Capital Budgeting notes.....:)

Nature of Capital budgeting

(a) expenditure plans involve a huge investment in fixed assets.

 

(b) Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss.

(c) Preparation of coital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects.
 

It may be asserted here that decision regarding capital investment should be taken very carefully so that the future plans of the company are not affected adversely.

Procedure of Capital Budgeting

Capital investment decision of the firm have a pervasive influence on the entire spectrum of entrepreneurial activities so the careful consideration should be regarded to all aspects of financial management .

In capital budgeting process, main points to be borne in mind how much money will be needed of implementing immediate plans, how much money is available for its completion and how are the available funds going to be assigned tote various capital projects under consideration. The financial policy and risk policy of the management should be clear in mind before proceeding to the capital budgeting process. The following procedure may be adopted in preparing capital budget :-

 

(1) Organisation of Investment Proposal.

The first step in capital budgeting process is the conception of a profit making idea. The proposals may come from rank and file worker of any department or from any line officer. The department head collects all the investment proposals and reviews them in the light of financial and risk policies of the organisation in order to send them to the capital expenditure planning committee for consideration.

 

(2) Screening the Proposals.

In large organisations, a capital expenditure planning committee is established for the screening of various proposals received by it from the heads of various departments and the line officers of the company. The committee screens the various proposals within the long-range policy-frame work of the organisation. It is to be ascertained by the committee whether the proposals are within the selection criterion of the firm, or they do no lead to department imbalances or they are profitable.

 

(3) Evaluation of Projects.

The next step in capital budgeting process is to evaluate the different proposals in term of the cost of capital, the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation techniques:-

 

(a) Degree of Urgency Method

 

(b) Pay-back Method

 

(c) Return on investment Method

 

(d) Discounted Cash Flow Method.

 

(4) Establishing Priorities.

After proper screening of the proposals, uneconomic or unprofitable proposals are dropped. The profitable projects or in other words accepted projects are then put in priority. It facilitates their acquisition or construction according to the sources available and avoids unnecessary and costly delays and serious cot-overruns. Generally, priority is fixed in the following order.

 

(a) Current and incomplete projects are given first priority.

 

(b) Safety projects ad projects necessary to carry on the legislative requirements.

 

(c) Projects of maintaining the present efficiency of the firm.

 

(d) Projects for supplementing the income

 

(e) Projects for the expansion of new product.

 

(5) Final Approval.

Proposals finally recommended by the committee are sent to the top management along with the detailed report, both o the capital expenditure and of sources of funds to meet them. The management affirms its final seal to proposals taking in view the urgency, profitability of the projects and the available financial resources. Projects are then sent to the budget committee for incorporating them in the capital budget.

 

(6) Evaluation.

Last but not the least important step in the capital budgeting process is an evaluation of the programme after it has been fully implemented. Budget proposals and the net investment in the projects are compared periodically and on the basis of such evaluation, the budget figures may be reviewer and presented in a more realistic way.

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Significance of Capital Budgeting

The key function of the financial management is the selection of the most profitable assortment of capital investment and it is the most important area of decision-making of the financial manger because any action taken by the manger in this area affects the working and theprofitability of the firm for many years to come.

The need of capital budgeting can be emphasised taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, long-term implications for the firm, irreversible decisions and complicates of the decision making. Its importance can be illustrated well on the following other grounds:-

 

(1) Indirect Forecast of Sales.

The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results.

 

(2) Comparative Study of Alternative Projects

Capital budgeting makes a comparative study of the alternative Projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each projects is estimated.

 

(3) Timing of Assets-Acquisition.

Proper capital budgeting leads to proper timing of assets-acquisition and improvement in quality of assets purchased. It is due to ht nature of demand and supply of capital goods. The demand of capital goods does not arise until sales impinge on productive capacity and such situation occur only intermittently. On the other hand, supply of capital goods with their availability is one of the functions of capital budgeting.


 

(4) Cash Forecast.

Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast.

 

(5) Worth-Maximization of Shareholders.

The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity share-holders.

 

(6) Other Factors.

The following other factors can also be considered for its significance:-

 

(a) It assist in formulating a sound depreciation and assets replacement policy.

 

(b) It may be useful n considering methods of coast reduction. A reduction campaign may necessitate the consideration of purchasing most up-to—date and modern equipment.

 

(c) The feasibility of replacing manual work by machinery may be seen from the capital forecast be comparing the manual cost an the capital cost.

 

(d) The capital cost of improving working conditions or safety can be obtained through capital expenditure forecasting.

 

(e) It facilitates the management in making of the long-term plans an assists in the formulation of general policy.

 

(f) It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation, insure and there fixed assets.

Methods Of Evaluating capital expenditure procedure

There are number of methods in use for evaluating a capital investment proposal. Different firms may use different methods for evaluating the project proposals.

Which method is appropriate for the particular purpose of the firm will depend upon the circumstances but one thing is very clear that management has to select the most profitable proposal out of the various proposals under consideration with the management. The most commonly used methods are given below:-

1. Degree of Urgency Method

2. Pay back Period Method

3. Unadjusted Rate of Return Method

4. Present Value Method

    (a) Time Adjusted Rate of Return Method

    (b) Net Present Value Method

Degree of Urgency Method

Virtually it is not a method of evaluation of a project. Sometimes, business operations are manged on an ad-hoc basis ad not as a part of well conceived plan.

Urgency plays an important role under this method. Some projects need immediate attention while others may be postponed for some time in order to avoid disruption in the working. The project that cannot be postponed are undertaken first. For example, if there is a break down production process due to loss of any component of the machinery which require immediate replacement in order to avoid disruption in production, shall be given firs priority over all other projects pending consideration with the management without any delay on the part of the management. In this way, urgency is the sole criterion for investing t funds in the project. It may, however, be possible that investment under this method is uneconomic.

Evaluation.

The method is very simple in principle as well as in practice. No technique is needed. Te project that seems urgent may be undertaken first. But the method is not a scientific method for evaluating the economic worth of t project. The main defects under this method may be enumerated as below:-

(1) Under this method, no methodical analysis is applied. The action may be correct but in most cases by coincidence. In case where projected outlay is large and far reaching g in effect, urgency cannot be a convincing influence.

(2) What is urgent and what is not is the sole decision of the top management. Each departmental incharge persuades the top management to assign first priority for the department project. The decisions are taken not on economic considerations but on the basis of 'power of persuasion' of the individual concern.

Pay - Back Method

This method is popularly known as pay-off, pay out or replacement period methods also. It is the most popular and widely recognised traditional method of evaluating capital projects.

It represents the number of years required to recover the original cash outlay invested in a project. It is based on the principle that every capital expenditure pays itself back over a number of years. It attempts to measure the period of time, it takes for the original cost of a project to be recovered from the additional earnings of the project. It means where the total earnings (or net cash inflow) from investment equals the total outlay, that period is the pay-back period. The standard recoupment period is fixed the management taking into account number of considerations. In making a comparison between two or more projects, the project having the lesser number of pay-back years within the standard recoupment limit will be accepted. Suppose, if an investment earns Rs. 5000 cash proceeds in each of the first two years of its use, the pay-back period will be two years.

For this purpose, net cash inflow shall be calculated first in the following manner:-

Cash inflow from sales revenue                        ..............................................

Less operating expenses including depreciation ............................................ 
                                                                         _____________________

        Net income (before tax)                         ...............................................

Less-Income tax                                            ...............................................

                                                                      _______________________

         Net income (after tax)                           ...............................................

Add depreciation                                           ...............................................

                                                                        ______________________

          Net cash inflows                                  ...............................................

                                                                       ______________________

Note:- As because depreciation does not affect the cash inflow, it shall not be taken into consideration in calculating net cash inflow. But it is an admissible deduction under income tax act. It has been deducted from the gross sale revenue and added in the Net-income (after tax).

Computation Of Pay- back method

If annual net cash-inflows are even or constant, the pay-back period can be computed dividing cash outlay original investment) by the annual cash-inflow.

It can be put as:-

                                               Original investment

Pay-back period         =     _____________________

                                              Annual Cash-inflow

If cash inflows are uneven, the calculation of pay-back period takes a cumulative form. In such case, the pay back period can be found out by adding up the figure of net cash inflows until the total is equal to the total outlay (or original investment).

Merits Of Pay- back method

The pay-back method is widely accepted method for .evaluating the various proposals.

The merits of this method are as follows:

 

(1) It is easy to calculate an simple to understand. It is an improvement over the criterion of urgency.

 

(2) It is preferred by executives who like snap answers for the selection of the proposal.

 

(3) It is useful where the firm is suffering from cash deficiency. The management may like to use pay-back method to emphasis those proposals which produce an early return of liquid funds. In other words, it stresses the liquidity objective.

 

(4) Industries which are subject to uncertainty, instability or rapid technological charges may adopt the pay-back method for a simple reason that the future uncertainty does not permit  projection of annual cash inflows beyond a limited period.  in this way, it reduces tehpossibility of loss through obsolescence.

 

(5) It is a handy device for evaluating investment proposals, where precision in estimates of profitability is not important.

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Limitations of Pay- back Method

The pay-back approach suffers from the following limitations.

(1) It completely ignores the annual cash inflows after the pay-back period.

 

(2) The method considers only the period of a pay back. It does not consider the pattern of cash inflows, i.e., the magnitude and timing of cash inflows. For example, if two projects involve equal cash outlay and yield equal cash inflows over equal time periods, it means both proposals are equally good. But the proposal with larger cash inflows in earlier years shall be preferred over the proposal which generated larger cash inflows in later years.

 

(3) It overlooks the cost of capital; i.e., interest factor which is a important consideration in making sound investment decisions.

 

(4) The methods is delicate and rigid. A slight change in operation cost will affect the cash inflows and as such pay-back period shall also be affected.

 

(5) It over-emphasises the importance of liquidity as a goal of capital expenditure decisions. The profitability of t project is completely ignored. Undermining the importune of profitability can in no way be justified.
 

Despite its weaknesses, the method is very popular in American and British industries for selecting investment proposals.

Unadjusted Rate of Return method

The method is also known as Accounting Rate of Return (ARR) Method because accounting information as revealed by the financial statement are used to measure the profitability of the investment proposals.

Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out.

 

The Accounting rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation.


                                                                      Average income

Accounting Rate of Return   (ARR) =       ______________
                                                                   Average investment

There are two variants of the accounting rate of return

(a) Original Investment Method, and

b) Average Investment Method.
 

(a) Original Investment Method.

Under this method average annual earnings or profits over the life of the project are divided by the total outlay of capital project, i.e., the original investment. Thus ARR under this method is the ratio between average annual profits and original investment established. We can express the ARR in the following way.


                       Average annual profits over the life of the project

ARR=          ____________________________________________

                                                  Original Investment

(b) Average Investment Method.

Under average investment method, average annual earnings are divided by the average amount of investment. Average investment is calculated, by dividing the original investment by two or by a figure representing the mid-point between the original outlay and the salvage of the investment. Generally accounting rate of return method is represented by the average investment method.

 

Rate of return.

Rate of Return, as the term is used in our foregoing discussion, may be calculated by taking

(a) income before taxes and depreciation,

(b) income before tax and after depreciation.

(c) income before depreciation an after tax, and

(d) income after tax an depreciation, as the numerator.

The use of different concepts of income or earnings as well as of investment is made. Original investment or average investment will give different measures of the accounting rate of return.

Methods of ARR

The following are the merits of the accounting rate of Return method.

(1) It is very simple to understand and use.

 

(2) Rate of return may readily be calculated with the help of accounting data.

 

(3) They system gives due weightage to the profitability of the project if based on average rate of Return. Projects having higher rat of Return will be accepted and are comparable with the returns on similar investment derived by other firm.

 

(4) It takes investments and the total earnings from the project during its life time.

Demerits of ARR

The method suffers from the following weaknesses

(1) It uses accounting profits and not the cash-inflows in appraising the projects.

(2) It ignores the time-value of money which is an important factor in capital expenditure decisions. Profits occurring in different periods are valued equally.

 

(3) It considers only the rat of return an not the length of project lives.

 

(4) The method ignores the fact that profits can be reinvested.

 

(5) The method does not determine the fair rate of return on investment. It is left at the discretion of the management. So, use of arbitrary rate of return cause serious distortion in the selection of capital projects.

 

(6) The method has different variants, each of which produces a different rate of return for one proposal due to the diverse version of the concepts of investment and earnings.
 

It is clear form the above discussion that the system is not much useful except in evaluating the long-term capital proposals.