capital budgeting project report
TRANSCRIPT
CAPITAL BUDGETING
Introduction
A Business organisation has to quite often face the problem of capital investment decisions. Capital
Investment refers to the investment in projects whose results would be available only after a year.
The investments in these projects are quite heavy and is to be made immediately but the return will
Be available only after a period of time. These investment decisions, popularly known as capital
Budgeting decisions. It requires comparisons of cost against benefits over a long period. Such
Investments may affect revenues for the time period ranging from 2 to 20 years or more.In other
Words, the system of capital budgeting is employed to evaluate expenditure decisions which involve
Current outlays but are likely to produce benefits over a period of time longer than one year. These
Benefits may be either in the form of increased revenues or reduction in costs.
FIXED ASSETS MANAGEMENT
Fixed Asset are those assets which are of a somewhat fixed or permanent nature ( a life expectancy
of more than one year ) and are used by a business in its normal operations; they do not include items
Offered for sale. Fixed assets management is the most important task which a management has to face
in its day-today situations, and is important for the following reasons :
i) There is risk involved in fixed assets because of their longer life.
ii) Fixed Asset usually have a relatively High cost.
iii) Fixed Assets create problems of acquisition and replacement. Acquisitions are additions
to fixed assets. The main purpose of acquisitions is to increase existing capability.
Replacements are the assets which take the place of existing assets with comparable
capacity. Betterments and improvements refer to capital expenditure which results in the
Physical change or alteration of an asset. The purchase of fixed assets is of particular
significance of business firms because the amount involved is relatively large and
represent commitments for a relatively long period of time. They are relatively long-lived
assets which are acquired for use in a business and not intended for sale.
iv) There is a greater tendency to make use of machines and invest more and more in fixed
assets. The use of efficient machinery is necessary for economics of scale, particularly in
conditions of increasing competition. Because of technological changes, the investment in
fixed assets is likely to increase, for all assets become outdated and may have to be
replaced. Planning for long-term capital expenditure is the most important function of
every business because substantial amounts are involved and the investment of funds is
spread over a considerable period of time, and returns flow back at varying intervals in
unknown amounts. Capital budgeting on a long-term basis is an essential part of fixed
assets management. While emphasising importance of fixed assets management, Johnson
points out that fixed financial obligations must be met when due, at an average and not in
most years but always. The policy in planning capital expenditure is not only important
for a company and its financial positions, but is also of strategic importance to the total
economy.
MEANING OF CAPITAL BUDGETING
The term capital budgeting contains two words , capital , the relatively scarce , non-human resource
of production enterprise, and budgeting thus indicating a detailed, quantified planning which guides
future activities of an enterprise towards the achievement of its profit goals. ‘Capital’ relates to total
funds employed in an enterprise as a whole. The capital fund is increased by an inward flow of cash
and decreased by an outward flow of cash and as such it is important for an enterprise to plan and
arrange cash flows properly. The power of the financial planning package lies in enabling borrowings
to be arranged sufficiently in advance to reduce the danger of a liquidity crisis also to provide
substantiating documents for loan negotiations. Capital budgeting then consist in planning the
deployment of available capital for the purpose of maximising the long-term profitability ( return on
investment ) of a firm. It refers to the process by which a firm determines where it should apply its
Comparatively limited financial resources.
Capital budgeting may be defined as the decision-making process by which a firm evaluates the
purchase of major fixed assets, including buildings, machinery and equipment. It deals exclusively
with major investment proposals which are essentially long-term projects and is concerned with the
allocation of the firms’ scarce financial resources among the available market opportunities. It is a
many-sided activity which includes a search for a new and more profitable investment proposal and
the making of an economic analysis to determine the profit potential of each investment proposal. The
term ‘capital expenditure projects’ is broad enough to include those projects in which the net assets of
a company are acquired by the issue of the capital stock of the acquiring company. Capital budgeting
involve a long-lived assets affects a forms operation over a period of time (years) . They are large,
permanent commitments which influence its long-run flexibility and earning power. It is a process by
which available cash and credit resource are allocated among competitive long-term investment
opportunities so as to promote the greatest profitability of a company over a period of time. It refers to
the total process of generating. Evaluating, selecting and following up on capital expenditure
alternatives.
SIGNIFICANCE OF CAPITAL BUDGETING
Capital budgeting is Significant for the following reasons:
i) The decision maker loses some of his flexibility, for the results continue over an extended
period of time. He has to make a commitment for the future.
ii) Asset expansion is related to future sales.
iii) The availability of capital assets has to be phased properly.
iv) Asset expansion typically involves the allocation of substantial amounts of funds.
v) Many firms fail because they have too much or too little capital equipment.
vi) Decisions relating to capital investment are among the difficult and at the same time, the
most critical because the effect of such decisions will have a far reaching influence on the
firms profitability for many years to come.
vii) The most important reason for capital budgeting decision is that they have long-term
implications for a firm. The effects of a capital budgeting decision extend into the future
and have to be put up with for a longer period than the consequences of current operating
expenditures.
viii) Capital budgeting is a vital function of the management, for it is one of the critical
determinants of the success or failure of a company. Excessive capital spending may
create excessive capacity and increase operati9ng costs, which limit the viability of
company funds and reduce its profits.
PRINCIPLES OF CAPITAL BUDGETING
Capital expenditure decisions should be taken on the basis of the following factors:
Creative Search for Profitable Opportunities : The first stage is the conception of the profits
making idea. Profitable investment opportunities should be sought to supplement existing proposals.
Long-Range Capital Planning: A fexible programme of a company’s expected future development
over a long period of time should be prepared.
Short-range Capital Planning: This is for short period. It indicates its sectoral demand for funds to
stimulate alternative proposals before the aggregate demand for funds is finalised.
Measurement of project Work: The economic worth of a project to a company is evaluated at this
stage. The project is ranked with other projects.
Screening and selection: The project is examined on the basis of selection criteria, such as the supply
and cost of capital, expected returns, alternative investment opportunities etc.
Post Mortem: The ex-post routines of a completed investment project should be re-evaluated in order
to verify their exact conformity with exact projections.
Retirement and Disposal: The expiry of the cycle in the life of a project is marked at this stage.
Forms and Procedures: These involve the preparation of reports necessary for any capital
expenditure programme.
Economics of Capital Budgeting: It includes estimating the rate of return on capital expenditures.A
knowledge theory underlying investment decisions is needed for this purpose. This broad field of
decision-making of capital investment is one of the most difficult, one of the most recurrent and one
of the most controversial of management areas; and it is also an area where there are tremendous
opportunities for basic improvements in operation and policies. It may be emphasised here that the
Use of a model or of any of the mathematical technique of the operations research does not imply
Management by computers. The mathematical model itself is a tool of management rather than a
Replacement for management.
Authorisation: Since capital expenditure budget does not contain detailed expenditure, it is essential
that before any individual projects relating to capital items are started, the expenditure should be
specially authorised.
CHARACTERISTICS OF CAPITAL BUDGETING:
Capital Expenditure for Long-Period: Capital budgeting entails heavy expenditure. Infact, this is a
very important characteristic which explains the importance of capital budgeting decisions to a firm.
Capital is sunk for a long period. This long-term commitment adds considerably to the risk of capital
budgeting decisions. Capital expenditure is the main link between the present and the future, for it is
the principal means by which an industrial company tries to attain its long-term goals and objectives.
Because of its relationship with long-term profit planning, its disproportionately heavy impact on
short-term profit and its high volume, capital expenditure should be planned and controlled. Decisi
ons which involve the authorisation of capital expenditure projects are among the most important for
the Boards of Directors and their managerial advisers. Most capital expenditures schemes call for a
permanent commitment of relatively large sums of money over a number of years. Capital
expenditure is Strategic investment of some magnitude and is of a non-routine nature; it has economic
life and its benefits continue over a series of years. From the standpoint of the stockholder and the
consumer, capital expenditure are the principal bulwark against the seemingly endless progression of
FEATURES OF
CAPITAL BUDGETING Forecasting
Capital expenditure for long
Planning Asset Capacities
wage increase. From the standpoint of labour, capital expenditure are the basic economic source of
future wage advances, for they embody the creative forward strides of advancing technology. Finally,
capital expenditure, both by their aggregate size and by their cyclical timing, have a graet deal to do
with the character of the economy as a whole , and therefore , with the government’s role in
maintaining stability.
i) Creative Search for Profitable Opportunities : The concept of the profit-making idea
must be embodied in the capital facility. Profitable opportunity for the company’s
invested capital must be turned up. A corporation’s future profitability and growth are
linked to the soundness of its capital expenditure management programme. These steps
then require to be integrated into a procedure to be used for the conduct of an
organisation’s capital expenditure programme.
ii) Long-range Capital Planning : To provide consistent benchmarks for proposal
Origination in all parts of the organisation, it is necessary to have some kind of a plan
sketched for the future even though it is a tentative plan. Consider the words of joel Dean:
“Today’s Capital expenditures make the bed that the company must lie in tomorrow. The
Capital expenditures budget embraces a company’s plans for replacing, improving and
adding to its capital equipment”.
iii) Short-range Capital Planning: The purpose of preparing a short-range capital budget is
to force the operating management to submit the bulk of its capital proposals early
enough to give the top management an indication of the company’s credit demands for
funds.
iv) Measurement of Project Worth: In order to permit an objective ranging of projects, the
productivity of the proposed outlay will have to be measured properly.
v) Screening and Selection: A screening standard should be set in the light of the supply of
cash available for capital expenditures, the cost of money to the company, and the
attractiveness of alternative investment opportunities.
vi) Control of Authorised Outlay: Control has to be exercised by the top management in
order to ensure that the facility conforms to specifications and that the outlay does not
exceed the amount authorised. Once the capital expenditure is incurred, it is most difficult
to change the course of expenditure. As capital assets are usually of limited specific use,
the future needs of such should be carefully assessed.
vii) Post Mortem: In order to preserve the integration of the estimates of projected earning’s,
a post-completion audit of the company’s performance should be affected.
viii) Retirement and Disposal: A management’s responsibility for an investment approach
ceases only when the facilities have been disposed of. The assets must be retained
throughout its economic life until it virtually becomes worthless at the time of disposal.
ix) Forms and Procedures: An effective system of capital expenditure control should be
Implemented with the use of specialised forms, written procedures etc. All tailored to the
Company’s need.
x) Economics of Capital budgeting: Good estimates of a rate of return of capital
expenditure projects pre-suppose an understanding of the economic concept that
Underline sound investment decisions.
xi) Increase the Breadth of Analysis Leading to Decision-Making: In evaluating capital
expenditure decision or a profit-plan , it has been fairly common to consider only an few
alternative strategies or economic assumptions before reaching a decision.
xii) Tool for Special Problems: More and more attention is being devoted by management to
temporary and special problem situations.
xiii) Understanding inherent Logic of the Financial System: As a by-product of financial
modelling, some executives have found that the act of defining the logic and interaction
Of the financial system in developing the model is, in itself , very important and revalling
activity.
Forecasting: As funds are committed over extended periods of time, there is a need for proper
forecasting. A bird in hand is worth two in the bush. There is an element of uncertainty and risk
Which may lie in store for the future. All these factors have to be properly evaluated in the process
of forecasting. A proper cost-benefit relationship should also be established.
Planning Asset Capacities: A firm has to assess the capacities of the assets properly before
arriving at its long-term decisions. Both under-capacities and over-capacities should be avoided.
Moreover, the management should determine the timing and the quality of asset acquisitions.
Asset capacities have to be related to market factors, which may change over a period of time
because of various cyclical fluctuations. A firm should, therefore plan and fix the capacities of its
asset in which long-term investment is going to be sunk. Far-sighted judgement is an essential
pre-requisite of wise decisions bearing on capital expenditures. But such a judgement, to be
sound, should ne based on an needs an objective means of measuring the economic worth of
individual investment proposals so that it may choose and select those which will have the most
profound impact on a company’s long-run prosperity. The real worth of an investment proposal
may ne traced to the credibility of the forecasts of the sales demand and production capacity
which underpin the validity of the assessments and any miscalculation of these is likely to be of
far greater consequences than the relatively marginal effects of errors caused by the use of a
wrong rate of interest in discounting calculations.
KINDS OF CAPITAL BUDGETING PROPOSALS
Replacements: Worn-out, obsolete equipment should be replaced at an appropriate time.
Expansion : If the product is in great demand, a firm may think of expanding its activities. Expansion involves an addition of capacity to the existing production facilities. The proposal would then include capital widening decisions and assist in the dynamic growth of the firm. Qualitative efforts should be made to increase the existing utilisation of capacity.
Modernisation of Investment Expenditures: These are capital-deep decisions. They make it easier for a firm to reduce costs and may coincide with replacement decisions.
Strategic Investment Proposals: There are capital budgeting decisions which do not assume that the return would be immediately or be measured over a long period of time. Strategic Investment may be
Kinds of Capital Budgeting Proposals
Replacement
Expansion
Modernisation of Investment
Strategic Investment Proposals
Diversification
Research & Development
defensive, Offensive and mixed-motive decision. The vertical integration of a firm is an example of a defensive investment in which a continues source of raw materials is assured. Horizontal and conglomerate combination is offensive investments, for they ensure a firms’s internal and external growth respectively. Mixed motive investments are outlays on research and development programmes.
Diversification: Diversification means operating in several markets or from one market into another market. It may even amount to changing product lines. A firm resorts to diversification to ensure breakeven risks involved in different products lines.
Research & Development: Where technology is rapidly changing, research and development becomes a continuous activity for any firm. Usually, large sums of money are invested in R&D activities which lead to capital budgeting decisions.
Ranking of Capital Budgeting Proposals
A firm should select its own projects after considering the merits and demerits of each one of them. For this purpose , it should rank the proposal. Proposals are ranked on the basis of the following considerations:
Mutually Exclusive Investment: Where it is technically impossible to undertake the first, when the second has been accepted, then the two investments are mutually exclusive. These projects do not depend upon each other. In other words, one can be rejected and the other can be accepted. It is easier for a firm to take capital budgeting decisions in such projects.
Contingent Projects: In this case, the utility of one proposal is mutually exclusive. In other words, with the acceptance of one project, a few other incidental projects have to be accepted. A project may be described here as the main project, which may be considered along with a bunch of other incidental projects.
An investment proposal is said to be economically independent, if the cash flows or benefits expected from it would be the same regardless of whether any other investment is accepted or rejected.
An investment is economically dependent if a decision to undertake an investment increases or decreases the benefits from another. In the first case, the second investment is the complement of the first. In the second case, it is a substitute for the firts.
Some investments may be economically independent statistically dependent. The statistical dependence affects the risk of the two investments.
CAPITAL RATIONING
Capital rationing means distribution of capital in favour of more acceptable proposals. A firm determines a certain cut-of-point for selecting accepted proposals. The basic reason for capital rationing is that funds to be invested over a long period of time must be distributed most judiciously. The capital rationing problem is one where not all projects with positive present values (items at the pre-rationing discount rate) can be taken up because of limits on the funds available for investment. It is also a situation in which some projects, with negative present or terminal values, may be expected if they generate funds at crucial times. There are two problems in capital rationing:
Given the cost of capital, which group of investment should be selected? The principle of accepting all the proposals have a positive present value of the firm’s cost of capital is obvious, for a failure to do so would prove critical. Adherence to this principle results in the present value of a firm’s net worth being at a maximum al all points of time.
Given a fixed sum for capital investment, which group of investment proposals should be undertaken?
a) When there is one accounting period, investment proposals should ne ranked according to their present values, until the fixed sum is exhausted.
b) The problem becomes more difficult when the choice is between a single big proposal and a combination of small proposals, though the latter may yield an increment in present values.
c) There may be increment proposals, some of which require net cash outlays in more than one accounting period. In such cases, a constraint is imposed not only by the fixed sum for capital investment but also by the fixed sums available to carry out present commitments in subsequent time periods.
d) The selection of the best among mutually exclusive alternatives is done on the basis of a rate of return available among different mutually exclusive projects.
The problems of capital rationing are felt more by firms with fixed capital budgets and a large variety of alternative opportunities which constrain them to take various investment decisions. Proposals are selected from among independent alternatives. Investments may be single-period and multi-period investments. In single-period investments, proposals are ranked according to their profitability index, which also maximises the present value of the owner’s equity. However, the situation involves outlay in several periods. Multi-period investments have to be accepted because they ensure multiple ratios of returns. There is need for capital rationing during a period of budget constraints. During other periods, there may not be any need for capital rationing. However, it is likely that budget constraints may arise during several period. In that case, rationing brings forth complicated problems. Proposals may be selected from among inter-dependent alternatives. There may be investment proposals where one cannot be abandoned at the cost of the other. Similarly, there may be contingent projects which are combined with each other. The existing and new asset selection may also raise unique problems in terms of the variability of their future flows. In this case, a firm should resort to portfolio selection. It may be possible for a firm to select proposals from among inter-dependent alternatives. At the same time, in relationship, there are three broad classifications of inter-dependence:
i) Structural Inter-dependence: It refers to the interaction of the inputs and output among firms and industries. The future earning from potential investment are likely to be affected by this inter-dependence, which is also referred to as “business risk”. These
difficulties might as well make a frims flows vulnerable to a collective disaster, which is referred to as ‘portfolio risk’ Added to this, if the firm is highly indebted or levered, the financial risk become indispensable.
ii) Macro-Economic Inter-dependence: It refers to the interaction of cyclical and seasonal effects on products and markets.
iii) Demographic Inter-dependence: It refers to the concentration and mobility of population. This might affect both the product and labour markets. This , in turn, is bound to influence investment decisions.
TECHNIQUE OF SELECTING CAPITAL BUDGETING PROPOSALS
TECHNIQUE OF SELECTING CAPITAL BUDGETING PROPOSALS
Payback Method
Average Rate of Return
Internal Rate of Return
Net Present Worth
Profitability Index
Adjusted Net Present value
Discounting Benefit Cost Ratio
Undiscounted benefit cost
Net Terminal Value
Annual Benefit Cost Ratio
Net Cost Criteria
Capital Allocation
Cut-off Point
Payback Period Method : The pay back method is based on the assumption that the degree of risk associated with the fixed asset is the time required to recover the investment from the firm’s cash flow. The payback period is defined as the length of time required for the stream of cash proceeds produced by an investment to equal the original cash outlay required by the investment. This method is also known as the pay-out method .
Payback period = Investment
Net Annual Cash Flow
The project required an investment of Rs.2, 00,000. It yields an annual cash flow of Rs .40, 000 for 9 years. Find out the payback period of the project.
Payback period = 200000 = 5 years
40000
This technique estimates the time required by the project to recover, through cash inflows the firm’s initial outlay. Beginning with the shortest layout period ‘different project are arrange in order of time required to recapture their respective estimated initial outlay. The payback period for each investment proposal is compare with the maximum period acceptable to the management and proposals than ranked and selected in order and those having minimum pay- out period.
In order to use the payback period as a decision rate for accepting or rejecting the projects the firms has to decide upon the appropriate cut-off date. Projects project with payback periods less than or equal to the cut-off date will accepted and others will be rejected. The payback is widely used investment appraisal criteria.
Advantages:
1. It is easy to calculate. An investment proposal can be ranked quickly.2. The pay- back method permits the firms to determine the length of time required to recapture
through cash flow, the capital expenditure incurred on a given project and thus helps it to determine the degree of the risk involved in each investment proposal.
3. This is an ideal in case of investment in foreign country with volatile political position and a long term projection of a political and difficult.
4. It help in weeding out risky project s by favouring only those projects which generate substantial inflows in earlier years.
Limitation:
1. It fails to consider the time value of money.
2. This method completely ignores all cash inflows accruing from the project after the payback period. The application for this method in the case of the project with longer gestation period will be misleading.
3. This method does not take into account the salvage or residual value of any, of the long term asset.
4. The payback technique ignores the cost of capital, as the cut- off factor affecting selection of investment proposal.
Average Rate of Return
The average rate or book rate of return is typically defined as follows:
Average rate of return (ARR) 100
TO use it as an appraisal criterion the ARR of a project is compared with the ARR of the firm as a whole or against sum external yardstick like the average rate of return for the industry as the whole. The ARR method facilitates the decision make to decide whether to accept or reject the investment proposal. Based on the ARR as the accept reject criterion the actual ARR compared with the predetermine or minimum required rate of return or cut of rate. A project is accepted when the actual ARR is higher than the minimum desired rate or return, otherwise the project is rejected.
Internal Rate of return:
The internal rate of return is the rate which equates the present value of expected future cash flows with cost of investment. The rate of discount is determined by the trial – and – error method to bring the present value project close to the investment. Subsequently, the exact internal rate of return is estimate with the help of interpolation. The discounted case flow is nothing but a true annual rate of return of the capital outstanding in the investment . The implicit discount rate – the expected rate of total return that equilibrate current price with forecast dividend stream-is the single most important piece of information to have about common stock . Risk premium and liquidity preference premiums play a pivotal role in explaining variations in discount rate . Although premiums are constantly changing , the effect of changes on the structure of implicit discount rates is systematic. In Particular, it is usually true that: (i) The higher the market risk of a stock, the higher the discount rate or expected return tend to be ; and (ii) The lower the market liquidity, the higher the discount rate or expected return tends to be.
IRR =
Net present worth:
A business firm has positive preference for the time factor .It prefers present goods to the same quality of commodity in future. The Present is here and now , and is more certain than future . The financial manager places a greaterl value on present fund than on future fund because : (1) the additional income is available now rather than in future;(2) there is greater certainty associated with present asset ; (3) future receipt are only current estimates ; (4) a risk is involved in future receipts
There is two aspect of problem. One is annuity principle and other is the present value of future income . According to the annuity principle:
Where
FV is the future value
P is principal value
r is rate of expected return .
According to this formula, the present value of future income is:
FC
PV = PV
Where
PV is the present value
FV is the future value
r is the rate of expected return
n is the number of years
This method calculates the net present worth of the expected net cash flows of each project, which is obtained by discounting the net cash flows of each project by a discount rate which equals the firm’s cost of capital. The net present value method is classic economics method of investment appraisal. While it is favoured by a majority of economists, it has not found much support elsewhere. In business, the discounted cash flow method is generally preferred. Net cash flow are the incremental cash receipts, less the incremental expenditure solely attributable the decision to proceed with the investment. The present value of the investment. May be described as the investment .without being financially worse off:
NPW = –
Where
NPW is the net present worth
K = Is the firm’s cost of capital
n is the proposal ‘s life in years.
Profitability Index:
The profitability index is the relationship that exit between the present values of net cash inflows and the present value of cash outflows. It is possible to make use of desirability. It relates the present value of net cash flow discounted at various rate of interest of capital cost of capital expenditure required for the project.
PI = =
Where
PI Is profitability index
K Is the firm’s cost of capital
n Is the proposal ‘s life in years.
Adjusted Net present worth:
This method assumed risk of possible insolvency and availability in earnings available to shareholder. For this purpose, the expected cash flow is substituted by the model cash flow. A financial executive should ascertain the probable distribution of the annual cash flows of the different project
Discounted Benefit cost ratio:
This is a ratio or present worth of all the future benefits to the present worth of the project outlay, both streams discounted at different rate. This discounted benefit – cost ratio is the ratio of present value of future benefit to the present value of the outlays
Gross BCRD =
Net BCRD = – 1
Undiscounted Benefit – cost relation:
Both benefits and cost are accounted without any discount for futurity, business risk or fianencial risk. It is computed with the help of following formula:
Undiscounted gross BCR =
Undiscounted net BCR =
Where
Cash flow generated during period t
C Original cost of project