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INTRODUCTION

The field of capital budgeting is both comprehensive and challenging it is


clearly plays a vital role in assisting most business firms to achieve there
various goals (e.g. ., profitability, growth, stability, risk reduction, social goals,
etc) it has been closely allied to the economic problem. This is rather broadly
defined as the allocation of scarcer resources among competing alternatives.

Capital budgeting may be defined as the planning, evalution, and


selection of capital expenditure proposal as distinguished from operating e
expenditures, whose chief benefits are recognized with in a period of one year,
capital expenditures present outlay whose principal benefits will be recognized
over longer period of time. Decision relating to capital expenditures as opposed
to those for operating expenditures, are generally irreversible, and they require
careful selection techniques and procedures.

Capital budgeting is commonly referred to as fixed asset management,


when integrated with the financial manger’s goal of attending proper
combination of assets) i.e., optimal asset mix), fixed asset assume a great deal
of significance. Fixed assets are also frequently termed as the ‘earning asset’ of
the firm since they usually generate large returns. Since assets are the sources of
revenue generation for the firm and fixed asset its principal sources, it appears
logical that future sales growth is heavily correlated with the expansion of
capital expenditures.

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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 in 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 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 share
holders. In other words, as the number of shares of a company increases, the
company ownership of the individual stockholder may proportionally decrease.

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DEFINITION:

Capital budgeting is defined as “the firm decision to invest its current


funds most effectively in long term activities in anticipation of an expected flow
of future benefit over a serious of year.

Capital budgeting includes are those expenditure which are expected to


produce benefits to the firm over more than more one year, and encompasses
both tangible and intangible assets. Many companies follow the traditional
benefits occurring only the expenditure on tangible fixed assets.

“Capital Budgeting involves the process of planning expenditure whose returns


are expected to extend beyond one year”.
-Weston & Brigham

“Capital budgeting is long term planning for making and financing proposed
capital outlay”

-Charles T.Horngere

FEATURES OF CAPITAL BUDGETING DECISION:

• Potentially large anticipated benefits.


• A relatively high degree of risk.

A relatively long time period between the initial outlay and the
anticipated returns.

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NATURE OF CAPITAL BUDGETING DECISIONS:

The investment decision of a firm are generally know 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 effectively in
the long – term asset are those that affect the firm’s operational beyond the one
year period.

Investment decisions generally include expansion, acquisition


modernization and replacement of the long term asset sale of a division or
business (divestment) is also an investment decision. Decision like the change
in the method of sales distribution, or an advertisement campaign or a research
and developing program have long – term implication for the firm’s
expenditures and benefits , and therefore e, they should also be evaluated as
investment decision.

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.

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SCOPE OF THI STUDY:


The study of capital budgeting in Tulasi seeds pvt Ltd includes analyzing
the investment decision of the firm. As substantial amounts are tied up in such
decision, it needs careful analysis and proper management in order to minimize
the manufacturing costs and maximize its profits. As the information available
is limited and the subject is vast the study is combined to overall capital
budgeting techniques followed at the firm.

CAPITAL BUDGETING PROCESS:

Capital budgeting is a complex process as it involves decisions relating to


the investment of current funds for the benefits to be achieved in future and the
future is always uncertain. However, the following procedure may be adapted in
the process of capital budgeting. There are five stages in the capital budgeting
process.

Identification of
Assembling of
Investment Decision making
investments
opportunities

Performance Implement Preparation of


review action capital budget

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Process of capital budgeting


 Identification of investment opportunities:

The capital budgeting process begins with the identification of potential


investment opportunities. Typically, the planning body (it may be an
individual or committee organized formally or informally) develops
estimates of future sales which identifying required investment in plant
and equipment.
Identification of investment ideas it is helpful to:
 Monitor external environment regularly to scout investment
opportunities.
 Formulate a well defined corporate strategy based on
through analysis of strengths, weaknesses, opportunities, and
threats.
 Share corporate strategy and respective with persons.
 Motivate employees to make suggestions.
 Assembling of investment proposals:
Investment proposal identified by the production department and other
department are usually submitted in a standardized capital investment proposal
form. Generally, most of the proposal, before they reach the capital budgeting
committee or viewed from different angle. It also helps in creating a climate for
bringing about co-ordinations of linters related activities.
Investment, proposals are usually classified into various categories for
facilitating decision – making, budgeting, and control.
 Replacement investments
 Expansion investments.
 New product investments.
 Obligatory and welfare investment.

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 Decision making:
A system of rupee gateways usually characterized capital
investment decision making. Under this system executive are
vested with power to pay investment proposals up to certain limits.
 Preparation of capital budgeting:

Projects involving smaller out lays and which can be decided by


executives at lower levels are often covered by a blanket
appropriation for expenditures action. Projects involving larger
outlays are included in the capital budget after necessary approvals.
Before under facing such projects an appropriation order is usually
required. The purpose of this check is mainly to ensure that the
funds position of the firm satisfactory at the time of
implementation.

 Implementation:

Translating an investment proposal in to a concert project is a


complex, time consuming, and risk-fraught task.

 Adequate formulation of projects


The major reasons for delay is insinuate formulation of projects
put differently, if necessary home work in terms of preliminary
comprehensive and detailed formulation of the project

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 Use of the principal of responsibility accounting:


Assigning specific responsibility to project managers for completing the
project within the defined time-frame and cost limits is helpful for execution
and cost control.

 Use of network techniques


For project planning and control several network techniques like
PERT (programmed evolution review techniques) and CPM
(critical path method) is available.

 Performance review:

Performance review, or post-completion audit, is a feed back device. It is


a means for comparing actual performance with projected performance. It
may be conducted, moat appropriately. When the operation of the project
have stabilized.

It is useful several ways.


 It throws light on how realistic were the assumption
underlying the project.
 It provided a documented log of experience that is highly
valuable for decisional making.

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COMPONENTS OF CAPITAL BUDGETING:

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 a
cash outflow during that period.

Net Cash benefits or savings from the operations:

This component is calculated as under:-


(The incremental change in operating revenues minus the incremental
change in the operating cost = Incremental net revenue) minus (taxes) plus or
minus (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.

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The Net Present Value technique:

Although there are several methods used in Capital Building, 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.

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

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.

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Investment decisions – Capital budgeting

Capital budgeting is vital in marketing decisions. Decisions on


investment, which take time to mature, have to be based on the returns which
that investment will make. Unless the project is for social reasons only, if the
investment is unprofitable in the long run, it is unwise to invest in it now.
Often, it would be good to know what the present value of the future
investment is, or how long it will take to mature (give returns). It could be much
more profitable putting the planned investment money in the bank and earning
interest, or investing in an alternative project.
Typical investment decisions include the decision to build another grain
silo, cotton gin or cold store or invest in a new distribution depot. At a lower
level, marketers may wish to evaluate whether to spend more on advertising or
increase the sales force, although it is difficult to measure the sales to
advertising ratio.

Objectives of capital budgeting:

This chapter is intended to provide:


o An understanding of the importance of capital budgeting in marketing
decision making
o An explanation of the different types of investment project

o An introduction to the economic evaluation of investment proposals


o The importance of the concept and calculation of net present value and
internal rate of return in decision making

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o The advantages and disadvantages of the payback method as a technique

for initial screening of two or more competing projects.

Structure of the chapter

Capital budgeting is very obviously a vital activity in business. Vast sums


of money can be easily wasted if the investment turns out to be wrong or
uneconomic. The subject matter is difficult to grasp by nature of the topic
covered and also because of the mathematical content involved. However, it
seeks to build on the concept of the future value of money which may be spent
now. It does this by examining the techniques of net present value, internal rate
of return and annuities. The timing of cash flows are important in new
investment decisions and so the chapter looks at this “payback” concept. One
problem which plagues developing countries is “inflation rates” which can, in
some cases, exceed 100% per annum. The chapter ends by showing how
marketers can take this in to account.

CAPITAL BUDGETING VERSUS CURRENT EXPENDITURES

A Capital investment project can be distinguished from current


expenditures by two features:

a) Such projects are relatively large

b) a significant period of time (more than one year) elapses between the
investment outlay and the receipt of the benefits.

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As a result, most medium-sized and large organizations have


developed special procedures and methods for dealing with these
decisions. A systematic approach to capital budgeting implies:

a) The formulation of long-term goals

b) The creative search for and identification of new investment


opportunities

c) Classification of projects and recognition of economically


and/or statistically dependent proposals.

d) The estimation and forecasting of current and future cash flows

e) A suitable administrative framework capable of transferring the


required information to the decision level

f) The controlling of expenditures and careful monitoring of

crucial aspects of project execution

g) A set of decision rules which can differentiate acceptable from


unacceptable alternatives is required.

The last point (g) is crucial and this is the subject of later sections
of the chapter.

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THE CLASSIFICATION OF INVESTMENT PROJECTS

a) By project size
Small projects may be approved by departmental managers. More careful
analysis and Board of Directors approval is needed for large projects of,
say, half a million dollars or more.

b) By type of benefit to the firm

 An increase in cash flow


 A decrease in risk
 An indirect benefit (showers for workers, etc).

c) By degree of dependence

 Mutually exclusive projects (can execute project A or B, but not

both
 Complementary projects: taking project A increases the cash flow
of project B.
 Substitute projects: taking project A decreases the cash flow of
project B.

d) By degree of statistical dependence

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 Positive dependence
 Negative dependence
 Statistical independence.

e) By type of cash flow

 Conventional cash flow only one change in the cash flow sign e.g -
++++ or +----, etc
 Non-conventional cash flows: more than one change in the cash
flow sign,
e.g. +/-/+++ or -/+/-++++, etc

The economic evaluation of investment proposals

The analysis stipulates a decision rule for:


I) accepting or
II) rejecting

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INVESTMENT PROJECTS:

The time value of money:

Recall that the interaction of lenders with borrowers sets an equilibrium


rate of interest. Borrowing is only worthwhile if the return on the loan exceeds
the cost of the borrowed funds. Lending is only worthwhile if the return is at
least equal to that which can be obtained from alternative opportunities in the
same risk class.

The interest rate received by the lender is made up of :

i) The time value of money: the receipt of money is preferred sooner rather
than later. Money can be used to earn more money. The earlier the money
is received, the greater the potential for increasing wealth. Thus, to forego
the use of money, you must get some compensation.

ii) The risk of the capital sum not being repaid. This uncertainty requires a
premium as a hedge against the risk; hence the return must be
commensurate with the risk being undertaken.

iii) Inflation: money may lose its purchasing power over time. The lender

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must be compensated for the declining spending/purchasing power of


money. If the lender receive no compensation, he/she will be worse
off when the loan is repaid than at the time of lending the money.

a) Future values/compound interest

Future value (FV) is the value in dollars at some point in the future of one
or more investments.

The general formula for computing Future Value is as follows:

FV n = Vo (I + r)n

Where:

Vo is the initial sum invested


r: is the interest rate
n: is the number of periods for which the investment is to receive interest.

Thus we can compute the future value of what Vo will accoumulate


to in n years when it is compounded annually at the same rate of r by
using the above formula.

We can derive the Present Value (PV) by using the formula:

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FV n = Vo (I + r)n

By denoting Vo by PV we obtain:

FV n = PV (I + r)n

Rationale for the formula:

As you will see from the following exercise, given the alternative of
earning 10% on his money, an individual (or firm) should never offer (invest)
more than $10.00 to obtains $11.00 with certainty at the end of the yea

METHODS FOR EVALUTION:

Capital
budgeting
techniques

Non-DCF
criteria DCF criteria

Non-DCF Non-DCF Non-DCF Non-DCF Non-DCF


criteria criteria criteria criteria criteria

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Non DCF criteria

(a) Pay back period


The pay back period one of the most popular and widely recognized
traditional methods of evaluation investment proposals. Pay back period is the
number of years required to recover the original cash outlay invested in a
project.
If the project generates constant annual cash flows, the pay back period
can be computed by dividing cash outlay by the annual cash inflows.

Initial investment Co
Pay back period = Annual cash inflows C

Co = Initial investment

C = Annual cash inflows

In the case of un equal cash inflows, the pay back period can be
found out by adding up the cash inflow until the total is equal to the initial cash
outlay.

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(a) Accounting Rate of Return (ARR)

The accounting rate of return (ARR) also known as the return on


investment (ROI) uses accounting information, as revealed by financial
statements, to measure to profitability of an investment. The accounting rate of
return is the ratio of the average after tax profit divided by the average
investment. The average investment would be equal to half of the original
investment if it were depreciated constantly.

Average Income x 100


ARR = Average investment

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DCF CRITERIA

(a) Net Present value (NPV)

The NPV present value (NPV) method is the classic method of evaluating
the investment proposals. If is a DCF technique that explicitly recognizes the
time value at different time periods differ in value and comparable only when
their equipment present values – are found out.

C1 C2 C3 ………… +Cn
+ + + -C0
2 3 3
N.P.V = (1+k) (1+k) (1+k) (1+k)

n
N.P.V = ∑ C1 -C0
1
i=0 (1+k)

Where

NPV = Net present value

Cfi= Cash flows occurring at time

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k = The discount rate

n = life of the project in years

C0 = Cash outla

(b) Internal Rate of Return (IRR)

The internal rate of return (IRR) method is another discounted cash


flow technique which takes account of the magnitude and thing of cash flows,
other terms used to describe the IRR method are yield on an investment,
marginal efficiency of capital, rate of return over cost, time adjusted rate of
internal return and soon.

n Cfi SV + WC
NPV = ∑ +
1
i=0 (1+k) (1+k)n

Where

Cfi = Cash flows occurring at different point of time

k = the discount rate

n = life of the project in year

C0 = Cash out lay

SV & WC = Salvage value and working capital at the end of the n years.

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A
(H-L)
IRR = L + (a – b)

Where

L = Lower discount rate at which NPV is positive

H = Higher discount rate at which NPV is negative

A = NPV at lower discount rate, L

B = NPV at higher discount rate, H

( C ) Profitability index (PI)

Yet another time – adjusted method of evaluating the investment


proposals is the benefit – cost (B/C.) ratio or profitability index (PI) Profitability
index is the ratio of the present valued of cash inflows, at the required rate of
return, to the initial cash out of the investment.

PV of Cash inflow
PI = Initial Cash outlay

Where PV = Present Value

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CRITERIAN TABLE:-

In the evaluation process or capital budgeting techniques there will be a


criteria to accept or reject the project. The criteria will be expressed as:

Criterian/Method Accept Reject Indifferent

Pay Back Period <Target Period >Target Period = Target period


(PBP)
Accounting Rate >Target Rate >Target Rate = Target rate
of Return (ARR)
Net Present >0 >0 =0
Value (NPV)
Internal Rate of >Cost of Capital >Cost of Capital = cot of capital
Return (IRR)
Profitability >1 >1 =1
index (PI)

TYPES OF CAPITAL BUDGETING DECISIONS:

Capital Budgeting decisions are of paramount importance in financial


decision making. In first place they affect the profitability of the firm. They also
have a bearing on the competitive position of the firm because they relate to
fixed assets. The fixed assets are true goods than can ultimately be sold for-

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profit. Generally the capital budgeting of investment decision includes addition,


disposition, modification, and replacement of fixed assets.

EXPANSION

DIVERSIFICATION

REPLACEMENT

Types of
Capital budgeting
Decisions

RESEARCH AND DEVELOPMENT

MISCELLANEOUS PROPOSAL

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Expansion:

The company may have to expand its production capacities on accounts


of high demand for its products or inadequate production capacity. This will
need additional capital equipment.
Diversification:

A company may intend to reduce it risk by operating in several activities.


In such a case capital investment may become necessary for purchase of new
machinery and facilities to handle the new product.

Replacement:

The replacement of fixed assets in place of existing assets, either being


worn out or become out dated on account of new technology.

Research and Development:

Large sums of money may have to be spent for research and


development, in case those industries where technology is rapidly changing. In
such cases large sums of money are needed for research and development
activities. So these are also included in the proposals of Capital Budgeting.

Miscellaneous Proposals:

A company may have to invest money in projects, which do not directly


helping achieving profit-oriented goals. For example, installation of pollution

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control equipment may be necessary on account of legal requirements.


Therefore, funds are required for such proposal also.

Capital Budgeting and Public Financial Management:

Public investment is an important potential contributor to economic


growth and achievement of social development objectives. In addition to the
level of investment and the sect oral allocation, the capital budgeting process is
an important determinant of the quality of investment projects and their
implementation.
Recent years have seen renewed attention to capital investment for
economic growth and development. In particular, much attention has been given
to finding fiscal space for increasing capital investment. But, absent good
processes for using existing or new funds, the impact of capital investments will
not yield the expected results. This post provides and overview of selected
issues regarding capital budgeting and capital budgeting systems as an aid in
understanding what goes wrong and what might be done about it. The post
draws directly from a chapter written by the author for a World Bank

Public financial management (PFM) and capital budgeting:

Countries commonly adopt special processes for addressing capital or


investment spending given the size of the expenditures, their long-term costs
and benefits and their importance for public service delivery and economic

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development. The special treatment of capital goes beyond simple budgeting to


capital asset management.

Despite the importance of special attention to capital assets, the capital


budgeting process cannot be considered outside of the over-all public financial
management system. Capital spending is only one component of spending, and
needs to be considered within the context of government-wide and sector-
specific multi-year strategies and objectives. The capital budgeting process must
be fully integrated into the general budgeting and public financial management
process.

Defining Capital
While seemingly a straightforward question, governments around the
world, and even within a country, may define capital’ differently. Capital
spending is generally about physical assets with a useful life of more than one
year. But it also includes capital improvements or rehabilitation of physical
assets that enhance or extend the useful life of the asset (as distinct from a repair
or maintenance, which assures the asset us functional for its planned life).
Capital spending is sometimes equated with investment or development
spending, where expenditures have benefits extending years into the future.
Under this definition, governments may include physical assets for government
use (e.g. office buildings), physical assets of a public good nature that also
enhance private sector development (e.g. roads, water systems), and intangibles
(e.g education, research). It can be quite difficult to distinguish between
investment and non-investment expenditures, and if investment spending
receives favored treatment in the annual budgeting process, nearly all spending,
whether recurrent or not, will end-up being classified as investment.

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Every government establishes some arbitrary cut-off print to distinguish


capital from current expenditures. For budgeting purposes, the relevant
distinction is between capital and current or operating expenditures. Current
expenditures are purchases of assets to be consumed within

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