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Subject

Paper No and Title Paper No 8: Financial Management

Module No and Title Module No 5: Capital budgeting – nature and process

Module Tag COM_P8_M5

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_ TABLE OF CONTENTS

1.LearningOutcomes

2. Introduction

3.Nature of Investment Decisions

4.Importance of Capital Budgeting Decisions

5.Types of Investment Decisions

6. Investment Decision
Criteria

7. Summary

1. Learning Outcomes
 After studying this
module, you will be able
to

∙ Understand the
meaning of Capital Budgeting.
∙ Appreciate the nature of Investment Decisions.
∙ Show the importance of
Capital Budgeting.
∙ Know the types of
Investment Decisions.
∙ Identify the Investment
Decision Criteria.

2. Introduction: Capital Budgeting

A corporate
entity exists
to serve
some goals. Its objectives are defined in its mission statement. Some companies thrive to
develop new products, some target new services and some other may have the desire to
provide quality products to its customers. The mission of the business is carried out by
developing various goods and services. The production of goods and services require
plant and machinery, tools, technologies, workers, raw material and other productive
assets. The assets of the company consist of long term assets like plant and machinery,
land and building. It also includes some short term assets like stocks of raw material and
so on.In order to carry out these goals, companies make proper planning to smoothly run
its operations. One of the major functions of the firm which has garnered significant
attention is the management of its financial matters. This module focuses on investment
decision of the corporate entity.The investment decision of long term assets of the firm is
called capital budgeting decision which is the subject matter of this module. The short
term assets are managed under working capital decision and this topic is discussed in a
separate module. Thus the capital budgeting decision is the long term investment decision
of the firm.
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3. Nature of Investment Decisions

Capital Budgeting has certain peculiar features which are as follows:

a) It is the long term investment plan of the firm whose payoff structure spreads over
a period of time. This period is usually more than a year.

b) It involves a pattern of cash flows over the years. Initially funds are tied up in
purchasing equipment and later on it is followed by the generation of revenue for
future years.

c) The element
of risk is
involved in the
investment as the funds are employed
immediately; however the return is anticipated to occur in future time period.

As future is uncertain, we cannot be certain about the realization of our expected

return.

d) It involves
sizable amount
of funds which makes it costly to rectify if planning
does not work properly.

The capital
budgeting
decisions are
very crucial
for the
success of
the business.
A simple
example of capital budgeting decisions may be the decision to open a new retail outlet in
a city by Reliance fresh. The decision to start a new manufacturing unit in India by Audi
is also an example of capital budgeting decision. The desire of Audi is to stay in business
for long period of time involves substantial financial commitment on its part which is
enough to qualify it as capital budgeting decision.

4. Importance of Capital Budgeting Decisions

The capital budgeting decision is one of the most important decisions taken by the
business entity.

The main reasons for its importance are:

 I. The survival of the firm depends on choosing the right kind of project. Therefore
proper care should be taken to ensure that the beneficial projects are taken by
using capital budgeting analysis.
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II. Once the survival of the firm is secured, the next

task is to make efforts to achieve consistent growth. The growth comes from
making profitable investment decision which is the subject matter of capital
budgeting decision.

III. The long term decisions are risky decisions due to element of uncertainty regarding
future events.

IV. The amount of funds involved is very high. The decision once taken cannot simply be
reversed without incurring huge costs.

The capital
budgeting
decisions
play an
important role in survival and success of the firm.

5. Types of Investment Decisions There are various types of investment decisions which
are taken by the firms. They can be simply starting a new business or expansion and
diversification of existing business.
 The main investment decisions are as follows:

1. Setting up a
new business
which requires
land and building, plant and machinery
and so on.

2. The existing
corporate
entities may also
take any of the following investment
decision in the course of running of the business.

a. Expansion: It refers to widening the production capacity of a firm.

Suppose Apple is manufacturing 1,00,000 units of its i-phone each year
with its given capacity. In case of increase in demand or its expectation of
increasing its sales, it decides to manufacture 2,00,000 units of cell
phones. This is the example of expansion which requires more capacity
and new machinery and equipment to deal with increased production
decision.

b. Diversification: It means entering into new areas of business to increase its

products base. Suppose a telecom operator such as Airtel which provides
its telecommunication services, now decides to manufacture cell phones.
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This will be termed as diversification and

is taken by using capital budgeting techniques.

c. Replacement: In case of a going concern, it is natural that some of its

equipment will wear out as the time proceeds. In order to maintain the
production capacity, firm needs to replace those assets with new ones.
This replacement decision is the most common investment decisions of the
firms.
 d. Modernization: The use of new technology and instruments to provide
good and services is known
as modernisation. The use
of computers
instead of
typewriters is
the simple example of modernisation.

The investment decision can also be classified on the basis of their manner of selection.

This categorization is as follows:

1. Independent investment decision: suppose a firm plans to manufacture tables and

chairs. It assesses its
costs and benefits.
The decision is
taken on the basis of
its
profitability without considering any other option. This kind of investment
decision is independent decision which is taken on its merit.

2. Mutually
exclusive
decision:
Another class of
decision is mutually exclusive.
Under this situation, there are various ways available for using given resources.

For a student, whether to attend the lecture or watch a movie is a mutually

exclusive decision. The selection of one alternative automatically involves
rejection of other alternative or alternatives. Similarly, in case of firms there are
alternative ways available for producing goods and services. For example,
suppose there are three machines A, B and C are available to produce any goods.
The selection of one machine will result in rejection of other machines. This type
of decision where selection of one alternative results in rejection of rest of the
available options is called mutually exclusive decisions.
 3. Contingent investment decision: Investment decisions which are contingent on
happening of any other event or decision are known as contingent investment
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decisions. For Example, when a project is taken by

the firm in remote areas, there is a need to build roads, medical house and other
infrastructure to support the production process. These addition investment plans
are contingent on taking the investment decision in remote area. Thus, these
decisions are contingent investment decisions.

6. Investment Decision Criteria

The basis of making an investment decision is guided by the overall objective of financial
management. The most commonly accepted goal of financial management is wealth

maximisation. It is reflected in the increase in market price of share. Thus the main
criterion of making investment decision is to assess its impact on its market price as
market price reflects the wealth of the shareholders.

The main process of taking investment decision is a three step process:

1. The cash flows associated with any project are forecasted. It involves a series of
 cash flows over a period of time. Initially when an investment is made, outflow of
cash takes place and
then it is followed
by the generation of
revenue from the
project’s activities.
Thus, the first step in capital budgeting decision is to estimate
the cash flows associated with that decision.

2. The cash
flows for various
years are not
directly comparable. For example,
suppose there is a project which costs Rs. 1,00,000 and it would generate the net
cash flows of Rs. 15,000 , Rs.20,000 , Rs. 22,000 , Rs. 250000 and Rs. 30,000 for
the five year’s life of the project. The cash flows which will be received in future
cannot be just added to compute the total amount of revenue which is estimated to
be earned by the project. The reason for this lies in the concept of time value of
money. This concept states that Rs. 100 received today is not the same as Rs. 100
to be received after a year.

The value of Rs. 100 to be received in future is less than the value of Rs. 100 to
be received today. In order to compute the value of Rs. 100 which is to be
received after one year now, we need to discount it at appropriate rate of interest.
Similarly, in order to make the money received in future time period comparable,
we need to discount these sums at the appropriate discount rate.
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This relevant discount rate is known as weighted

average cost of capital or overall cost of capital. In the present module, we will
assume it as given as this topic is discussed in great detail in some other module.

3. Once we compute the relevant cash flows and we have appropriate discount rate
at our disposal to compute their present values, we can proceed to use various
capital budgeting techniques to make investment decision. The most common and
easiest way to make investment decision is to compare the investment or the cost
 of the project with the present value of the cash flows to be generated by the
project. Suppose in above example, the present value of all the cash inflows for
the five years is Rs. 1,20,000 . Under this situation, the benefits in present value
terms exceed the
cost of undertaking
the project which is
Rs. 1,00,000. More
precisely, the net amount generated by the project is Rs. 20,000, it is also known
as net present value (NPV). Thus a project is accepted when it has positive NPV,
otherwise it is
rejected. There are
other capital
budgeting
techniques also
which
are discussed in other modules.

7. Summary

• The investment decision of long term assets of the firm is called capital budgeting
decision.

• Capital
Budgeting has
certain peculiar
features such as it is the long term
investment plan, involves a pattern of cash flows over the years, element of risk is
involved in the investment, it involves sizable amount of funds and it is costly to
reverse.

• The capital
budgeting decision
is one of the most important decisions taken by the
business entity because the survival and consistent growth of the firm depends on
choosing the right kind of project, long term decisions are risky decisions and the
amount of funds involved is very high.

• There are various types of investment decisions which are taken by the firms such
as setting up a new business, expansion, diversification, replacement,
modernization. Also, investment decisions can be independent, mutually
exclusive or contingent.

• The main process of taking investment decision is a three step process. First, the
cash flows associated with any project are forecasted. Secondly, we have to
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choose appropriate discount rate at our disposal to

compute their present values. Finally, we can proceed to use various capital
budgeting techniques to make investment decision.

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