Q4. Examine the importance of capital budgeting.

Answer: Capital budgeting decisions are the most important decisions in corporate financial management.These decisions make or mar a business organization. These decisions commit a firm to investits current funds in the operating assets (i,e long-term assets) with the hope of employing themmost efficiently to generate a series of cash flows in future.These decisions could be grouped into1. Replacement decisions: These decisions may be decision to replace the equipments formaintenance of current level of business or decisions aiming at cost reductions.2. Decisions on expenditure for increasing the present operating level or expansion throughimproved network of distribution.3. Decisions for products of new goods or rendering of new services.4. Decisions on penetrating into new geographical area.5. Decisions to comply with the regulatory structure affecting the operations of the company.Investments in assets to comply with the conditions imposed by Environmental Protection Actcome under this category.6. Decisions on investment to build township for providing residential accommodation toemployees working in a manufacturing plant.There are many reasons that make the Capital budgeting decisions the most crucial for financeManagers1. These decisions involve large outlay of funds now in anticipation of cash flows in future. Forexample, investment in plant and machinery. The economic life of such assets has longperiods. The projections of cash flows anticipated involve forecasts of many financialvariables. The most crucial variable is the sales forecast.a. For example, Metal Box spent large sums of money on expansion of its productionfacilities based on its own sales forecast. During this period, huge investments in R & D inpackaging industry brought about new packaging medium totally replacing metal as an 1

important component of packing boxes. At the end of the expansion Metal Box Ltd founditself that the market for its metal boxes had declined drastically. The end result is thatMetal Box became a sick company from the position it enjoyed earlier prior to theexecution of expansion as a blue chip. Employees lost their jobs. It affected the standardof lining and cash flow position of its employees.This highlights the element of risk involved in these type of decisions.b. Equally we have empirical evidence of companies which took decisions on expansionthrough the addition of new products and adoption of the latest technology creating wealthfor shareholders. The best example is the Reliance group.c. Any serious error in forecasting Sales and hence the amount of capital expenditure cansignificantly affect the firm. An upward bias may lead to a situation of the firm creating idlecapacity, laying the path for the cancer of sickness.d. Any downward bias in forecasting may lead the firm to a situation of losing its market to itscompetitors. Both are risky fraught with grave consequences.2. A long term investment of funds sometimes may change the risk profile of the firm. A FMCGcompany with its core competencies in the business decided to enter into a new business of power generation. This decision will totally alter the risk profile of the business of the company. Investors perception of risk of the new business to be taken up by the companywill change his required rate of return to invest in the company. In this connection it is to benoted that the power pricing is a politically sensitive area affecting the profitability of theorganization. Therefore, Capital budgeting decisions change the risk dimensions of thecompany and hence the required rate of return that the investors want.3. Most of the Capital budgeting decisions involve huge outlay. The funds requirements duringthe phase of execution must be synchronized with the flow of funds. Failure to achieve therequired coordination between the inflow and outflow may cause time over run and cost overrun. These two problems of time over run and cost overrun have to be prevented fromoccurring in the beginning of execution of the project. Quite a lot empirical examples arethere in public sector in India in support of this argument that cost overrun and time over run can make a companys operations unproductive. But the major challenge that the

management of a firm faces in managing the uncertain future cash inflows and out flowsassociated with the plan and execution of Capital budgeting decisions. 4. Capital budgeting decisions involve assessment of market for companys products and services, deciding on the scale of operations, selection of relevant technology and finallyprocurement of costly equipment. If a firm were to realize after committing itself considerablesums of money in the process of implementing the Capital budgeting decisions taken that thedecision to diversify or expand would become a wealth destroyer to the company, then thefirm would have experienced a situation of inability to sell the equipments bought. Lossincurred by the firm on account of this would be heavy if the firm were to scrap the 2

equipments bought specifically for implementing the decision taken. Sometimes theseequipments will be specialized costly equipments. Therefore, Capital budgeting decisions areirreversible.5. The most difficult aspect of Capital budgeting decisions is the influence of time. A firm incursCapital expenditure to build up capacity in anticipation of the expected boom in the demandfor its products. The timing of the Capital expenditure decision must match with the expected boom in demand for companys p roducts. If it plans in advance it may effectively manage thetiming and the quality of asset acquisition. But many firms suffer from its inability to forecastthe future operations and formulate strategic decision to acquire the required assets inadvance at the competitive rates.6. All Capital budgeting decisions have three strategic elements. These three elements arecost, quality and timing. Decisions must be taken at the right time which would enable thefirm to procure the assets at the least cost for producing the products of required quality forcustomer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of Capital expenditure decision taken will strategically affect the firm s profitability.7. Liberalization and globalization gave birth to economic institutions like World Tradeorganization. General Electrical can expand its market into India snatching the share alreadyenjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of G E to sell itsproducts in India at a rate less than the rate at which Indian Companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be proactive. Proactive firms cannot avoid the risk of taking challengingCapital budgeting decisions for growth. Therefore, Capital budgeting decisions for growth havebecome an essential characteristics of successful firms today.8. The social, political, economic and technological forces generate high level of uncertainty infuture cash flows streams associated with Capital budgeting decisions. These factors makethese decisions highly complex. 9. Capital expenditure decisions are very expensive. To implement these decisions firm s will have to tap the Capital market for funds. The composition of debt and equity must be optimalkeeping in view the expectation of investors and risk profile of the selected project

O. 5 Explain briefly Capital Rationing? (May 2004,May2006) Meaning : Capital Rationing is a situation where a constraint or budget ceiling is placed on

the total size of capital expenditures during a particular period. In other words Capital Rationing refers to a situation where a company cannot undertake all positive NPV projects it has identified because of shortage of capital . Reasons For Capital Rationing : External Factors : Under this the firm does not have funds & it also cannot raise them from finincial markets.Some reasons can be : (i) imperfections in capital markets (ii) non-availability of market information (iii) investors attitude (iv) Firms lack of credibility in market (v) High Flotation costs Internal Factors :Internal capital rationing arise due to the self-imposed restrictions imposed by management .Under this though the funds can be arranged but firm itself impose restrictions on investment expenditure . Some reasons can be : (i) not to take additional burden of debt funds (ii) laying down a specified minimum rate of return on each project (iii) No further Equity Issue to prevent dilution of control , (iv) Divisional Budgets used to prevent any inefficency or wastage of funds by them Different Situations of Capital Rationing : (i) Single Period Capital Rationing : Funds limitation is there only for one year. Thereafter , no Financial constraints. (ii) Multi Period Capital Rationing : Funds limitaton is there in more than one years. (iii) Divisible Projects : These are the projects which can be accepted fully as well as in fractions. NPV is also adjusted to the same fraction as cash outflows. (iv) Indivisible Projects :These are the projects which can only be accepted fully, not in fractions. Ways of Resorting Capital Rationing : There are various ways of resorting to capital rationing, some of which are : (i) By way of Retained Earnings : A firm may put up a ceiling when it has been financing investment proposals only by way of retained earnings (ploughing back of profits). Since the amount of capital expenditure in that situation cannot exceed the amount of retained earnings, it is said to be an example of capital rationing. (ii) By way of Responsibility Accounting : Capital Rationing may also be introduced by following the concept of responsibility accounting, whereby management may introduce capital rationing by authorising a particular department to make investment only upto a specified limit, beyond which the investment decisions are to be taken by higher-ups. (iii) By making full utilization of budget as primary consideration : In Capital Rationing it may also be more desirable to accept several small investment proposals than a few large investment proposals so that there may be full utilisation of budgeted amount. This may result in accepting relatively less profitable investment proposals if full utilisation of budget is a primary consideration. Thus Capital Rationing does not always lead to optimum results

6. Explain the concepts of working capital Ans. Money required by the company to meet out day today expenses to finance production and stocks to pay wages and other production etc. is called the working capital of the company. Working capital is used in operating the business. It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. It is because of this regular cycle that the working capital requirements are usually for short periods. Though, both fixed and working capitals shall be recovered from the business, the differences lies in the rate of their recovery. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. As the process of production become more round about and complicated the production to fixed working capital increase correspondingly.
Therefore, working capital management refers to the management of current assets and current liabilities. Working capital, however, represents investment in current assets, such as cash, marketable securities, inventories and bills receivables. Current liabilities mainly include bills payable, notes payable and miscellaneous accruals. Net working capital is the excess of current assets over current liabilities here. Current assets are those assets which are normally converted into cash within an accounting year; and current liabilities are usually paid within an accounting year.

What for is working capital required by firm very much depends on the nature of the business which the firm is conducting. If the firm has business which deals with public utility services, obviously the requirement will be low. It is primarily because the amount becomes available as soon as services are sold and also the services arranged by the firm and immediately sold, without much difficulty and complication. On the other hand trading concerns need heavy amounts because these require funds for carrying goods traded. Similarly many industrial units will also need heavy amounts for carrying on their business. Many manufacturing concerns will also need sufficiently heavy amounts, that of course depends on the nature of commodities which are being manufactured.