SUBJECT: FINANCIAL MANAGEMENT

TOPIC: CAPITAL BUDGETING

INTRODUCTION:-
Capital budgeting (or investment appraisal) is the planning process used to
determine whether an organization’s long term investments such as new
machinery, replacement machinery, new plants, new products, and research
development projects are worth pursuing. It is budget for major capital, or
investment, expenditures.
Definition: Capital Budgeting may be defined as the decision-making process by
which firms evaluate the purchase of major fixed assets including buildings,
machinery etc. which are not meant for sale.
According to Charles T. Horngreen, “Capital Budgeting is long term planning for
making and financing proposed capital outlay.”
Milton H. Spencer has defined Capital Budgeting as, “Capital Budgeting involves
the planning of expenditure for assets, the returns from which be realized in
future time period.”
Again in the words of Robert N. Anthony, “The Capital Budget is essentially a list
of what management believes to be the worthwhile projects for the acquisition of
new capital assets together with the estimated cost of each project.”
From the above definitions, it may be concluded that, capital budgeting is an
evaluation process for a proposed project to forecast the likely or expected return
from the project. This evaluation generally begins with an expenditure of cash at
the beginning of the project’s service life and a stream of cash flowing to the firm
over the period of the project.

IMPORTANCE OF CAPITAL BUDGETING:-

Capital Budgeting decisions are of extremely important to any modern firm to
survive. The profitability, growth and the long run survival largely depends on
Capital Budgeting Decisions. Its survival in the competitive market depends on
the constant flow of new investment ideas for modernization of the production
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process, diversification of products, etc. Apart from these some other significances
of Capital Budgeting decisions are as follows:-
• Substantial amount of investments: The Capital Budgeting decisions generally
involve substantial amount of funds which make it imperative for the firm to
plan its investment programmes very carefully. As a substantial portion of
capital funds are being blocked in the capital budgeting decisions, it affects
the financial health of the firm for a long period of time. The wrong and hasty
decisions of the firm will not only result into heavy capital losses in time to
come but may also account for the financial failure of the firm.
• Irreversible decisions: It is also important to note that the major part of a
capital investment project is irreversible in the sense that once such project
is undertaken, it becomes difficult to take investment decisions of a different
nature for a short period. Prudent decisions are an essential part of capital
budgeting. Proper procedures are needed for screening such investment
projects.
• Long term implications: One of the most important reasons for capital
budgeting decisions 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
expenditure.
• Complex decisions: Decisions relating to capital budgeting are among the
difficult and at the same time, the most critical. Moreover its very difficult to
quantify all the benefits or costs relating to a particular investment decision,
as these are largely dependent on economic, political, social and
technological factors.
• Sales forecast: Investments in fixed assets is related with implied forecast of
future sales. For example, investment in machinery will help the firm to meet
the demand in the future by forecasting sales.
• Cash forecast: Capital investment requires substantially large amount of
funds. This fund can only be arranged by making serious efforts to ensure
their availability at the right time. It facilitates cash forecast to plan the
investment proposals carefully, so that the firm can meet its long term
obligations without any delay and difficulty.
• Over and undercapacity : Investment decisions based on sophisticated
techniques, managerial skill and experience will usually improve the timing
and quality of asset acquisition. If done poorly, it can cost the firm large
sums of money because of overcapacity or undercapacity or both.
• Social importance: From macro point of view, individual investment decisions
should have a substantial impact on the society because it determines
employment, economic activities and economic growth.
• Impact on other financial decisions: Financing decisions and dividend
decisions are some areas of financial management where capital budgeting
decisions have remarkable impact. Decision in respect of a profitable
investment project not only justifies the appropriate financing decisions but it
has impact on the dividend decisions of the firm too.
• Wealth maximization to the share holders: Most of the firms are suffering
from financial failure because they do not have proper balance among
investment projects because either they have too much or too little capital
equipment in comparison to their needs. Therefore management facilitates
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the wealth maximization of shareholders by avoiding over-investment and

under-investment in fixed assets.

Thus decisions in respect of capital budgeting should be taken very carefully so

that the future plans of the firm are not affected adversely.

TYPES OF CAPITAL BUDGETING DECISIONS:-

There are many ways to classify the capital budgeting decision. Generally capital
investment decisions are classified in two ways. One way is to classify them on
the basis of the firm’s existence. Another way is to classify them on the basis of
decision situation.
1. On the basis of firm’s existence: The capital budgeting decisions are taken by
both newly incorporated firms as well as existing firms. The new firms may be
required to take decision in respect of selection of a plant to be installed. The
existing firm may be required to take decisions to meet the requirement of new
environment or to face the challenges of competition. These decisions may be
classified as follows:-
• Replacement and Modernization decisions: These decisions aim to improve
operating efficiency and reduce cost. Generally all types of plant and
machinery require replacement either because economic life of plant or
machinery is over or because it has become technologically outdated. The
former decision is known as replacement decisions and the later is known
as modernization decisions.
• Expansion decisions: Existing successful firms may experience growth in
demand of their product line. If such firms experience shortage or delay in
the delivery of their products due to inadequate production facilities, they
can consider proposal to add capacity to existing product line.
• Diversification decisions: These decisions require evaluation of proposals to
diversify into new product lines, new markets etc. for reducing the risk of
failure by dealing in different products or by operating in several markets.
2. On the basis of decision situation: The capital budgeting decisions on the basis of
decision situation are classified as follows:-
• Mutually exclusive decisions: The decisions are said to be mutually
exclusive if two or more alternative proposals are such that the acceptance
of one proposal will exclude the acceptance of the other alternative
proposals. For instance, a firm may be considering proposal to install a
semi-automatic or highly automatic machine. If the firm installs a semi-
automatic machine, it excludes the acceptance of proposal to install highly
automatic machine.
• Accept-reject decisions: The accept-reject decisions occur when proposals
are independent and do not compete with each other. The firm may accept
or reject a proposal on the basis of a minimum return on the required
investment.
• Contingent decisions: The contingent decisions are dependable proposals.
The investment in one proposal requires investment in one or more other
proposals. For example, if a company accepts a proposal to set up a factory
in a remote area, it may also have to invest in infrastructure etc.
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CAPITAL BUDGETING PROCESS:-

The extent to which the capital budgeting process needs to be formalized and
systematic procedures established depends on the size of the organization; the
composition of the firm’s existing assets and management’s desire to change that
composition; timing of expenditures associated with the projects that are finally
accepted.
• Planning: The capital budgeting process begins with the identification of
potential investment opportunities. The opportunity then enters the
planning phase when the potential effect on the firm’s fortunes is assessed
and the ability of the management of the firm to exploit the opportunity is
determined. Opportunities having little merit are rejected and promising
opportunities are advanced in the form of a proposal to enter the evaluation
phase.
• Evaluation: This phase involves the determination of proposal and its
investments, inflows and outflows. Investment appraisal techniques,
ranging from the simple payback method and accounting rate of return to
the more sophisticated discounted cash flow techniques, are used to
appraise the proposals. The technique selected should be one that enables
the manager to make the best decision in the light of prevailing
circumstances.
• Selection: Considering the returns and risks associated with the individual
projects as well as the cost of capital to the organization, the organization
will choose among projects so as to maximize shareholders’ wealth.
• Implementation: When the final selection has been made, the firm must
acquire the necessary funds, purchase the assets, and begin the
implementation of the project.
• Control: The progress of the project is monitored with the aid of feedback
reports. These reports will include capital expenditure progress reports,
performance reports comparing actual performance against plans set and
post completion audits.
• Review: When a project terminates, or even before, the organization should
review the entire project to explain its success or failure. This phase may
have implication for firms planning and evaluating procedures. Further, the
review may produce ideas for new proposals to be undertaken in the future.

Basic Steps of Capital Budgeting:-

1. Estimate the cash flows

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or
payback < policy.
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PROJECT CASH FLOWS:-

One of the most important tasks in capital budgeting is estimating future cash
flows for a project. The final decision we make at the end of the capital budgeting
process is no better than the accuracy of our cash-flow estimates. The project
cash flow stream consists of cash inflows and cash outflows. The costs are
denoted as cash outflows whereas the benefits are denoted as cash inflows. Cash
flows can be calculated as follows:-
Initial cash flow:
Cost of new assets + Installation/Set up Costs +(-) Increase (Decrease) in Net
Working Capital level (-) Net Proceeds from sale of old asset (if it is a replacement
situation) +/(-) Taxes (tax saving) due to sale of old assets (if it is a replacement
situation) = INITIAL CASH OUTFLOW.
Interim Incremental cash flows:
Net increase (decrease) in operating revenue +(-) Net increase (decrease) in
operating expenses excluding depreciation = Net change in income before taxes.
+(-) Net decrease (increase) in taxes = Net change in income after taxes.
+(-) Net increase (decrease) in tax depreciation charges = INCREMENTAL NET
CASH FLOW FOR THE PERIOD.
Terminal-Year Incremental Net cash flow:
Incremental Net cash flow for the period +(-) Final salvage value (disposal cost)
of asset -(+) Taxes (tax saving) due to sale or disposal of assets +(-) Decreased
(increased) level of Net Working Capital = TERMINAL-YEAR INCREMENTAL NET
CASH FLOW.

SOME IMPORTANT TERMS:-

• Payback period: Payback period of an investment is the expected number

of years required to recover a project’s cost.
• Net Present Value (NPV): The difference between the present value of cash
inflows and the present value of cash outflows. NPV is used in capital
budgeting to analyze the profitability of an investment or project.
• Internal Rate Of Return (IRR): The discount rate often used in capital
budgeting that makes the net present value of all cash flows from a
particular project equal to zero. Generally speaking, the higher a project's
internal rate of return, the more desirable it is to undertake the project.
• Modified IRR (MIRR): The MIRR is similar to the IRR, but is theoretically
superior in that it overcomes two weaknesses of the IRR. The MIRR
correctly assumes reinvestment at the project’s cost of capital and avoids
the problem of multiple IRRs. However, the MIRR is not used as widely as
the IRR in practice.
• Profitability Index (PI): The profitability Index or PI,method compares the
present value of future cash inflows with the initial investment on a
relative basis. Therefore, the PI is the ratio of the present value of cash
flows (PVCF) to the initial investment of the project.

CONCLUSION:-
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In the form of either debt or equity, capital is a very limited resource. There is a
limit to the volume of credit that the banking system can create in the economy.
Commercial banks and other lending institutions have limited deposits from which
they can lend money to individuals, corporations, and governments. Any firm has
limited borrowing resources that should be allocated among the best investment
alternatives. One might argue that a company can issue an almost unlimited
amount of common stock to raise capital. Increasing the number of shares of
company stock, however, will serve only to distribute the same amount of equity
among a greater number of shareholders. In other words, as the number of
shares of a company increases, the company ownership of the individual
stockholder may proportionally decrease.
Faced with limited sources of capital, management should carefully decide
whether a particular project is economically acceptable. In the case of more than
one project, management must identify the projects that will contribute most to
profits and, consequently, to the value (or wealth) of the firm. This, in essence, is
the basis of capital budgeting.

REFERENCES
Financial Management by Majumdar, Nisha, Ali
Financial Management for IPCC issued by ICAI
www.wikipedia.org
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