UNIT No. 3 Capital Budgeting Nature Significance Technique of Capital Budgeting Pay back Method Accounting Rate of Return Net Present Value Profitability Index

Introduction The finance manager concerned with the investment decision, popularly known as capital budgeting decision, require comparison of cost against benefits over the long period. For Example : The deployment finances of additional plant and equipment cannot be recovered in the short run. Such investment may affect revenues for the period ranging from 2 to 20 years or more. Such investment decision involve a careful consideration of various factors viz profitability, safety, liquidity and solvency.

Cases of Capital Budgeting Replacement Expansion Diversification Research and development Miscellaneous

Concept of Capital Budgeting The term capital budgeting refers to long term planning for proposed outlays (Expenditure)and their financing. It may defined as “the firms formal financial process for the acquisition and investment of capital” It is the decision making process by which the firm evaluate the purchase of major fixed asset.

Capital Budgeting includes… Searching for new and profitable investment proposal Investing, engineering and marketing considerations to predict the consequences of accepting the investment. Making economic analysis to determine the profit potential of each investment. Thus, Capital budgeting consist in planning the development of available capital for the purpose of maximizing the long term profitability (i.e. ROI) of the firm.

Importance of Capital Budgeting…. 1. Involvement of heavy fund. 2. Long term implication 3. Irreversible decisions 4. Most difficult to make

Involvement of Heavy Fund Capital budgeting decisions require large capital outlays. It is therefore absolutely necessary that the firm should carefully plan they are put to most profitable use. An opportune investment decision can give spectacular results. On the other hand, an ill advised and incorrect decision can jeopardize the survival of even the biggest firm.

Long term implication The effect of capital budgeting decision will be felt by the firm over a long period and therefore they have decisive influence on the rate and direction of the growth of the firm.

In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital assets. The only alternative will be to scrap the capital assets so purchased or sell them at a substantial loss in the event of the decision being proved wrong. Irreversible Decision

Most Difficult to Make The capital budgeting decision require an assessment of future events which are uncertain. It is really difficult task to estimate the probable future events, the probable benefits and cost accurately in quantitative terms because of economic,political, social, and technological factors.

Capital Budgeting Process Capital budgeting is a difficult process to the investment of available funds. The benefit will attained only in the near future but, the future is uncertain. 1. Identification of various investments proposals 2. Screening or matching the proposals 3. Evaluation 4. Fixing priority 5. Final approval 6. Implementing 7. Performance review of feedback

Identification of various investments proposals The capital budgeting may have various investment proposals. The proposal for the investment opportunities may be defined from the top management or may be even from the lower rank. The heads of various department analyse the various investment decisions, and will select proposals submitted to the planning committee of competent authority.

Screening or matching the proposals The planning committee will analyse the various proposals and screenings. The selected proposals are considered with the available resources of the concern. Here resources referred as the financial part of the proposal. This reduces the gap between the resources and the investment cost.

Evaluation After screening, the proposals are evaluated with the help of various methods, such as pay back period proposal, net discovered present value method, accounting rate of return and risk analysis. Each method of evaluation used in detail in the later part of this chapter.

Fixing priority After the evolution, the planning committee will predict which proposals will give more profit or economic consideration. If the projects or proposals are not suitable for the concern’s financial condition, the projects are rejected without considering other nature of the proposals.

Final Approval... The planning committee approves the final proposals, with the help of the following: (a) Profitability (b) Economic constituents (c) Financial violability (d) Market conditions. The planning committee prepares the cost estimation and submits to the management.

Implementing... The competent autherity spends the money and implements the proposals. While implementing the proposals, assign responsibilities to the proposals, assign responsibilities for completing it, within the time allotted and reduce the cost for this purpose. The network techniques used such as PERT and CPM. It helps the management for monitoring and containing the implementation of the proposals

Performance review of feedback The final stage of capital budgeting is actual results compared with the standard results. The adverse or unfavourable results identified and removing the various difficulties of the project. This is helpful for the future of the proposals.

Factor Influencing Capital Budgeting…. Degree of Certainty. Intangible Factors Legal Factors. Availability of Fund Future Earning/ Source of Finance Research & Development Cost of Capital

Techniques of Capital budgeting  Pay Back Method  Accounting rate of return  Net Present Value  Profitability Index

Payback Period Method…. The pay back period is defined s the number of years required for the proposals cumulative cash inflows to be equal to its cash outflows. In other words the payback period is the length of time required to recover the initial cost of the project. The payback period is the length of time required to recover the initial cost of the project. The payback period therefore can be looked upon as the length of time required for a proposal to break even on its net investment.

Calculation of the payback period… When Annual Inflow are Equal. When the Annual Cash Inflow are Unequal.

Numerical…

Merits Simple to calculate Liquidity Indications Break even o finvestment can be calculated.

Demerits Ingnores the profitability factor Its is the method of recovery Ingnores salvage Value Ignores the time value of money.

Accept/Reject criteria If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted. If not, it would be rejected.

Accounting Rate of Return or Average Rate of Return Average rate of return means the average rate of return or profit taken for considering the project evaluation. This method is one of the traditional methods for evaluating the project proposals:

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 It ignores the time value of money. It ignores the reinvestment potential of a 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.

Numericals..

Profitability Index It is also a time adjusted method of evaluating investment proposal. Profitability index also called as Benefit- Cost ratio or desirability factor is relationship between present value of cash inflow and the present value of cash outflow.

Formula Present Value of Cash Inflow Profitability Index = Present Value of Cash Outflow /Investment

Merits It is consistent with goal of maximising the shareholders wealth. It uses cash flow. It recognised the time value of money.

Demerits The main demerit of this method is that is requires detailed long term forecast of incremental benefits and costs. Its also have the difficulty in determining appropriate discount rate.