(LEARNING ( OBJECTIVES | — 7.1 Introduction to Capital Budgeting Capital Budgeting 7 i 7.2 Relevance of Capital Budgeting Decisions 7.3 Process of Capital Budgeting 7.4 Problems in Capital Budgeting 75 Kinds of Capital Budgeting Decisions 7.6 Capital Budgeting Decisions — Assumptions 7.7 Principles of Capital Budgeting 7.8 Accounting Profit and Cash Flow Analysis 7.9 Patter of Cash Flows 7.10 Incremental Cash Flows 7.41. Techniques — Traditional and Modern/Discounting Techniques 7.12 Techniques of Evaluation 7.13 Traditional Techniques 7.44. Discount Cash Flow Techniques 7.4 INTRODUCTION TO CAPITAL BUDGETING Capital budgeting techniques are used in financial management for planning long-term funds. Since these funds are high in volume, they have long-term implications. They also affect the profitability of the company/firm. Capital bud; plant and machine ting decisions pertain tothe purchase of assets lke Tand, building, and development programmes of a product, Such decisions 3 also taken at the time of diversification or expansion of product line or introduction of new products Research and development, and promotional expenses form part of long-term decision-making process Capital budgeting is a process, which is a continuous activity in an organization Work within the firm is dynamic in nature and may require expansion. diversification or replacement of assets.Fundamentals of Financial Managemen, al costs. Machine ‘A’ is manufactured in Germany st equa company evaluates two proposals: of eq! ai ae costs and similar featu and machine *B’ is manufactured in Korea. Having similar costs features, th which is better suited to its environment in India. If \; Indian company will have to decide ~ machine “B* will be rejected ant or Contingent decisions mean that to fit a requirement of company, there has to be a change in installation of other machines to fit with the new machine If a project begins for e.g., shoe project with showroom, leather treatment, uppers ctc., all of it is treated like one investment. Thus the new shoe project cannot begin working unless other decides on machine ‘/ (c) Contingent Decisions: Depend conditions are also fulfilled. 1 Rationing Decisions: When a firm has a very large 1 amount of funds at its disposal, then may either take up one project at a time or it may decide to do all the projects together. But it has to extend the budget in such a manner that itis able to cover the minimum costs of all the projects that it wants to cover. In no case can it exceed its budget, Such decisions are called “capital rationing’. Capital budgeting decisions are assumed to be taken by firms, which do not have the pressure of capital rationing. Projects are selected and when they are completed, new projects are undertaken with enough resources to work to investment and it has a limited make the projects successful. 7.6 CAPITAL BUDGETING DECISIONS - ASSUMPTIONS Capital budgeting decisions have implications over a long-term period of time. In order to analyse projects, which constitute capital proposal some assumptions, have to be taken. These are as follows: (i) Profit Motive: Capital budgeting decisions assume that the motive for making a large investment is enhancing the profitability of the firm/company. ') Costs and Benefits: It is assumed that while evaluating projects, the estimation of costs and benefits can be done for the complete period of the project. Capital budgeting decisions involve huge outlay of funds and cover more than one year. It may extend to period of 5 years. 10 years, 15 years or even 20 years. The assumption is that there is an accurate estimation of future costs and benefits for the entire life of the project. (iii) Availability of Capital: One important assumption is that capital is sufficient and does not need to be rationed for other uses. Projects are selected according to need and usefulness and that the decision is made with the view that the capital can be arranged and used when the project demands it in the course of its operations. Capital budgeting decisions can be put into action after certain important principles of decision making are considered. The three important decision-making aspects are considered. These are (a) estimating costs and benefits of a proposal, (b) finding the required rate of return, and (0) selecting the technique. These principles are discussed separately in the next section.geting Pl jon of the Market Share: tn this case ea @ jj find out the future costs and benetigg qr Pial budgeting de wien the benefits exceeds the costs, The ying PUTAS OF new leo ‘0 be analysed cine. Y OF the asset should be i be made only siacing and Modernizing Plant ang ial at ren the asset has completed its lifetime achinery: A in efficiency. Dring about red iversifying into New Prod a (o Diversify 7 ; 7 ets: Capital budgeting decisi intention of increasing the revenue of the company. It ig imme Ne "© be taken with the Wis impor: 4 cor tolook into the usefulness of the product. Time value of mono ake €aSh flow analysis inestablishing the need for diversification and ca sea an incremental analysis help * Pital budgeting d riekinds of capital budgeting decisions to be taken in the case of tlyon alias say be summarized as: 4 new firm and an existing firm * Capital budgeting decision for acquisition of new assets in a new fim. + Decision to purchase new asset in an existing firm for expansion, + Decision to purchase new asset for replacement and modernization, + Decision to purchase new ‘et for diversification to increase revenue of the firm, (i Capital Budgeting Decisions in Different Situations Gyptal budgeting decisions are classified on the basis of whether it is a new firm or an existing fim. It takes decisions from the point of view of different situations like taking a decision on a single independent proposal, mutually exclusive project, contingent decision and capital rationing projects. (@) Single Independent Proposal: Each project should be evaluated on its own merit when there are single independent proposals. This means that the proposal has to be of some merit to be accepted or else it should be rejected. This is called accept-reject decision. Such projects are analysed and evaluated by taking into consideration their costs and benefits by making ess flows, using time value techniques and also applying capital bu Se et bin Projects do not affect any other proposals. Many proposals may be eval ed without their own competitive strength to find out their usefulness for the company ole ee ©) Mutually Exclusive: If one investment is undertaken. it 1 aki i have to be rejected as they are all of the same type. The — San panos eae of ‘wo proposals are equally competitive and useful for the soos the company should be able them is selected. This means that when there are two alterna Saha the ‘select only one and reject the other. For example, on€ ™ achine has to be purchase eelFundamentals of Financial Managemen, 7.4 PROBLEMS IN capt Capital budgeting decisions Kinds of problems. They are to the following reasons One of the The outflow of cas! ITAL BUDGETING sons are confronted with differen, jronmental factors. The problem, ‘These det complex in nature, J external env! internal and are affected by arise du Long-term Implications: of outflows and inflows of cash. incurred in the beginning of the proses funds is in the future period. The problem that project. The longer the time period, the grea cash inflows and cash outflows, the major problems if capital budgeting relates to Comparison Jy is immediate as the cost of the project i, Fut the inflow begins in the FUNaTe “The recovery of the arises is to compare the Cost and benefits of the em of comparison. In order to ter is the proble' ‘ime value of money is used to Make compare the adjustments (ii) Risk and Uncertainty: In the proc and coordinated. There is also a rev' programme evaluation technique t0 measure time period involved in the project is long guarantee of returns due to change in demand, «¢ of capital budgeting, @ project 1S analysed, evaluated *y and feedback of the project. There 18 cost control and the performance of the project. However, the and the decisions cannot undertake complete ature competition, political changes, tax laws and legal procedures. (iii) Measurement: The measurement of capital budgeting decisions is extremely difficult in quantitative terms. The assessment of costs and benefits are difficult as the incidences of cash ows are at different timings. Sometimes there may be an counting profit and a cash flow ‘Accounting profits consider non-cash items Tike depreciation ut cash flow do not consider such items. In such matters, measurement in quantitative terms 1S very difficult. 7.5 KINDS OF CAPITAL BUDGETING DECISIONS Capital budgeting decisions have to be taken by identifying certain background features. The deeisions depend on the (i) Type of firm/company for which decisions have to be taken and for i) different situations. These are classified as follows: (i) Type of Firm/Company Capital budgeting decisions depend on the nature of a firm. A firm may be a new firm or an existing firm. New Firm: ‘A new firm would be interested in purchasing new assets for the use of the compan When it is at the start-up stage, there would be a large requirement for the purchase of new equipment and begin new projects. ‘The financial manager will have to analyse and evaluate the requirement ot purchases for long-term use. He must use capital budgeting techniques for taking the right decision Existing Firm: When it is an existing company i . i pany it would require capi “etine decisions i three different situations: quire capital budgeting decisionwe udgeting a 4 process OF CAPITAL BUDGETING ay , ting decisions should be ta - . budgeti ‘ould be taken by formulating g aysing and evaluating the projects. The Process wil id potential losses and to ¢: oe 4M good revenue, 1; Identification of Investment Opportunities: ent opportunities and prepare a document by formula ibe investment proposal. He should try to a. ASSESS the costs the political, social and cultural factors that will attest g iylground of the project. This is the introductory phase aoa esures on the project. A financial manager should identify the advantages and disadvantages ‘and benefits of the project. He may the project. He must be aware of the hhe must ensure all the environmental ep 2: Coordinating Investment Proposals: The financial manager must take th ‘ifferent departments in the company about Project proposals. He should form iia "s die whether the proposal willbe useful forthe company’s requirements atthe tans me ould be classified to find out whether the investment asset, (1 ed : will be (i) to purchase a new asset, (ii) to alae an asset (if) to expand an existing investment, and (iv) to find out ifthe investment is for oviding social welfare Sep 3: Analysis of Investment Proposals: Proposals are analysed by estimating the (i) capital ‘mount or cost of the investment, (ii) estimation of future cash inflows, (iii) applying capital budgeting techniques like average rate of return, payback, such as and discounted cash flow techniques like ™{ present values, profitability index and internal rate of return to judge the applicability of the vestment to the needs of the firm. . Sp 4: Preparing a Capital Budget Programme: The financial manager has to take a decision ‘the right project through the application of the techniques. When a decision is taken the financial Bnwzer has to prepare the methodology of conducting the programme. He has to devide onthe nt timing of beginning a project, continuing it and monitoring the amount spent on investment. I: The project has to be implemented in an 4 financial manager has to provide guidelines agement, cost limits and cost control Delays “installing evaluation review techniques. Sep 5: Implementation of the Investment Propos ent manner, To bring about efficiency in a project. the different departments emphasizing on time mana about losses, The project has to be controlled by ‘ isly compare 8ep6: Review d Feedback of Performance: The financial manager has toca ycomp i S and Feedback ot : Jl be useful in providing a revie\ “tual performance with the projected performance. This vill be wi ne pr st change the Performance. If he is not satisfied with the performance, the Financ Ot Which the ementing the ct yy problems and menting the project many Pro! in whi ork is bei While implementing ! ‘iq Hf k is being done. i f th Nr e discus: les may arise. Some of these problems are di sed in the next section.SEENON, NUIT Fundamentals of Financial Managemen, 8 Capital budgeting can thus we defined as an important decision to invest in long-term assets with view to get the benefit of cash inflows over many years. The Jong-term Eset are usually those assets, which would affect a firms operation that extend beyond a one-year period. The focus of capital budgeting decisions is on acquisition, modernization, expansion and eplacement of assets ‘These decisions have a direct impact on the value of the firm and in maximizing the wealth of the shareholders. If the investments are profitable, it will add value to the firm. If cash inflows are higher than the opportunity cost of capital, it will provide an increase (0 the wealth of the shareholder “The financial manager is expected to analyse each proposal and after evaluating alterna he should select that proposal which contributes to enhancin; long-term period of time. Ve proposal, 2 the wealth of the shareholders over a 7.2 RELEVANCE OF CAPITAL BUDGETING DECISIONS Capital budgeting decisions are significant because of the involvement of a huge reservoir funds that have implications on the growth of a company. A decision, which brings about positive cash inflows, will help to maximize the wealth of the shareholders. If the cash inflows are negative, it means that the decision is incorrect. This will affect the firm’s value and its reputation will fall. The following reasons show how capital budgeting decisions will affect the firm: ( High Commitment of Funds: In capital budgeting decisions the commitment of funds is very high, The long-term nature of commitment of funds makes the investment risky. A company expects a good return but it has to be careful ofthe risk associated with the return, The company can have high capital gains as well as high capital losses. The presence of large volume of funds for making investments makes capital budgeting decisions very significant. (ii) Long-term Decisions: Capital budgeting decisions extend for long periods. They make a assessment of future requirement of a firm. Since the decisions influence a period of more than one year, the decisions are very complex in nature. The decisions to invest funds covet internal risks as well as external risks caused by uncontrollable factors like market risks economic risks and political risks. (iii) Irreversible Decisions: Capital budgeting decisions cannot be reversed because a huge out of funds is invested. It is not possible to abandon the project once the funds have been invested in it. If the company plans to scrap the assets without using them, the loss will be very high Capital budgeting decisions should be taken only after a careful analysis of the project: ™ projects should be such that it will help in expanding revenues of a company or Fes its costs. Capital budgeting decisions should follow a certain process for taking wise decisions: ™ process can be analysed in six different steps. These are discussed in the next section.