15.

CAPITAL BUDGETING

15.1 INTRODUCTION

Capital Budgeting is perhaps one of the most important branches of Managerial Economics. According to

Charles T Hormgrem

“CapitalBudgeting is a long term

planning for making and financingproposed capital outlays

”

According to

Eugene F

Brigham

“CapitalBudgeting is in essence, an application of the classic

propositionfrom the economic theory of the firm, namely, a firm shouldoperate at a point where marginal revenue is just equal to itsmarginal cost. When this rule is applied to the capital budgetingdecision marginal revenue is taken to be the percentage rate of return on investments and marginal cost is the firms’ percentagecost of capital.”

Capital budgeting decisions are essentially

long-term investmentdecisions

. They have to be taken very carefully because once thesedecisions are taken and implemented they become very expensive if theyare to be reversed. The time factor involved in financial planning is of fairly distant future and the capital expenditure can be recovered onlyover a fairly long period of time. Due to this time element, capitalbudgeting decisions are subject to greater degree of risks and uncertainty. The long term investment decisions therefore, must be based on soundbudgeting procedures. The nature of budgeting problem revolves roundthree basic questions.i) How much money will be needed for expenditure in the coming period?ii) How much money will be available at what cost?iii) How should the available money be distributed amongst variousprojects?

The first question deals with demand for capital

. As the aim of capital expenditure is to make profits, this problem involves a survey of profitable opportunities of investments on the basis of their yields.

The second question concerns the supply of capital

. The supplyside has three aspects.a) How much can we raise internally from depreciation and retainedearnings?b) How much can be procured from outside agencies?c) What shall be the cost of capital?

The third question relates to rationing of funds

. How muchshould be spent in all and where?These questions are analyzed by referring to the demand for capital,supply of capital and the cost of capital.

15.2 DEMAND FOR CAPITAL

The demand schedule for capital refers to the arrangementof the various proposed projects in a descending order accordingto their estimated rates of return together with required amountsof capital needed by the respective projects.

Before analyzing the investments, the management mustunderstand the nature of opportunities. Some investments arecomplimentary i.e. making one investment implies that anotherinvestment will be necessary. Some investments are mutually exclusivei.e. acceptance of one, implies rejection of others and some investmentsare independent. It is therefore necessary to identify the variousopportunities of investments. Alternative investments can be rankedaccording to their relative profitability. It is also important to distinguishbetween cost reducing investment and revenue increasing investment.

According to W.W. Haynes

“any investment decision is profitableif it adds more to revenue than to cost or if it reduces cost morethan the revenue.”

An important element in the analysis of demand forcapital is the productivity of proposed capital outlay. The yield must becalculated in terms of individual projects. It is the expected productivity of marginal unit of capital i.e. the key factor in the appraisal of allocatingcapital funds and not the profitability of the old and sunk investmentbased on the estimates of the historical costs. The past is useful only as aguide to the future i.e. the future profit which is more relevant andinfluences demand for capital; besides the capital yield should becalculated over the whole lifetime of the asset. Undoubtedly all the futureventures of capital investment involve risks.

INVESTMENT WORTH OR PROFITABILITY OF A PROJECT

One of the most significant aspects of capital budgeting is themeasurement of investment worth.For appraising the profitability of a project following criteria have beenproposed:A] The Payback Period MethodB] The Discounted Present Value MethodC] Internal Rate of Return Method

The Payback Period Method:A Payback Period = Initial Investment OutlayAnnual Cash Flow

For example If initial investment outlay is Rs 1, 00, 000/- and cashinflow per year is Rs 25, 000/- then payback period is 1, 00, 000 = 4 years25, 000

From among the several projects the one which has the shortestPayback Period may be selected.

Merits

1.Simple and easy to calculate.2.It takes care of liquidity problem of the firm.3.Favours less risky projects.

Demerits

1.It ignores profitability.2.It ignores changes in cash flows over a long period.3.It disregards time value of money i.e. simply adds up annuities withoutproper discounting.4.It ignores cash inflow after the payback.

B] The Discounted Present Value Method (DPV) DPV = R

+ R

+ - - - - - - R

1+i (1+i )

(1+i)

i) Project cost is given.ii) Market rate of interest is given.iii) R

are known.

Find the DPV.Compare it with the cost.Investment is worthwhile if DPV > Cost.Illustration: Assume that a machine has a life of 2 years, each year it yields Rs1210. The present cost of the machine is Rs 2000 and the current rate of interest is 10%. Is the investment worthwhile?Applying the formula DPV = R

+ R

1+i (1+i )

= 1210 + 1210(1+.1) (1+.1)

= 1210 + 12101.1 (1.1)

= 1210 + 121011 121