Capital Budgeting: Definitions Given by Authors and Capital Budgeting Decisions Include

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Topics to be Covered

  • Capital Budgeting meaning and definitions
  • Capital budgeting decisions include
  • Importance of capital budgeting
  • Problems in capital budgeting
  • Types of investment projects
  • Kinds of investment decision
  • Decision making procedure
  • Conventional and non-conventional cash flows
  • Capital budgeting evaluation techniques
  • Selection of an evaluation technique

Capital Budgeting

Capital budgeting or capital expenditure decision involves the investment of current cash outlay or a series of cash outlays in long term assets (projects) of the firm in return for future benefits in the form of cash inflows.

Definitions Given by Authors

  • R. N. Anthony defines the capital expenditure as “any investment involving commitment of funds now with the expectations of earning a satisfactory return on these funds over a period of time in future.”
  • Prof. G. D. Quirin has defined a capital investment project as any project which involves the outlay of cash in return for an anticipated flow of future benefits.

Capital Budgeting Decisions Include

  • Acquisition of long-term assets like plants, machineries, buildings etc.
  • Modification of the existing facilities for enhancing capacities.
  • Replacement of existing assets either for generating more revenue or cost reduction.
  • Incorporation of new technology.
  • Manufacturing process improvement.
  • Development of new products or their new use.
  • Research and Development.
  • Acquisition of new business.

Importance of Capital Budgeting

  • Long term implications.
  • Involves large amount of funds.
  • Change the risk complexion of the firm.
  • Irreversible decision.
  • Helps in gaining Competitive Advantage.
  • Difficult and Complex Decision.

Problems in Capital Budgeting

  • Risk and Uncertainty.
  • Time element.
  • Difficult to measure.
  • Capital Rationing.

Types of Investment Projects

  • Replacement/Modification Project: When the plant is replaced after completion of its economic life, it is called replacement decision and when the plant is replaced due to obsolete technology, it is called modification decision. Both of these decision are taken either to reduce the cost or increase the efficiency in production.
  • Growth/Expansion Project: Growth plans can be pursued for expanding sales in the domestic market or to make foray in foreign markets. Expansion projects make an addition to the existing capacity of the firm.
  • Diversification Project: Firm may want to enter into new product line or new markets. Diversification also requires a lot of investment in research and development, market research, advertising and promotion.
  • New Project/New firm: At the initial stage, there would be a large requirement of funds for the purchase of new project. For this purpose, Financial Manager must use capital budgeting techniques for taking the right decision.
  • Mandatory Projects: There are projects which are undertaken not for the business purpose but for the compliance of legal requirements i.e.. , projects like installing fire-fighting equipment or project to control the pollution level.

Kinds of Investment Decisions

  • Independent Projects (Accept/Reject) decision: An independent project is one whose acceptance or rejection does not affect the acceptance or rejection of the other proposals.
  • Mutually exclusive projects: Two or more projects are said to be mutually exclusive projects when the acceptance of one project rules out the acceptance of the other projects.
  • Contingent Decision: Contingent project is one whose acceptance depends on the adoption of another project.
  • Capital Rationing Decisions: Capital rationing is the process of putting restrictions on the projects that can be undertaken by the company or the capital that can be invested by the company. This aims in choosing only the most profitable investments of the investment decision.

Capital Budgeting: Decision Making Procedure

  • Estimation of cost and benefits of an investment proposal
  • Estimation of the minimum required rate of return
  • Application of a suitable Capital Budgeting Technique

Conventional and Non-Conventional Cash Flows

  • Conventional Cash Flows: Conventional Cash Flow for a project or investment is typically structured as an initial outlay or outflow, followed by a number of inflows over a period of time.
  • Non-Conventional Cash Flows: In Non-Conventional Cash Flow, there may be more than one cash outflows.

Capital Budgeting Evaluation Techniques

Capital Budgeting Evaluation Techniques

Traditional Techniques

Payback Period

Payback period is the length of time required to recover the initial investment made in a project.

The payback period can be calculated in two situations:

1. When equal Cash Inflows are generated every year

2. When Cash Flow are unequal

where, P = Number of years immediately preceding the year of final recovery

B = Balance amount to be recovered in the year of final recovery

C = Cash inflow in the year of final recovery

Payback Period

Advantages and Disadvantages of Payback Period

Advantages and Disadvantages Payback Period

Accounting Rate of Return

  • The ARR method is based on the return on investment concept. This method is based on the accounting profits of the company and not on the cash flows.
  • Computation of ARR

1. When the profits (after tax) to be earned, every year are equal

2. When the profit (after tax) to be earned during every year are different

Advantages and Disadvantages of Accounting Rate of Return

Advantages and Disadvantages Accounting Rate of Return

Discounted Cash Flow Techniques

Net Present Value (NPV) Method

Net present value is the difference between the present value of cash inflows and present value of cash outflows of a project.

Formula:

where , are the cash inflows at the end of year 1,2 … . nth

is the cash outflow (initial investment) of the project at zero period.

k = discounting rate

If the cash outflow also occurs at other points of time, then the formula for calculating NPV would be

Advantages and Disadvantages of NPV

Advantages and Disadvantages NPV

Profitability Index (PI) Method

This method is a variation of NPV method. While NPV method is an absolute measure of project evaluation, PI is a relative measure. It is also known as Benefit Cost Ratio ( Ratio) .

Advantages and Disadvantages PI

Internal Rate of Return (IRR)

It is defined as the discount rate which equates the present value of expected cash inflows from an investment proposal to the present value of initial cash outflow. This method is also known as yield on investment, marginal efficiency of capital, rate of return, time adjusted rate of return.

Mathematically, IRR can be written as:

where, = Cash outflow at time zero

, , , are the cash inflows at the end of year 1,2 … .

SV = salvage value realised in nth period (terminal year)

WC = working capital realised in nth period (terminal year)

n = life span of the project in years

r = Internal rate of return (to be calculated)

Hence at IRR: PV of net cash inflows = PV of net cash outflows

Advantages and Disadvantages of IRR

Advantages and Disadvantages IRR

Discounted Payback Period

  • Discounted payback period is calculated in the same way as we calculate the traditional payback period method. The only difference under the discounted method is that here we use present value of cash inflows and outflows instead of only cash flows under traditional method.
  • This method enjoys all the merits of traditional payback period as well as the advantages of time value of money for comparison purpose.

Selection of an Evaluation Technique

NPV, IRR and PI are the most appropriate techniques. These techniques will give identical results in most of the projects. These techniques will give identical results in most of the project evaluation situations. This means a project with positive NPV will have PV > 1and IRR > cost of capital. If one is asked to decide one technique, then NPV method can be described as the best method. However, it is always advisable that a finance manager should evaluate investment proposals on more than one criterion before making a final choice.

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