The most important decision which a management has to take is decision to invest i.e. to incur expenditure now which will produce a stream of benefits over a period of time. Investment decisions are different from operating decisions. In the case of investment decisions, the time horizon over which benefits accrue is longer than one year and the money spent is termed as capital expenditure. In the case of an operating decision the time horizon is shorter than one year and the amount spent is considered as a revenue expense. Need for Capital Budgeting 1. The capital allocation is a basic business decision on which many others depend and it is one of the firms fundamental decisions. 2. The kind of investment project which the firm is going to launch will determine the nature of the firms future for better or worse, because the type of the product of the firm plans to produce will determine whether it will continue to grow.

3. The effect of investment decision extends beyond the current period and its result is not immediately reported in the profit and loss account. Therefore, its apparent right or wrong nature cannot be quickly found out. 4. It broadens the base on which profit will be earned through return on capital employed. Rate of return is an important factor in assessment of efficiency of the firm. 5. The investment decision extends to the future. There is much uncertainty about the size of the future cash flow generated by an investment project. 6. Investment decisions are usually costly or impossible to reverse. Production facilities and machinery are highly specialized and there may not be second market for disposing them. Also, it is costly to disassemble production equipment. For those reasons the firm should have a procedure for analyzing and selecting the most desirable investment project from various alternatives that are available. Capital budgeting is simply a plan for the investment of funds, whose benefits will be received over a period of time. It formulates a basis on which to choose among competing investment projects. It determines the relative benefit each investment project may bring to the firm and the relative cost each may incur. It is for this reason that the analysis at times referred to as a cost benefit analysis. Budgeting is also known as investment decision making, equipment replacement policy or the analysis of capital expenditure. Capital budgeting decisions belong to the most important areas of managerial decisions as they involve more extended estimation and prediction of things to come requiring a high order of intellectual ability for their economics analysis. Heavy spending on capital assets in the recent years has stimulated a genuine interest among the economist, financial analysis and accounts in managerial approaches to capital budgeting decision.

Criteria for Capital Budgeting Decisions Potentially, there is a wide array of criteria for selecting projects. Some shareholders may want the first to select projects that will show immediate surges in cash inflows, other may want to emphasize long-term growth with little importance on short term performance. Viewed in this way, it would be quite difficult to satisfy the differing interests of all the shareholders. Fortunately there is a solution. The goal of the firm is to maximize present shareholder value. This goal implies that projects should be undertaken that result in a positive net [present value, that is the present value of the expected cash inflow less the present of the required capital expenditures. Using net present value (NPV) as measure, capital budgeting involves selecting those projects that increase the value of the firm because they have a positive NPV. The timing and growth rate of the incoming cash flow is important only to the extent of its impact on NPV. Using NVP as the criterion by which to select projects assumes efficient capital markets so that the firm has access to whatever capital is needed to pursue the positive NPV projects. In situation where this is not the case, there may be capital rationing and capital budgeting process becomes more complex. Note that it is not the responsibility of the firm to decide whether to please particular groups of shareholders who prefer longer or shorter term result. Once the firm has selected the projects to maximize its net present value, it is up to the individual shareholders to use the capital markets to borrow or lend in order to move the exact timing of their own cash inflows forward or backward. This idea is crucial in the principal-agent relationship that exists between shareholders and corporate managers. Even though each may have their own individual preferences, the common goal is that of maximizing the present value of the corporation. Method of Apprising Project Profitability A firm always aims to maximize its profits. Therefore, selection of projects on the basis of their profitability becomes the essential task in the decision making process for investing funds. Therefore, the projects have to be

evaluated regarding their profitability and ranked. The firm has to write down the list from low priority to high priority proposals. If the funds are limited the most profitable projects have to be selected. There are many methods that can be used to assess the investment opportunities. Let us discuss about 1) Internal Rate of Return 2) Net Present Value Method Internal Rate of Return(IRR) This method considers the time value of money. IRR is the rate at which the present value of future cash flows from an investment project is equated with the present value of the cash outflows of an investment. In other words, the internal rate of return is the interest rate at which sums the net present value of an investment projects to zero. IRR is determined solely by outlay and proceeds associated with the project. It does not depend on any rate determined by outside investment. The formula for IRR is C = R1/(1+r1) + R2/(1+r2) + R3/1+r3) + ..+ Rn(1+rn) Where C = the amount of capital invested R1 Rn N = Cash inflow in the first year = Cash inflow in the nth year = Life period of the project

Investment project would be accepted if the IRR is greater than the cut-off rate. Investment project will be rejected if the rate of return is less than the cut off rate. Alternative investment projects can be ranked in the order of IRR.

The weakness of this method is that it is cumbersome one involving computational problems. This method may not solve problems under all situations. Net Present Value Method(NPV) This method is concerned mainly with ascertaining the present worth of the future earnings by the application of the appropriate rate of interest. This method compares the present value of the future benefits with the present value of the investment. This is done by discounting cash flows by an appropriate rate of interest. When the present value of benefits does not exceed the present value of investment, the proposal for investment should be rejected. This method allows comparison of the project having different service lives. The formula for finding out the total present value of all cash inflows generating out of the investment is presented below. NPV = R1/(1+i1) + R2/(1+i2)2 + R3/(1+i3)3 + Rn/(1+in)n Where NPV denotes present value, i denotes rate of discount, R1, R2, R3 Rn are the net cash flows from the project in the year 1,2,3 etc. N = life of the asset. The project selection rule in this method is to accept the project if the NPV is < 0 Net present value indices are calculated by dividing the net present value by initial cost of the project and simplifying it by 100. i.e. NPVI = NPV/initial cost x 100 Alternative project can be ranked in the order of NPVI The demerits of this method are 1. it lacks simplicity

2. it is based on the assumption that discount rate is known in calculating the net present value. 3. this method may not offer proper help and guidance when projects with different amount of investment are compared.

Scope of the Study The efficient allocation of capital is the most important finical function in the modern world. The scope of the study is limited to prepare a capital budget for a yarn industry. ABC yarn industry is considering investing in a project with the following cash flows: Time 0 1 2 3 Actual Cash Flows (Rs) (100,000) 90000 80000 70000

An ABC yarn industry requires a minimum return of 40% under the present conditions. Inflation is currently running at 30% a year, and this is expected to continue indefinitely. Let us take a look at ABC yarn industrys required rate of return. if it invested Rs 10,000 for one year on 1 January, then on 31 December it would require a minimum return of Rs4000 . With the initial investment of Rs10,000, the total value of the investment by 31st December must increase to Rs14,000. During the year, the purchasing value of the dollar would fall due to inflation. we can restate the amount received on 31 December is terms of the purchasing power of the dollar at 1 January as follows:

Amount received on 31 December in terms of the value of the dollar at 1 January: 14,000 / ( 1.30)1 = 10,769 in terms of the value of the dollar at 1 January, ABC yarn industry would make a profit of Rs 769 which represents a rate of return of 7.69% in todays money terms. This is known as the real rate of return. the required rate of 40% is a money rate of return (sometimes known as a nominal rate of return). The money rate measures the return in terms of the dollar, which is falling in value. the real rate measures the return in constant price level terms. the two rates of return and the inflation rate are linked by equation: (1 + 0.4) = (1 + 0.0769) * (1 + 0.3) = 1.4 if the cash flows are expressed in terms of actual dollars that will be received or paid in the future, the money rate for discounting should be used. if the cash flows are expressed in terms of the value of the dollar at time 0 (i.e. in constant price level terms), the real rate of discounting should be used. In ABC yarn industrys case, the cash flows are expressed in terms of the actual dollars that will be received or paid at the relevant dates. Therefore, we should discount them using the money rate of return. Time 0 1 2 Cash flow Rs (150,000) 90,000 80,000 Discount factor 40% 1.000 0.714 0.510 PV Rs (100,000) 64,260 40,800

70,000

0.364

25,480 30,540

The project has a positive net present value of Rs30,540, so ABC yarn industry should go ahead with the project. The future cash flows can be re-expressed in terms of the value of the dollar at time 0 as follows, given inflation at 30% a year Time 0 1 2 3 Actual Cash flow Rs (100,000) 90,000 80,000 70,000 Cash flow at time 0 price level Rs (100,000) 90,000 * 1 /(1.30)1 69,231 2 80,000 * 1 /(1.30) 47,337 3 70,000 * 1 /(1.30) 31,862

The cash flows expressed in terms of the value of the dollar at time 0 can now be discounted using the real value of 7.69%. Time 0 1 2 3 Cash flow Rs (100,000) 69,231 47,337 31,862 Discount factor 7.69% 1.000 1 /(1.0769)1 1 /(1.0769)2 1 /(1.0769)3 Pv Rs (100,000) 64,246 40,804 25,490 30,540

The NPV is the same as before.