CAPITAL BUDGETING

 
Capital budgeting is the process by which the financial manager decides whether to invest
in specific capital projects or assets. In some situations, the process may entail in acquiring
assets that are completely new to the firm. In other situations, it may mean replacing an
existing obsolete asset to maintain efficiency.
 
INTRODUCTION:-

Capital budgeting is the process by which the financial manager decides

whether to invest in specific capital projects or assets. In some situations, the process may
entail in acquiring assets that are completely new to the firm. In other situations, it may
mean replacing an existing obsolete asset to maintain efficiency.

capital budget may be defined as “ the firm’s decision to invest its current
funds most efficiently in the long-term assets in anticipation if an expected flow of benefits
over a series of years. Therefore it involves a current outlay or series of outlay of cash
resources in return for an anticipated flow of future benefits. Capital budgeting is the
process of identifying , analyzing and selecting investment projects whose returns (cash
flow) are expected to extend beyond one year.

Long-term investments represent sizable outlays of funds that commit a firm

to some course of action. Consequently, the firm needs procedures to analyze and properly
select its long-term investments. It must be able to measure cash flows and apply
appropriate decision techniques. As time passes, fixed assets may become obsolete or may
require an overhaul; at these points, too, financial decisions.

Capital budgeting is the process of evaluating and selecting long-term investments

that are consistent with the firm’s goal of maximizing owner wealth. Firms typically make a
variety of long-term investments, but the most common for the manufacturing firm is in
fixed assets, which include property (land), plant, and equipment. These assets, often
referred to as earning assets, generally provide the basis for the firm’s earning power and
value.
Definition

According to Larence J Gitman (Principles of Managerial Finance),“Capital budgeting is the

process of evaluating and selecting long-term investments that are consistent with the
firm’s goal of maximizing owner wealth.”

Capital budgeting is the process by which the financial manager decides whether to invest
in specific capital projects or assets. In some situations, the process may entail in acquiring
assets that are completely new to the firm. In other situations, it may mean replacing an
existing obsolete asset to maintain efficiency. The investment decisions of a firm are
generally known as the capital budgeting, or capital expenditure decisions.

A capital budgeting decision may be defined as the firm’s decision to invest its current
funds most efficiently in the long-term assets ill anticipation of an expected flow of benefits
over a series of years.

Component of Capital Budget

Initial Investment Outlay

It includes the cash required to acquire the new equipment or build the new plant less any
net cash proceeds from the disposal of the replaced equipment. The initial outlay also
includes any additional working capital related to the new equipment. Only changes that
occur at the beginning of the project are included as part of the initial investment outlay.
Any additional working capital needed or no longer needed in a future period is accounted
for as a cash outflow or cash inflow during that period.

Net Cash benefits or savings from the operations:

This component is calculated as follow:

The incremental change in operating revenues-The incremental change in the operating

cost = Incremental net revenue-Taxes ± Changes in the working capital and other
adjustments
Terminal Cash flow

It includes the net cash generated from the sale of the assets, tax effects from the
termination of the asset and the release of net working capital.

The Net Present Value technique

Although there are several methods used in Capital Budgeting, the Net Present Value
technique is more commonly used. Under this method a project with a positive NPV implies
that it is worth investing in.

Example: A company is studying the feasibility of acquiring a new machine. This machine
will cost $350,000 and have a useful life of three years after which it will have no salvage
value. It is estimated that the machine will generate operating revenues of $300,000 and
incur $75,000 in annual operating expenses over the useful life of three years. The project
requires an initial investment of $15,000 in working capital which will be recovered at the
end of the three years. The firm’s cost of capital is 16%. The firm’s tax rate is 25%.

Steps in Capital Budgeting

Capital budgeting is the process of determining whether a big expenditure is in a

company's best interest. Here are the basics of capital budgeting and how it works. 

Company undertakes capital budgeting in order to make the best decisions about utilizing
its limited capital. For example, if we are considering opening a distribution center or
investing in the development of a new product, capital budgeting will be essential. It will
help we decide if the proposed project or investment is actually worth it in the long run.

Identification or Innovation of Investment Projects

The first step in the capital budgeting process is to identify the opportunities that we have.
Many times, there is more than one available path that a company could take. We have to
identify which projects we want to investigate further and which ones do not make any
sense for company. If we overlook a viable option, it could end up costing us quite a bit of
money in the long term. 
Estimating Cash Flow

We need to determine how much cash flow it would take to implement a given project. We
also need to estimate how much cash would be brought in by such a project. This process is
truly one of estimating--it takes a bit of guesswork. We need to try to be as realistic as we
can in this process. Do not use the best-case scenario for numbers. Most of the time, we
need to use a fraction of that number to be realistic. If the project takes off and the best-
case scenario is reached, that is great. However, the odds of that happening are not the best
on new projects.

Evaluate The Investment Projects

Once have identified the reasonable opportunities, we need to determine which ones are
the best. Look at them in relation to overall business strategy and mission. See which
opportunities are actually realistic at the present time and which ones should be put off for
later. 

Selection the Best Investment Project

After we look at all of the possible projects, it is time to choose the right project mix for
company. Evaluate all of the different projects separately on their own merits. We need to
come up with the right combination of projects that will work for company immediately.
Choose only the projects that mesh with company goals.

Implementation of The Project

Once the decisions have been made, it is time to implement the projects. Implementation is
not really a budgeting issue, but we will have to oversee everything to be sure it is done
correctly. After the project gets started, we will need to review everything to make sure the
finances still make sense.

Continious Evaluation of The Selected Project

Here, project manager has to see the performance of the selected project. He has to check
the any one error and calculate the profit as per cash flow.

Application/Grounds of Capital Budgeting

Have already discussed capital budgeting is used to talk decision for future financial
investment for big amount.
Purchases of Fixed Assets

Capital budgeting is used to take decision for new investment to purchases land,
equipment, building for any company.

Modernization of Production Process

Here need to distinguish a new production method and old. Need to compare
administrative disbursement, life time of projects, salvage value, market price etc by
financial investment method and determine which is best one and which method
need to continuation of old method or set new production method?

Expansion of business

When a company wants to expanse business, he needs to take decision for such
reason. Such needs to set a machine for production. In this case, company production
manager need to calculate the total net cash outlet for machine setup and the total
profit from this machine for selected year.

Introduction of new product

When a firm invent a new product and going to enter the market. The firm needs to
know the public demand, production cost, administrative cost, profit etc. By
calculating all things, firm will decide, they will enter market or not?
 Importance of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decision. So it needs

special care on account of the following reasons:

Long-term Implications

A capital budgeting decision has its effect over a long time span and inevitably affects the
company’s future cost structure and growth. A wrong decision can prove disastrous for the
long-term survival of firm. On the other hand, lack of investment in asset would influence
the competitive position of the firm. So the capital budgeting decisions determine the
future destiny of the company.

Involvement of large amount of funds

Capital budgeting decisions need substantial amount of capital outlay. This underlines the
need for thoughtful, wise and correct decisions as an incorrect decision would not only
result in losses but also prevent the firm from earning profit from other investments which
could not be undertaken.

Irreversible decisions

Capital budgeting decisions in most of the cases are irreversible because it is difficult to
find a market for such assets. The only way out will be scrap the capital assets so acquired
and incur heavy losses.

Risk and uncertainty

Capital budgeting decision is surrounded by great number of uncertainties. Investment is

present and investment is future. The future is uncertain and full of risks. Longer the period
of project, greater may be the risk and uncertainty. The estimates about cost, revenues and
profits may not come true.
Difficult to make

Capital budgeting decision making is a difficult and complicated exercise for the
management. These decisions require an over all assessment of future events which are
uncertain. It is really a marathon job to estimate the future benefits and cost correctly in
quantitative terms subject to the uncertainties caused by economic-political social and
technological factors.

Kinds of capital budgeting decisions

Generally the business firms are confronted with three types of capital budgeting decisions.

Accept-reject decisions

Business firm is confronted with alternative investment proposals. If the proposal is

accepted, the firm incur the investment and not otherwise. Broadly, all those investment
proposals which yield a rate of return greater than cost of capital are accepted and the
others are rejected. Under this criterion, all the independent proposals are accepted.

Mutually exclusive decisions

It includes all those projects which compete with each other in a way that acceptance of
one precludes the acceptance of other or others. Thus, some technique has to be used for
selecting the best among all and eliminates other alternatives.

Capital rationing decisions

Capital budgeting decision is a simple process in those firms where fund is not the
constraint, but in majority of the cases, firms have fixed capital budget. So large amount of
projects compete for these limited budgets. So the firm rations them in a manner so as to
maximize the long run returns. Thus, capital rationing refers to the situations where the
firm has more acceptable investment requiring greater amount of finance than is available
with the firm. It is concerned with the selection of a group of investment out of many
investment proposals ranked in the descending order of the rate or return.
 Limitation of Capital Budget

Capital budgeting is very important to take future financial decision. Because future profit
and loss depends of capital budgeting. But capital budgeting has some limitations. Such:

Lack of Adequate Data, Lack of Reliability of the Data, Problem of Measuring Future,
Timing of the Projects, Problems of Quantification, Personal Judgment of the
Decision.

RESEARCH METHODOLOGY

Methodology: Methodology may be a description of process, or may be expanded to

include a philosophically coherent collection of theories, concepts or ideas as they relate to
a particular discipline or field of inquiry

Methodology may refer to nothing more than a simple set of methods or procedures, or it
may refer to the rationale and the philosophical assumptions that underlie a particular
study relative to the scientific method. For example, scholarly literature often includes a
section on the methodology of the researchers.

RESEARCH: Research is defined as human activity based on the intellectual application in

the investigation of matter. The primary purpose for applied research is discovering,
interpreting, and the development of the methods and systems for the advancement of
human knowledge on a wide variety of scientific matters of our world and the universe.
Research can use the scientific method, but need not do so.

SCOPE OF RESEARCH: Research needs valuable resources such as money, time, materials,
manpower and machines to get the work done effectively to minimize input value for a unit
value of output and the return-on-investment.

Aim of the research

The assigned task was to conduct a survey for a well reputed company. Research is
concerned with the systematic and objective collection, analysis and evaluation of
information about specific aspects in order to help management make effective decisions.
Once the aspect is identified and defined it is the responsibility of the researcher to chalk
out a comprehensive plan explaining each step required to conduct the research in a
successful manner.
OBJECTIVES OF RESEARCH: The principal objective of research it to find solutions to
problems in a systematic way. In general, the objectives of research can be specified as:

•To acquire familiarity with a phenomenon.

•To study the frequency of connection or independence of any activity or occurrence.
•To determine the characteristics of an individual or a group of activities and the frequency
of the occurrence of these activities.
•To test a hypothesis about a causal relationship that exists between variables.

The first step in research is setting the objectives for which their study is to be undertaken.
It is essential that objectives are set before hand. The objectives must be hierarchical,
quantifiable, realistic and verifiable.
The main objective of this study is to study how the employees value for rewards and
recognition (non-monetary rewards) in Tata Consultant.

Period of study:
The time period was three months for the study, starting from January to March _ _ _ _.

DataUsed:
The type of data collected comprises of Primary data and Secondary data.
Primary data is the first hand data collected from the employees. It was collected through
questionnaire.

Secondary data for the study has been compiled from the reports and official publication of
the organization, which have been helped in getting an insight of the present scenario
existing in the operation of the company.

Method and Research Design

PURPOSE

The method section answers these two main questions:

1. How was the data collected or generated?
2. How was it analyzed?
In other words, it shows your reader how you obtained your results.
But why do you need to explain how you obtained your results?
We need to know how the data was obtained because the method affects the results. For
instance, if you are investigating users' perceptions of the efficiency of public transport in
Bangkok, you will obtain different results if you use a multiple choice questionnaire than if
you conduct interviews. Knowing how the data was collected helps the reader evaluate the
validity and reliability of your results, and the conclusions you draw from them.
 Often there are different methods that we can use to investigate a research
problem. Your methodology should make clear the reasons why you chose a particular
method or procedure.
The reader wants to know that the data was collected or generated in a way that is
consistent with accepted practice in the field of study. For example, if you are using a
questionnaire, readers need to know that it offered your respondents a reasonable range of
answers to choose from (asking if the efficiency of public transport in Bangkok is "a.
excellent, b. very good or c. good" would obviously not be acceptable as it does not allow
respondents to give negative answers).
The research methods must be appropriate to the objectives of the study. If you
perform a case study of one commuter in order to investigate users' perceptions of the
efficiency of public transport in Bangkok, your method is obviously unsuited to your
objectives.
The methodology should also discuss the problems that were anticipated and
explain the steps taken to prevent them from occurring, and the problems that did occur
and the ways their impact was minimized.
In some cases, it is useful for other researchers to adapt or replicate your
methodology, so often sufficient information is given to allow others to use the work. This
is particularly the case when a new method had been developed, or an innovative
adaptation used.

During the capital budgeting process answers to the following questions are sought:
 What projects are good investment opportunities to the firm?
 From this group which assets are the most desirable to acquire?
 How much should the firm invest in each of these assets

WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty of a financial manager is to

choose investments with satisfactory cash flows and rates of return. Therefore, a financial
manager must be able to decide whether an investment is worth undertaking and be able
to choose intelligently between two or more alternatives. To do this, a sound procedure to
evaluate, compare, and select projects is needed. This procedure is called capital
budgeting.

Capital budgeting is investment decision-making as to whether a project is worth

undertaking. Capital budgeting is basically concerned with the justification of capital
expenditures.
Current expenditures are short-term and are completely written off in the same year
that expenses occur. Capital expenditures are long-term and are amortized over a period
of years are required by the IRS.
 CAPITAL IS A LIMITED RESOURCE

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. In addition, the Federal Reserve System
requires each bank to maintain part of its deposits as reserves. Having limited resources to
lend, lending institutions are selective in extending loans to their customers. But even if a
bank were to extend unlimited loans to a company, the management of that company
would need to consider the impact that increasing loans would have on the overall cost of
financing.

In reality, 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.

The argument that capital is a limited resource is true of any form of capital, whether
debt or equity (short-term or long-term, common stock) or retained earnings, accounts
payable or notes payable, and so on. Even the best-known firm in an industry or a
community can increase its borrowing up to a certain limit. Once this point has been
reached, the firm will either be denied more credit or be charged a higher interest rate,
making borrowing a less desirable way to raise capital.

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. JOY