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Capital Budgeting Unit- 5

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Capital budgeting

The decisions regarding the amount to be invested in fixed assets is called as capital budgeting It is the decision whether or not the money should be invested in long term projects The term capital budgeting contains two words Capital- the relatively scarce 4/17/12 resource of production

Budgeting- indicates detailed, quantified planning which guides future activities of an enterprise towards the achievement of its profit goals. Capital funds is increased by an inward flow of cash and is decreased by outward flow of cash It is therefore important for an enterprise to plan and arrange cash flows properly
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The investment in these projects are quite heavy and are to be made immediately but the returns will be available only after a period of time. It requires the comparison of cost against the benefit over a long period of time. Capital budgeting is planning of deployment of available capital for maximizing the long term profitability
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Features of capital budgeting:

1. 2. 3.

Potentially large anticipated benefits A relatively high degree of risk Relatively long time period between the initial outlay and anticipated return

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Types of Capital Budgeting decisions:

1. 2. 3. 4.

Replacement Expansion Diversification Other projects which are of statutory requirement

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Capital Budgeting process:

It involves generation, evaluation , selection and follow up of capital expenditure alternatives The firm comes across three types of decisions Accept reject decision: Here the projects do not compete with each other they are independent All those projects, which yield return

1. -.

-.

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2. Mutually exclusive :
-

These are the projects which competes with other project in such a way that the acceptance of one will exclude the acceptance of other project Only one project can be selected at a time

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3. Capital rationing decision :

-

In a situation where the firm has unlimited funds, all independent projects yielding greater returns than the predetermined level can be selected However in practice these situation does not prevail in most of the business firms A company may have several proposals involving capital

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However the main constraint in such a case is the availability of funds required to finance all these proposals In such a case there is need of capital rationing which ensures that the available funds are used in an optimum manner A company shall have to rank the various proposals on the basis of highest priority, may be on the basis of rate of return or urgency or both 4/17/12

A cut off point is decided and the projects above cutoff point are selected and below cut off point are rejected or delayed

Capital rationing means choice of investment proposals under financial constraints Capital rationing means utilization of existing funds in a most profitable manner by selecting the acceptable projects in the descending order
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Capital rationing may arise due to : Scarcity of funds Internal constraints imposed by management Capital rationing is utilized as a means of putting a limit or cap on portion of the existing budget This approach helps to ensure that funds available for basic operations are not diverted elsewhere, which helps to maintain stability. 4/17/12

Impact of inflation on capital budgeting decisions

Inflation may be defined as decline in purchasing power of money Inflation affects future cash flows and returns expected by the investors i.e. the discount rate The discount rate consist of the required rate of return on a riskless investment plus risk premium that is related to a projects risk
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Inflation affects both risk-free

While analyzing inflation, we distinguish between the real rate of interest and nominal rate of interest Nominal rate of interest ( Money rate of interest) consist of: The real rate of interest Inflation element, i.e. the premium demanded because of anticipated decline in the general purchasing power of money

1.

a) b)

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2. Real rate of interest also consist of two parts:

a)

A risk-free element ( pure rate of interest paid on long term government securities and bonds ) A business risk element( the risk premium above the pure rate that is demanded for undertaking risk )

b)

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According to Irving Fisher ( Theory of interest) , the noted economist , interest rates quoted on risk-free investment reflect anticipated inflation. Fisher recommended following equation dealing with normal rate of interest , the real rate of interest and the expected inflation (1+ Nominal rate of interest)= (1+ real rate of interest)*( 1+ Expected rate of inflation) 4/17/12

Factor to be considered in Capital Budgeting:

1. 2. 3. .

Cash outflow Cash inflow Estimated time The estimation of cash flows- both inflows and outflows is the crux for evaluation of projects this estimation should be done as carefully as possible.

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How to compute cash flows?

1.

Cash outflow= Cost of new equipment or plant + Installation Expenses + Other Capital Expenditure + Additional working capital Tax benefits on account of loss on sale of old plant (if any) Salvage value of old plant + Tax liability on account of capital gain on sale of old plant( if any)

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