Capital Budgeting

A Report On

Capital Budgeting
Submitted By, Mr. Ganesh V. a!ar MBA" art"# "$%&$, Roll 'o()*, Seat no( +)$ Submitted to( Mr. A G. Surya!anshi
MBA ,nit, Shi-a.i ,ni-ersity,/olhapur

1 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

Meaning o0 Capital Budgeting

Capital e1penditure budget or 2apital budgeting is a pro2ess o0 ma3ing de2isions regarding in-estments in 0i1ed assets !hi2h are not meant 0or sale su2h as land, building, ma2hinery or 0urniture. $he %ord invest&ent re'ers to the e(penditure %hi)h is re*uired to +e &ade in )onne)tion %ith the a)*uisition and the develop&ent o' long,ter& 'a)ilities in)luding 'i(ed assets. It re'ers to pro)ess +y %hi)h &anage&ent sele)ts those invest&ent proposals %hi)h are %orth%hile 'or investing availa+le 'unds. -or this purpose, &anage&ent is to de)ide %hether or not to a)*uire, or add to or repla)e 'i(ed assets in the light o' overall o+je)tives o' the 'ir&. .hat is )apital e(penditure, is a very di''i)ult *uestion to ans%er. $he ter&s )apital e(penditure are asso)iated %ith a))ounting. /or&ally )apital e(penditure is one %hi)h is intended to +ene'it 'uture period i.e., in &ore than one year as opposed to revenue e(penditure, the +ene'it o' %hi)h is supposed to +e e(hausted %ithin the year )on)erned.

Procedure of Capital Budgeting

4&5 Organisation o0 #n-estment roposal. $he 'irst step in )apital +udgeting pro)ess is the )on)eption o' a pro'it &a0ing idea. $he proposals &ay )o&e 'ro& ran0 and 'ile %or0er o' any depart&ent or 'ro& any line o''i)er. $he depart&ent head )olle)ts all the invest&ent proposals and revie%s the& in the light o' 'inan)ial and ris0 poli)ies o' the organisation in order to send the& to the )apital e(penditure planning )o&&ittee 'or )onsideration. 4$5 S2reening the roposals. In large organisations, a )apital e(penditure planning )o&&ittee is esta+lished 'or the s)reening o' various proposals re)eived +y it 'ro& the heads o' various depart&ents and the line o''i)ers o' the )o&pany. $he )o&&ittee s)reens the various proposals %ithin the long,range poli)y,'ra&e %or0 o' the organisation. It is to +e as)ertained +y the )o&&ittee %hether the proposals are %ithin the sele)tion )riterion o' the 'ir&, or they do no lead to depart&ent i&+alan)es or they are pro'ita+le. 465 7-aluation o0 ro.e2ts. $he ne(t step in )apital +udgeting pro)ess is to evaluate the di''erent proposals in ter& o' the )ost o' )apital, the e(pe)ted returns 'ro& alternative invest&ent opportunities and the li'e o' the assets %ith any o' the 'ollo%ing evaluation te)hni*ues1,

2 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

4a5 2egree o' Urgen)y Method 4b5 Pay,+a)0 Method 425 3eturn on invest&ent Method 4d5 2is)ounted Cash -lo% Method. 4)5 7stablishing riorities. A'ter proper s)reening o' the proposals, une)ono&i) or unpro'ita+le proposals are dropped. $he pro'ita+le proje)ts or in other %ords a))epted proje)ts are then put in priority. It 'a)ilitates their a)*uisition or )onstru)tion a))ording to the sour)es availa+le and avoids unne)essary and )ostly delays and serious )ot,overruns. 4enerally, priority is 'i(ed in the 'ollo%ing order. 4a5 Current and in)o&plete proje)ts are given 'irst priority. 4b5 Sa'ety proje)ts ad proje)ts ne)essary to )arry on the legislative re*uire&ents. 425 Proje)ts o' &aintaining the present e''i)ien)y o' the 'ir&. 4d5 Proje)ts 'or supple&enting the in)o&e 4e5 Proje)ts 'or the e(pansion o' ne% produ)t. 4+5 8inal Appro-al. Proposals 'inally re)o&&ended +y the )o&&ittee are sent to the top &anage&ent along %ith the detailed report, +oth o the )apital e(penditure and o' sour)es o' 'unds to &eet the&. $he &anage&ent a''ir&s its 'inal seal to proposals ta0ing in vie% the urgen)y, pro'ita+ility o' the proje)ts and the availa+le 'inan)ial resour)es. Proje)ts are then sent to the +udget )o&&ittee 'or in)orporating the& in the )apital +udget. 495 7-aluation. 5ast +ut not the least i&portant step in the )apital +udgeting pro)ess is an evaluation o' the progra&&e a'ter it has +een 'ully i&ple&ented. Budget proposals and the net invest&ent in the proje)ts are )o&pared periodi)ally and on the +asis o' su)h evaluation, the +udget 'igures &ay +e revie%er and presented in a &ore realisti) %ay.

3 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

ay"Ba23 Method
#t represents the number o0 years re:uired to re2o-er the original 2ash outlay in-ested in a pro.e2t. It is +ased on the prin)iple that every )apital e(penditure pays itsel' +a)0 over a nu&+er o' years. It atte&pts to &easure the period o' ti&e, it ta0es 'or the original )ost o' a proje)t to +e re)overed 'ro& the additional earnings o' the proje)t. It &eans %here the total earnings (or net )ash in'lo%) 'ro& invest&ent e*uals the total outlay, that period is the pay,+a)0 period. $he standard re)oup&ent period is 'i(ed the &anage&ent ta0ing into a))ount nu&+er o' )onsiderations. In &a0ing a )o&parison +et%een t%o or &ore proje)ts, the proje)t having the lesser nu&+er o' pay,+a)0 years %ithin the standard re)oup&ent li&it %ill +e a))epted. Suppose, i' an invest&ent earns 3s. 6!!! )ash pro)eeds in ea)h o' the 'irst t%o years o' its use, the pay, +a)0 period %ill +e t%o years. -or this purpose, net )ash in'lo% shall +e )al)ulated 'irst in the 'ollo%ing &anner1, Cash in'lo% 'ro& sales revenue .............................................. 5ess operating e(penses in)luding depre)iation ............................................ 777777777777777777777

/et in)o&e (+e'ore ta() 5ess,In)o&e ta( /et in)o&e (a'ter ta() Add depre)iation /et )ash in'lo%s

............................................... ............................................... 77777777777777777777777 ............................................... ............................................... 7777777777777777777777 ............................................... 7777777777777777777777

/ote1, As +e)ause depre)iation does not a''e)t the )ash in'lo%, it shall not +e ta0en into )onsideration in )al)ulating net )ash in'lo%. But it is an ad&issi+le dedu)tion under in)o&e ta( a)t. It has +een dedu)ted 'ro& the gross sale revenue and added in the /et,in)o&e (a'ter ta().

Computation o0 ay"ba23 Method

4 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

I' annual net )ash,in'lo%s are even or )onstant, the pay,+a)0 period )an +e )o&puted dividing )ash outlay original invest&ent) +y the annual )ash,in'lo%. It )an +e put as1, Original in-estment ay"ba23 period ; <<<<<<<<<<<<<<<<<<<<<

Annual Cash"in0lo! I' )ash in'lo%s are uneven, the )al)ulation o' pay,+a)0 period ta0es a )u&ulative 'or&. In su)h )ase, the pay +a)0 period )an +e 'ound out +y adding up the 'igure o' net )ash in'lo%s until the total is e*ual to the total outlay (or original invest&ent).

Merits o0 ay"ba23 Method

$he pay,+a)0 &ethod is %idely a))epted &ethod 'or .evaluating the various proposals. 4&5 It is easy to )al)ulate an si&ple to understand. It is an i&prove&ent over the )riterion o' urgen)y. 4$5 It is pre'erred +y e(e)utives %ho li0e snap ans%ers 'or the sele)tion o' the proposal. 465 It is use'ul %here the 'ir& is su''ering 'ro& )ash de'i)ien)y. $he &anage&ent &ay li0e to use pay,+a)0 &ethod to e&phasis those proposals %hi)h produ)e an early return o' li*uid 'unds. In other %ords, it stresses the li*uidity o+je)tive. 4)5 Industries %hi)h are su+je)t to un)ertainty, insta+ility or rapid te)hnologi)al )harges &ay adopt the pay,+a)0 &ethod 'or a si&ple reason that the 'uture un)ertainty does not per&it proje)tion o' annual )ash in'lo%s +eyond a li&ited period. in this %ay, it redu)es teh possi+ility o' loss through o+soles)en)e. 4+5 It is a handy devi)e 'or evaluating invest&ent proposals, %here pre)ision in esti&ates o' pro'ita+ility is not i&portant.

A22ounting Rate o0 Return

$he &ethod is also 0no%n as Unadjusted 3ate o' 3eturn Method .
5 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

$he A))ounting rate o' 3eturn is 'ound out +y dividing the average in)o&e a'ter ta(ed +y the average invest&ent, i.e., average net value a'ter depre)iation. $he a))ounting rate o' return, thus, is an average rate and )an +e deter&ined +y the 'ollo%ing e*uation. A-erage in2ome <<<<<<<<<<<<<< A-erage in-estment

A22ounting Rate o0 Return 4ARR5 ;

$here are t%o variants o' the a))ounting rate o' return (a) 8riginal Invest&ent Method, and 9+) Average Invest&ent Method. 4a5 Original #n-estment Method. Under this &ethod average annual earnings or pro'its over the li'e o' the proje)t are divided +y the total outlay o' )apital proje)t, i.e., the original invest&ent. $hus A33 under this &ethod is the ratio +et%een average annual pro'its and original invest&ent esta+lished. .e )an e(press the A33 in the 'ollo%ing %ay. A-erage annual pro0its o-er the li0e o0 the pro.e2t <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< Original #n-estment

ARR;

4b5 A-erage #n-estment Method. Under average invest&ent &ethod, average annual earnings are divided +y the average a&ount o' invest&ent. Average invest&ent is )al)ulated, +y dividing the original invest&ent +y t%o or +y a 'igure representing the &id,point +et%een the original outlay and the salvage o' the invest&ent. 4enerally a))ounting rate o' return &ethod is represented +y the average invest&ent &ethod. Rate o0 return. 3ate o' 3eturn, as the ter& is used in our 'oregoing dis)ussion, &ay +e )al)ulated +y ta0ing (a) in)o&e +e'ore ta(es and depre)iation, (+) in)o&e +e'ore ta( and a'ter depre)iation. ()) in)o&e +e'ore depre)iation an a'ter ta(, and (d) in)o&e a'ter ta( an depre)iation, as the nu&erator. $he use o' di''erent )on)epts o' in)o&e or earnings as %ell as o' invest&ent is &ade. 8riginal invest&ent or average invest&ent %ill give di''erent &easures o' the a))ounting rate o' return.

Merits o0 A22ounting Rate o0 Return Method

&5 It is very si&ple to understand and use.

6 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

4$5 3ate o' return &ay readily +e )al)ulated %ith the help o' a))ounting data. 465 $hey syste& gives due %eightage to the pro'ita+ility o' the proje)t i' +ased on average rate o' 3eturn. Proje)ts having higher rat o' 3eturn %ill +e a))epted and are )o&para+le %ith the returns on si&ilar invest&ent derived +y other 'ir&. 4)5 It ta0es invest&ents and the total earnings 'ro& the proje)t during its li'e ti&e. =e"Merits o0 A22ounting Rate o0 Return Method

4&5 It uses a))ounting pro'its and not the )ash,in'lo%s in appraising the proje)ts. 4$5 It ignores the ti&e,value o' &oney %hi)h is an i&portant 'a)tor in )apital e(penditure de)isions. Pro'its o))urring in di''erent periods are valued e*ually. 465 It )onsiders only the rat o' return an not the length o' proje)t lives. 4)5 $he &ethod ignores the 'a)t that pro'its )an +e reinvested. 4+5 $he &ethod does not deter&ine the 'air rate o' return on invest&ent. It is le't at the dis)retion o' the &anage&ent. So, use o' ar+itrary rate o' return )ause serious distortion in the sele)tion o' )apital proje)ts. 495 $he &ethod has di''erent variants, ea)h o' %hi)h produ)es a di''erent rate o' return 'or one proposal due to the diverse version o' the )on)epts o' invest&ent and earnings. It is )lear 'or& the a+ove dis)ussion that the syste& is not &u)h use'ul e()ept in evaluating the long,ter& )apital proposals.

resent Value Method

$he &ethod is also 0no%n as :$i&e adjusted rate o' return: or :internal rate o' 3eturn: Method or 2is)ounted )ash,'lo% &ethod In re)ent years, the &ethod has +een re)ognised as the &ost &eaning'ul te)hni*ue 'or 'inan)ial de)isions regarding 'uture )o&&it&ents and proje)ts. $he &ethod is +ased on the assu&ption that 'uture rupee value )annot +e ta0en as e*uivalent to the rupee value in the present. .hen %e )o&pare the returns or )ash in'lo%s %ith the a&ount o'
7 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

invest&ent or )ash out'lo%s, +oth &ust +e stated on a present value +asis i' the ti&e value o' &oney is to +e given due i&portan)e. $he pro+le& o' di''eren)e in ti&e (%hen )ash out'lo%s and in'lo%s ta0e pla)e) )an +e resolved +y )onverting the 'uture a&ounts to their present values to &a0e the& )o&para+le. $he dis)ounted )ash 'lo% rate o' return or internal rt o' return o' n invest&ent is the rate o' interest (dis)ount at %hi)h the present value o' )ash in'lo%s and the present value o' )ash out'lo%s +e)o&e e*ual). $he present value o' 'uture )ash in'lo%s )an +e )al)ulated %ith help o' 'ollo%ing 'or&ula1 S ; <<<<<<<< 4& > i 5n ?ere P ; Present value o' 'uture )ash in'lo%s i ; 3ate o' 3eturn or re*uired earning rate $his &ethod )an +e e(a&ined under t%o heads. 4a5 /et Present value &ethod, and (+) Internal rate o' return &ethod. 4a5 'et resent Value Method. $he net present value &ethod also 0no%n as dis)ounted +ene'it )ost ratio. <()ess present value &ethod or /et gain &ethod ta0es a))ount o' all in)o&e %henever re)eived. Under this &ethod, a re*uired rate o' return is assu&ed, and a )o&parison is &ade +et%een the present value o' )ash in'lo%s at di''erent ti&es and the original invest&ent in order to deter&ine the prospe)tive pro'ita+ility. $his &ethod is +ased on the +asi) prin)iple i' the present value o' )ash in'lo%s dis)ounted at a spe)i'ied rate o' return e*uals o' e()eeds the a&ount o' invest&ent proposal should +e a))epted. $his dis)ounted rate is also 0no%n a the :re*uired earning ratio:. Present value ta+les are generally used in order to &a0e the )al)ulations pro&pt and to 0no% the present value o' the )ash in'lo%s at re*uired earning ration )orresponding to di''erent periods. .e )an, ho%ever, use the 'ollo%ing 'or&ula to 0no% the present value o' 3e. " to +e re)eived a'ter a spe)i'ied period at a given rate o' dis)ount. S ; -uture value o' a su& o' &oney n ; /u&+er o' year

S V; <<<<<< 4& > i 5n .here P= ; Present =alue r ; rate o' dis)ount

71ample. 5et us suppose an invest&ent proposal re*uires an initial outlay o' 3s. >!!!! %ith an
8 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

e(pe)ted )ash,in'lo% o' 3s. ",!!! per year 'or 'ive years. Should the proposal +e a))epted i' the rate o' dis)ount is (a) "6 ? or (+) @? A .e )an 'ind the present value o' )ash in'lo%s %ith the help o' present value ta+les as 'ollo%s B "6 ? and @ ? 1,

@ear Cash inflows (2) 4&5 &. &,%%%

Cotal resent Value resent Value o0 A &+ B4$5 D 465 Re & A &+ B 465 .E*% E*%

resent Value o0 Re & A 9B 4+5 .F)6

Cotal resent -alue A 9B 4$5 D 4+5 F)6

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)F* <<<<<<<<< 66+6 <<<<<<<<

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*)* <<<<<<<< )$&$ <<<<<<<<

$he &ethod is regarded as superior to other &ethods o' invest&ent appraisal in several %ays1, 4&5 Che &ethod ta0es into a))ount the entire e)ono&i) li'e o' the proje)t invest&ent and in)o&e. 4$5 It gives due %eight age to ti&e 'a)tor o' 'inan)ing. Cen)e valua+le in long ter& )apital de)isions. In the %ords o' Charles Corngren, :Be)ause the dis)ounted )ash 'lo% &ethod e(pli)itly and routinely %eighs the ti&e value o' &oney, it is the +est &ethod, to use 'or long,range de)isions.:

9 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

465 it produ)es a &easure %hi)h is pre)isely )o&para+ly a&ong proje)ts, regardless o' the )hara)ter and ti&e shape o' their re)eipts an outlays. 4)5 $his approa)h provides 'or un)ertainty and ris0 +y re)ogniDing the ti&e 'a)tor. It &easures the pro'ita+ility o' )apital e(penditure +y redu)ing the earnings to the present value. 4+5 It is the +est &ethod o' evaluating proje)t %here the )ash 'lo%s are uneven. Cash in'lo%s and out'lo%s are dire)tly )onsidered under this &ethod %hile they re averaged under other &ethods. As the total present value o' 3s. ##6# at a dis)ount rat o' "6 ? is less than 3s. >!!! (the initial invest&ent) the proposal )annot +e a))epted, i' %e ignore the other non,*uantitative )onsiderations. But the present value o' 3s. > " at a dis)ount rate o' @ ? e()eeds the initial invest&ent o' 3s. >,!!!, the proposal )an +e a))epta+le. $he a+ove e(a&ple sho%s an even )ash in'lo%s every year. But i' )ash in'lo%s is uneven, the pro)edure to )al)ulate the present values is so&e%hat di''i)ult. -or e(a&ple, i' %e e(pe)t )ash 'lo%s at , 3e. " one year a'ter, 3s. # t%o years a'ter. 3s. > three years a'ter the present value at "6 ? dis)ount tat %ould +e1, P= o' 3e. " to +e re)eived at the end o' one year E " (.FG!) ; .FG! P= o' 3e. # to +e re)eived at the end o' one year E (.G6@) ; ".6"

P= o' 3e. > to +e re)eived at the end o' one year E # (.@6F) ; ".9G> 77777777 Present value o' series >.#6@ 777777777

4b5 #nternal Rate o0 Return Method. $his &ethod is popularly 0no%n as :ti&e adjusted rate o' return &ethod:, :dis)ounted )ash 'lo% rate o' return &ethod:, :yield rate &ethod:, :investor:s &ethod:, or :Marginal e''i)ien)y o' )apital: &ethod. In present value &ethod the re*uired earning rate is sele)ted in advan)e. But under internal rate o' return &ethod, rate o' interest or dis)ount is )al)ulated. Internal rate o' return is the rate o' interest or dis)ount at %hi)h the present value o' e(pe)ted )ash 'lo%s is e*ual to t total invest&ent outlay. A))ording to the /ational Asso)iation o' A))ountants, A&eri)a H$i&e adjusted rate o' 3eturn is the &a(i&u& rte o' interest that )ould +e paid 'or the )apital e&ployed over the li'e o' an invest&ent %ithout loss on the proje)t. H $his rate is usually 'ound +y trial and error &ethod. -irst
10 Shivaji University,Kolhapur(M.B.A. Part I) !"#

Capital Budgeting

%e sele)t an ar+itrary rate o' interest and 'ind the present value o' )ash 'lo%s during the li'e o' invest&ent at tat sele)ted rate. $hen %e )o&pare present value %ith the )ost o' invest&ent. I' the present value i' higher or lo%er than the )ost o' invest&ent, % try another rate and repeat the pro)ess. I' present value is higher than the )ost, %e shall try a higher rat o' interest or vi)e,versa. $his pro)edure )ontinues till the present values and the )ost o' invest&ent (total outlay in proje)t) are e*ual or nearly e*ual. $he rate at %hi)h present value and )ot o' invest&ent are e*ual. $he at is )alled internal rate o' return.

11 Shivaji University,Kolhapur(M.B.A. Part I) !"#