Treatise on Capital Budgeting: Estimation

of Cash Flows
1. Introduction

Many important business decisions require the selection of projects (investments) whose
outlays or benefits are spread out over several periods of time. The decision to acquire a
factory building, for example, may require a large immediate outlay of funds, and also
commits the company to the maintenance and operation of the building for a long period of
years. In evaluating investments proposals, it is important to weigh the expected benefits of
the investments against the expenses associated with it. For capital budgeting decisions, the
costs and benefits are measured more appropriately by the cash flows attributable to the
investment.

Capital budgeting decisions are related to the allocation of funds to different long term assets.
Broadly speaking, the capital budgeting decision denotes a decision situation where the lump
sum funds are invested in the initial stages of a projects and the returns are expected over a
long period. Though there is no hard and fast rule to define the long term, yet period
involving more than a year may be taken as a long period for investments decisions. The
capital budgeting decision involve the entire process of decision making relating to
acquisition of long term assets whose returns are expected to arise over a period beyond one
year.

Some of the capital budgeting decisions may be to buy land, building or plants; or to
undertake a program on research and development of a product, to diversify into a new
product line; a promotional campaign, etc. Some of these decisions may directly affect the
profit of the firm e.g., launching a new product, whereas some other decision may affect the
profit by reducing the costs e.g. replacing an existing machine by a more efficient one. But in
both the cases, the decision once taken set the profit line of the firm for several years.

All the relevant a functional departments play a crucial role in the capital budgeting decision
process of any organization, yet for the time being, only the financial aspects of capital
budgeting decisions are considered. The role of a finance manager in the capital budgeting
basically lies in the process of critical and in-depth analysis and evaluation of various
alternative proposals and then to select one out of these. The objective of capital budgeting is
to select those long-term investment projects that are expected to make maximum
contribution to the wealth of the shareholders.

2. Features and Significance

Capital budgeting decisions are those decisions that involve current outlay in return for a
series of benefits in coming years. The capital budgeting decisions are often said to be the
most important part of corporate financial management. Any decision that requires the use of
resources is a capital budgeting decision; thus the capital budgeting decisions cover
everything from broad strategic decisions at one extreme to say computerization of the office,
at the other. The capital budgeting decisions affect the profitability of a firm for a long
period, therefore the importance of these decisions is obvious. Even a single wrong decision
by a firm may endanger the existence of the firm as a profitable firm. There are several
factors and considerations which make the capital budgeting decisions as the most important
decisions of a finance manager. The relevance and significance of capital budgeting may be
stated as follows :

(a) Long-Term Effects : Perhaps, the most important features of a capital budgeting decision
and which makes the capital budgeting so significant is that these decisions have long term
effects on the risk and return composition of the firm. These decision affect the future
position of the firm to a considerable extent as the capital budgeting decisions have long term
implications and consequences. By taking a capital budgeting decision, a finance manager in
fact makes a commitment into the future, both by committing to the future needs of funds of
the projects and by committing to its future implications.

(b) Substantial Commitments : The capital budgeting decisions generally involve large

commitment of funds and as a result substantial portion of capital funds are blocked in the
capital budgeting decisions. In relative terms therefore, more attention is required for capital
budgeting decisions, otherwise the firm may suffer from the heavy capital losses in time to
come. It is also possible that the return from a projects may not be sufficient enough to justify
the capital budgeting decision.

(c) Irreversible Decisions : Most of the capital budgeting decisions are irreversible

decisions. Once taken, the firm may not be in a position to revert back unless it is ready to
absorb heavy losses which may result due to abandoning a project in midway. Therefore, the
capital budgeting decisions should be taken only after considering and evaluating each and
every minute detail of the project, otherwise the financial consequences may be far reaching.

(d) Affect the Capacity and Strength to Compete : The capital budgeting decisions affect
the capacity and strength of a firm to face the competition. A firm may loose competitiveness
if the decision to modernize is delayed or not rightly taken. Similarly, a timely decision to
take over a minor competitor may ultimately result even in the monopolistic position of the
firm.

Thus, the capital budgeting decisions involve a largely irreversible commitment of

resources i.e., subject to a significant degree of risk. These decisions may have far reaching
effects on the profitability of the firm. These decisions therefore, require a carefully
developed decision making process and strategy based on a reliable forecasting system.

3. Problems and Difficulties in Capital Budgeting

The capital budgeting decisions are not only critical and analytical in nature, but also involve
various difficulties which a finance manager may come across. The problems in capital
budgeting decisions may be as follows :

(a) Future Uncertainty : All capital budgeting decisions involve long term which is
uncertain. Even if every care is taken and the project is evaluated to every minute detail, still
100% correct and certain forecast is not possible. The finance manager dealing with the
capital budgeting decisions, therefore, should try to be as analytical as possible. The
uncertainty of the capital budgeting decisions may be with reference to cost of the project,
future expected returns from the project, future competition, expected demand in future, legal
provisions, political situation etc.
(b) Time Element : The implications of a capital budgeting decision are scattered over a long
period. The cost and benefit of a decision may occur at different point of time. As a result, the
cost and benefits of a capital budgeting decision are generally not comparable unless adjusted
for time value of money. The cost of a project is incurred immediately, however, it is
recovered in number of years. These total returns may be more than the cost incurred (in
absolute terms), still the net benefit cannot be ascertained unless the future benefits are
adjusted to make them comparable with the cost. Moreover, the longer the time period
involved, the greater would be the uncertainty.

(c) Measurement Problem : Some times a finance manager may also face difficulties in
measuring the cost and benefits of a projects in quantitative terms. For example, the new
product proposed to be launched by a firm may result in increase or decrease in sales of other
products already being sold by the same firm. But how much ? This is very difficult to
ascertain because the sales of other products may increase or decrease due to other factors
also.

4. Types of Capital Budgeting Decisions

Every capital budgeting decision is a specific decision in the given situation, for a given firm
and with given parameters and therefore, an almost infinite number of types or forms of
capital budgeting decisions may occur. Even if the same decision being considered by the
same firm at two different points of time, the decision considerations may change as a result
of change in any of the variables. However, the different types of capital budgeting decisions
undertaken from time to time by different firms can be classified on a number of dimensions.
In general, the projects can be categorized as follows:

4.1 From the Point of view of Firm’s existence 

The capital budgeting decisions may be taken by a newly incorporated firm or by an already
existing firm.

(a) New Firm : A newly incorporated firm may be required to take different decisions such
as selection of a plant to be installed, capacity utilization at initial stages, to set up or not
simultaneously the ancillary unit etc.

(b) Existing Firm : A firm which is already existing may also be required to take various
decisions from time to time to meet the challenges of competition or changing environment.
These decision may be :

(i) Replacement and Modernization Decision : This is a common type of a capital

budgeting decision. All types of plant and machineries eventually requires replacement. If the
existing plant is to be replaced because the economic life of the plant is over, then the
decisions may be known as a replacement decision. However, if an existing plant is to be
replaced because it has become technologically outdated (though the economic life may not
be over), the decision may be known as a modernization decision. In case of a replacement
decision, the objective is to restore the same or higher capacity, whereas in case of
modernization decision, the objective is to increase the efficiency and/or cost reduction. In
general, the replacement decision and the modernization decisions are also known
as cost reduction decisions.
(ii) Expansion : Sometimes, the firm may be interested in increasing the installed production
capacity so as to increase the market share. In such a case, the finance manager is required to
evaluate the expansion program in terms of marginal costs and marginal benefits.

(iii) Diversification : Sometimes, the firm may be interested to diversify into new product
lines, new markets, production of spare parts etc. In such a case, the finance manager is
required to evaluate not only the marginal cost and benefits, but also the effect of
diversification on the existing market share and profitability. Both the expansion and
diversification decisions may also be known as revenue increasing decisions.

(iv) Contingent Decisions : Sometimes, a capital budgeting decision is contingent to some

other decision. For example, computerization of a bank branch may require not only air-
conditioning but also transfer of some staff member to other branches. Similarly, installing a
project at some remote location may require expenditure or development of infrastructure
also. Any capital budgeting decision must be evaluated by the finance manager in its totality.
The contingent decision, if any, must be considered and evaluated simultaneously.

4.2 From the Point of view of Decision situation

The capital budgeting decisions may also be classified from the point of view of the decision
situation as follows :

(a) Mutually Exclusive Decisions : Two or more alternative proposals are said to be

mutually exclusive when acceptance of one alternative result in automatic rejection of all
other proposals. The mutually exclusive decisions occur when a firm has more than one
alternative but competitive proposals before it. For example, selecting one advertising agency
to take care of the promotional campaign out rightly rejects all other competitive agencies.
Similarly, selection of one location out of different feasible locations is a mutually exclusive
decision.

(b) Accept-Reject Decisions : An Accept-Reject decision occurs when a proposal is

independently accepted or rejected without regard to any other alternative proposal. This type
of decision is made when:

(i) proposal’s cost and benefit neither affect nor are affected by the cost and benefits of other
proposals

(ii) accepting or rejecting one proposal has not impact on the desirability of other proposals

(iii) the different proposals being considered are not competitive.

5. Capital Budgeting Decisions and Funds Availability

No business firm can possibly afford to undertake all the profitable proposals. The reason is
obvious i.e., no firm has unlimited funds. Had the funds available been un-limited, the firms
could have accepted and implemented all the projects which were expected to contribute to
the wealth of the firm, however small such contribution was. But this is not so in actual
practice. Every firm has only limited funds available and these funds are to be invested in
such a way so as to bring maximum contribution to the wealth of the firm.
Therefore, only those decisions are to be implemented which fulfil the following two
conditions :

(i) The cost of the project does not exceed the funds available, and

(ii) The benefits expected from the project are more than the cost.

The situation where the firm is not able to finance all the profitable investment opportunities
is known as capital rationing. If the total funds required by the profitable opportunities at
any particular point of time exceed the available funds with the firm, then the firm is said to
be operating under conditions of capital rationing. The capital rationing implies that the firm
is unable or unwilling to procure the additional funds needed to undertake all the capital
budgeting proposals before it. The problem faced by a finance manager in this situation is as
to how to allocate the available scarce capital among various proposal. Out of different
independent proposals (accept reject decisions), only those may be accepted in order of
priority which entails the total cost within the limit of available fund. In case of mutually
exclusive proposals, the cost of selected proposal must not exceed the available fund.

6. Capital Budgeting Decisions : Assumptions and Procedure

The capital budgeting decision process, as already stated is a complete multifaceted and
analytical process. A finance manager however, has to concentrate only on the financial
aspects of the proposal and therefore he is likely to ignore the non-financial considerations. A
number of assumptions are required to be made in order to concentrate on the financial
aspects. These assumptions in fact constitute a general set of conditions within which the
financial aspects of different proposals are to be evaluated. Some of these assumptions are :

1. Certainty With Respect to Cost and Benefits : This assumption implies that the cost and
benefits associated with a proposal are known with certainty. It may be difficult to estimate
the cost and benefits proposals for a period beyond 2-3 years in future. However, for a capital
budgeting decision, it is assumed that accurate forecast of cost and benefits of a proposals is
available for the entire economic life of the proposal. Moreover, it is reasonable to resolve the
certainty problem before being concerned with the process of capital budgeting decisions.

2. Profit Motive : Another assumption is that the capital budgeting decisions are taken with a
primary motive of increasing the profit of the firm. No other motive or goal affect the
underlying efforts of the finance manager.

3. No Capital Rationing : The capital budgeting decisions being discussed here assume that
there is no scarcity of capital funds and the firm is not faced with capital rationing.

The capital budgeting decision procedure basically involves the evaluation of the desirability
of an investment proposal. It is obvious that the firm must have a systematic procedure for
making capital budgeting decisions. The procedure must be consistent with the objective of
wealth maximization. In view of the significance of capital budgeting decisions, the
procedure must consist of step by step analysis. The finance manager should use the best
information and techniques available to take the capital budgeting decisions. In the process,
he may undertake the following steps:
(a) Estimation of Costs and Benefits of a Proposal : The most important step required in
the capital budgeting decisions is to estimate the cost and benefit associated with all the
proposals being considered. The cost of a proposal is generally the capital expenditure
required to install a project or to implement a decision. However, the benefits of a proposal
may be in the form of increased output, increased sales, reduction in labour cost, reduction in
wastages etc. Every proposal is to be examined in the light of its cost and benefits. The
estimation of cost and benefit has been discussed at a later stage in the same chapter.

(b) Estimation of the Required Rate of Return : The rate of return expected from a
proposal is to be estimated in order to (i) adjust the future cost and benefit of a proposal for
time value of money, and (ii) thereafter, determining the profitability of the proposal. This
required rate of return is also known as Cost of Capital and has been discussed in detail in
Chapter 10. The funds available to a firm can either be invested in a capital budgeting
proposal or can be invested elsewhere. So, a firm should invest the funds in a capital
budgeting proposal, only if the return is at least equal to the return available from investments
made elsewhere. This rate of return is known as opportunity cost or minimum required rate of
return. It is used as a discount rate in capital budgeting.

(c) Using the Capital Budgeting Decision Criterion : A proper capital budgeting technique
is to be applied to select the best alternative. So, in the first instance the technique itself is to
be selected and then is to be applied for a better decision making.

However, in the following paragraphs, the first step i.e., the estimation of cost and benefits
has been discussed in detail.