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MEANING OF CAPITAL BUDGETING Meaning of Capital Budgeting Capital expenditure budget or capital budgeting is a process of making decisions regarding

investments in fixed assets which are not meant for sale such as land, building, machinery or furniture. The word investment refers to the expenditure which is required to be made in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm. What is capital expenditure, is a very difficult question to answer. The terms capital expenditure are associated with accounting. Normally capital expenditure is one which is intended to benefit future period i.e., in more than one year as opposed to revenue expenditure, the benefit of which is supposed to be exhausted within the year concerned.


Creative Search for Profitable Opportunities: The concept of the profit making idea must be embodied in the capital facility. Profitable opportunities for the companys invested capital must be turned up. A corporations future profitability and growth are linked to the soundness of its capital expenditure policy. Long-Range Capital Planning To provide consistent benchmarks for proposals originating in all parts of the organisation, it is necessary to have some kind of a plan sketched and for the future even though it is a tentative plan 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 companys credit demands for funds Measurement of Project Worth: In order to permit an objective of the projects, the productivity of the proposed outlay will have to be measured properly.

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 Control of authorized Outlays;

Control has to be exercised by the top management in order to ensure that the facility conforms to the specifications and that the outlay expenditure is incurred, it is most difficult to change the course of expenditure.

CAPITAL BUDGETING PROCESS Capital budgeting is process of selecting best long term investment project . Capital budgeting is long term planning for making and financing proposed capital out laying Steps for capital budgeting process 1. Identification involved in capital budgeting proposals 2. Screening the proposal 3. Evaluation of various proposals 4. Fixing the priorities 5. Final approval and planning the capital expenditure 6. Implementing the proposal 7. Performance review Identification of Potential Investment Opportunities: The capital budgeting process begins with the identification of potential investment opportunities. Usually, the planning body (it can be an individual or a committee, formal or informal) develops estimates for future sales which serve as the basis of setting production targets. This information, in turn, helps one to identify required investments in plant and equipment.

For imaginative identification of investment ideas, it is helpful to: (a) monitor external environment regularly to scout for investment opportunities; (b) formulate a well defined corporate strategy based on a thorough analysis of strengths, weakness, opportunities, and threats; (c) share corporate strategy and perspectives with persons who are involved in the process of capital budgeting, and (d) motivate employees to make suggestion.

Assembling of investment Proposals: Investment proposals identified by the production department and other departments are usually submitted on a standardized capital investment proposal form. Generally, most of the proposals are routed through several persons before the reach the capital budgeting committee or some other body which assembles them. The purpose of this is primarily to ensure that the proposal is viewed from different angles. It also helps in creating a climate for the coordination of interrelated activities.

Investment proposals are usually classified into various categories for facilitating decision making budgeting and control. An illustrative classification is given below: Replacement investments Expansion investments New product investments Obligatory and welfare investments.

Decision Making: A system of rupee gateway usually characteristics the capital investment decision making in practice. Under this system, executives are vested with the power to okay investment proposals up to certain limits. For example, in one company the plant superintendent can okay investment outlay up to Rs 100,000 the works manager up to Rs 500,000 and the managing director up to Rs 2,000,000. Investments requiring higher outlays need the approval of the board of directors.

Preparation of capital Budget and Appropriations: Projects involving smaller outlays and those can be decided by executives at lower levels are often covered by a blanket appropriation for expeditious action. Projects which need larger outlays

are included in the capital budget after necessary approvals. Before undertaking such projects, an appropriate order is usually required. The purpose of this check is mainly to ensure that the funds position of the firm is satisfactory at the time of implementation of the project. Further it provides an opportunity to review the project before implementation. Implementation: Translating an investment proposal into a concrete project is a complex, risky and time consuming task. Delays in implementation, which are common, may lead to substantial cost overruns. For expeditious implementation at reasonable cost, the following are helpful.

1. Adequate formulation of projects: the major reason for delay is inadequate formulation of projects. In other words, if necessary homework in terms of preliminary studies and comprehensive detailed formulation of the project has not been done, many surprises and shocks are likely to spring on the way. Hence, the need for adequate formulation of the project cannot be over emphasized. 2. Use of the principle of responsibility accounting: Assigning specific responsibilities to project managers for completing the project within the defined time frame and cost limits is helpful for expeditious execution and cost control. 3. Use of network techniques: For project planning and control several network techniques such as PERT (Program Evaluation Review Techniques) and CPM (Critical Path Method ) are available. With the help of these techniques monitoring of a project becomes easier.


Screening Decisions and Preference Decisions: Define, explain and give examples of screening and preference decisions. Capital budgeting decisions fall into two broad categories: 1. 2. Screening decisions. Preference decisions.

Screening Decisions - Definition and Explanation: Screening decisions relate to whether a proposed project meets some preset standard of acceptance. For example, a firm may have a policy of accepting projects only if they promise a retune of, say, 20% on the investment. The required rate of return is the minimum rate of return a project must yield to be acceptable. Preference Decisions - Definition and Explanation: Preference decisions relate to selecting from among several competing courses of action. To illustrate, a firm may be considering several different machines to replace an existing machine on the assembly line. The choice of which machine to purchase is a preference decisions.

TYPES OF CAPITAL BUDGETING DECISIONS Types of Capital Budgeting Decisions Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new Investment proposals. Basically, the firm may be confronted with three types of capital budgeting decisions: . 1. 2. 3. Accept-Reject Decision. Mutually Exclusive Project Decision Capital Rationing Decision .


Accept-Reject Decision This is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it; if the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. By applying this criterion, all independent projects are accepted. Independent projects are the projects that do not compete with one another in such a way that the acceptance of one precludes the possibility of acceptance of another. Under the accept-reject decision, all independent projects that satisfy the minimum investment criterion should be implemented.


Mutually Exclusive Project Decision Mutually Exclusive Projects are those which compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are

mutually exclusive and only one may be chosen. Suppose a company is intending to buy a new folding machine. There are three competing brands, each with a different initial investment and operating costs. The three machines represent mutually exclusive alternatives, as only one of these can be selected. Moreover, the mutually exclusive project decisions are not independent of the accept-reject decisions. The project should also be acceptable under the latter decision. Thus, mutually exclusive projects acquire significance when more than one proposal is acceptable under the accept-reject decision.


Capital Rationing Decision In a situation where the firm has unlimited funds, all independent investment proposals yielding returns greater than some pre-determined level are accepted. However, this situation does not prevail in most of the business forms in actual practice. They have a fixed capital budget. A large number of investment proposals compete for these limited funds. The firm must, therefore, ration them. The firm allocates funds to projects in a manner that it maximizes long-run returns. Thus, capital rationing refers to a situation in which a firm has more acceptable investments than it can finance. It is concerned with the selection of a group of Investment proposals out of many investment proposals acceptable under the accept-reject decision. Capital rationing employs ranking of acceptable Investment projects. These projects can be ranked on the basis of a pre-determined criterion such as the rate of return. The projects are ranked in descending order of the rate of return.

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.


Fixed Asset usually have a relatively High cost.


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.


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.


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.


Asset expansion is related to future sales.


The availability of capital assets has to be phased properly.


Asset expansion typically involves the allocation of substantial amounts of funds.


Many firms fail because they have too much or too little capital equipment.


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.


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 companys 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.

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 prerationing 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 firms 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 firms 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 owners 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:


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 w ell 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.


Macro-Economic Inter-dependence: It refers to the interaction of cyclical and seasonal effects on products and markets.


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.


The capital market is the market for securities, where Companies and governments can raise long-term funds. It is a market in which money is lent for periods longer than a year. A nation's capital market includes such financial institutions as banks, insurance companies, and stock exchanges that channel long-term investment funds to commercial and industrial borrowers. Unlike the money market, on which lending is ordinarily short term, the capital market typically finances fixed investments like those in buildings and machinery.

Nature and Constituents: The capital market consists of number of individuals and institutions (including the government) that canalize the supply and demand for longterm capital and claims on capital. The stock exchange, commercial banks, co-operative banks, saving banks, development banks, insurance companies, investment trust or companies, etc., are important constituents of the capital markets. The capital market has three important Components, namely the suppliers of loanable funds, the borrowers and the Intermediaries who deal with the leaders on the one hand and the Borrowers on the other.

Indian Financial Market consists of the following markets: Capital Market/ Securities Market o Primary capital market o Secondary capital market Debt Market Primary capital market- A market where new securities are bought and sold for the first time

Types of issues in Primary market Initial public offer (IPO) (in case of an unlisted company), Follow-on public offer (FPO), Rights offer such that securities are offered to existing shareholders, Preferential issue/ bonus issue/ QIB placement Composite issue, that is, mixture of a rights and public offer, or offer for sale (offer of securities by existing shareholders to the public for subscription).

Secondary Market: In the secondary market the investors buy / sell securities through stock exchanges. Trading of securities on stock exchange results in exchange of money and securities between the investors. Secondary market provides liquidity to the securities on the exchange(s) and this activity commences subsequent to the original issue. For example, having subscribed to the securities of a company, if one wishes to sell the same, it can be done through the secondary market. Similarly one can also buy the securities of a company from the secondary market. A stock exchange is the single most important institution in the secondary market for providing a platform to the investors for buying and selling of securities through its members. In other words, the stock exchange is the place where already issued securities of

companies are bought and sold by investors. Thus, secondary market activity is different from the primary market in which the issuers issue securities directly to the investors. Traditionally, a stock exchange has been an association of its members or stock brokers, formed for the purpose of facilitating the buying and selling of securities by the public and institutions at large and regulating its day to day operations. Of late however, stock exchanges in India now operate with due recognition from Securities and Exchange Board of India (SEBI) / the Government of India under the Securities Contracts (Regulation) Act, 1956. The stock exchanges are either association of persons or are formed as companies. There are 24 recognized stock exchanges in India out of which one has not commenced its operations. Out of the 23 remaining stock exchanges, currently only on four stock exchanges, the trading volumes are recorded. Most of regional stock exchanges have formed subsidiary companies and obtained membership of Bombay Stock Exchange, (BSE) or National Stock Exchange (NSE) or both. Members of these stock exchanges are now working as sub-brokers of BSE / NSE brokers. Securities listed on the stock exchange(s) have the following advantages: The stock exchange(s) provides a fair market place. It enhances liquidity. Their price is determined fairly. There is continuous reporting of their prices. Full information is available on the companies. Rights of investors are protected.

Settlement cycles: Settlement is the process whereby the trader who has made purchases of scrip makes payment and the seller selling the scrip delivers the securities. This settlement process is carried out by Clearing Houses for the stock exchanges. The Clearing House acts like an intermediary in every transaction and acts as a seller to all buyers and buyer to all sellers.

Significance of Capital Markets A well functioning stock market may help the development process in an economy through the following channels: 1. Growth of savings, 2. Efficient allocation of investment resources, 3. Better utilization of the existing resources. In market economy like India, financial market institutions provide the avenue by which long-term savings are mobilized and channelled into investments. Confidence of the investors in the market is imperative for the growth and development of the market. For any stock market, the market Indices is the barometer of its performance and reflects the

prevailing sentiments of the entire economy. Stock index is created to provide investors with the information regarding the average share price in the stock market. The ups and downs in the index represent the movement of the equity market. These indices need to represent the return obtained by typical portfolios in the country. Generally, the stock price of any company is vulnerable to three types of news: Company specific Industry specific Economy specific An all share index includes stocks from all the sectors of the economy and thus cancels out the stock and sector specific news and events that affect stock prices, (law of portfolio diversification) and reflect the overall performance of the company/equity market and the news affecting it. The most important use of an equity market index is as a benchmark for a portfolio of stocks. All diversified portfolios, belonging either to retail investors or mutual funds, use the common stock index as a yardstick for their returns. Indices are useful in modern financial application of derivatives. Capital Market Instruments some of the capital market instruments are: Equity Preference shares Debenture/ Bonds ADRs/ GDRs Derivatives

Shares The total capital of a company may be divided into small units called shares. For example, if the required capital of a company is US $5,00,000 and is

divided into 50,000 units of US $10 each, each unit is called a share of face value US $10. A share may be of any face value depending upon the capital required and the number of shares into which it is divided. The holders of the shares are called share holders. The shares can be purchased or sold only in integral multiples. Equity shares signify ownership in a corporation and represent claim over the financial assets and earnings of the corporation. Shareholders enjoy voting rights and the right to receive dividends; however in case of liquidation they will receive residuals, after all the creditors of the company are settled in full. A company may invite investors to subscribe for the shares by the way of: Public issue through prospectus Tender/ book building process Offer for sale Placement method Rights issue

Stocks The word stock refers to the old English law tradition where a share in the capital of the company was not divided into shares of fixed denomination but was issued as one chunk. This concept is no more prevalent, but the word stock continues. The word joint stock companies also refers to this tradition. Debentures/ Bonds The term Debenture is derived from the Latin word debere which means to owe a debt. A debenture is an acknowledgment of debt, taken either from the

public or a particular source. A debenture may be viewed as a loan, represented as marketable security. The word bond may be used interchangeably with debentures. Debt instruments with maturity more than 5 years are called bonds Yields Most common method of calculating the yields on debt instrument is the yield to maturity method, the formula is as under: YTM = coupon rate + prorated discount / (face value + purchase price)/2 Preference shares Preference shares are different from ordinary equity shares. Preference share holders have the following preferential rights (i) The right to get a fixed rate of dividend before the payment of dividend to the equity holders. (ii) The right to get back their capital before the equity holders in case of winding up of the company. IPO Conditions for IPO: (all conditions listed below to be satisfied) Net tangible assets of 3 crore in each of the preceding 3 full years, of which not more than 50% are held in monetary assets: Track record of distributable profits for 3 out of the immediately preceding 5 years: Net worth of 1 crore in each of the preceding three full years; Issue size of proposed issue + all previous issues made in the same financial year does not exceed 5 times its pre-issue net worth as per the audited balance sheet of the preceding financial year; In case of change of name within the last one year, 50% of the revenue for the preceding 1 full year earned by it from the activity indicated by the new name.

Derivatives A derivative picks a risk or volatility in a financial asset, transaction, market rate, or contingency, and creates a product the value of which will change as per changes in the underlying risk or volatility. The idea is that someone may either try to safeguard against such risk (hedging), or someone may take the risk, or may engage in a trade on the derivative, based on the view that they want to execute. The risk that a derivative intends to trade is called underlying. A derivative is a financial instrument, whose value depends on the values of basic underlying variable. In the sense, derivatives is a financial instrument that offers return based on the return of some other underlying asset, i.e the return is derived from another instrument. The best way will be take examples of uncertainties and the derivatives that can be structured around the same. Stock prices are uncertain - Lot of forwards, options or futures contracts are based on movements in prices of individual stocks or groups of stocks. Prices of commodities are uncertain - There are forwards, futures and options on commodities. Interest rates are uncertain - There are interest rate swaps and futures. Foreign exchange rates are uncertain - There are exchange rate derivatives. Weather is uncertain - There are weather derivatives, and so on.

DERIVATIVES PRODUCTS Some significant derivatives that are of interest to us are depicted in the accompanying graph: Major types of derivatives

FUTURES, FORWARDS AND OPTIONS An option is different from futures in several ways. At practical level, the option buyer faces an interesting situation. He pays for the options in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him. This is different from futures, where one is free to enter, but can generate huge losses. This characteristic makes options attractive to many market participants who trade occasionally, who cannot put in the time to closely monitor their futures position. Buying put options is like buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full amount to which Nifty drops below the strike price of the put option. This is attractive to traders, and to mutual funds creating guaranteed return products.

FORWARDS A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for

the same price, other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchange.

FUTURES Futures contract is a standardized transaction taking place on the futures exchange. Futures market was designed to solve the problems that exist in forward market. A futures contract is an agreement between two parties, to buy or sell an asset at a certain time in the future at a certain price, but unlike forward contracts, the futures contracts are standardized and exchange traded To facilitate liquidity in the futures contracts, the exchange specifies certain standard quantity and quality of the underlying instrument that can be delivered, and a standard time for such a settlement. Futures exchange has a division or subsidiary called a clearing house that performs the specific responsibilities of paying and collecting daily gains and losses as well as guaranteeing performance of one party to other. A futures' contract can be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and month of delivery The units of price quotation and minimum price change