SUBJECT: FINANCIAL MANAGEMENT TOPIC: CAPITAL BUDGETING

INTRODUCTION:Capital budgeting (or investment appraisal) is the planning process used to determine whether an organizations long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Definition: Capital Budgeting may be defined as the decision-making process by which firms evaluate the purchase of major fixed assets including buildings, machinery etc. which are not meant for sale. According to Charles T. Horngreen, Capital Budgeting is long term planning for making and financing proposed capital outlay. Milton H. Spencer has defined Capital Budgeting as, Capital Budgeting involves the planning of expenditure for assets, the returns from which be realized in future time period. Again in the words of Robert N. Anthony, The Capital Budget is essentially a list of what management believes to be the worthwhile projects for the acquisition of new capital assets together with the estimated cost of each project. From the above definitions, it may be concluded that, capital budgeting is an evaluation process for a proposed project to forecast the likely or expected return from the project. This evaluation generally begins with an expenditure of cash at the beginning of the projects service life and a stream of cash flowing to the firm over the period of the project.

IMPORTANCE OF CAPITAL BUDGETING:Capital Budgeting decisions are of extremely important to any modern firm to survive. The profitability, growth and the long run survival largely depends on Capital Budgeting Decisions. Its survival in the competitive market depends on the constant flow of new investment ideas for modernization of the production

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process, diversification of products, etc. Apart from these some other significances of Capital Budgeting decisions are as follows: Substantial amount of investments: The Capital Budgeting decisions generally involve substantial amount of funds which make it imperative for the firm to plan its investment programmes very carefully. As a substantial portion of capital funds are being blocked in the capital budgeting decisions, it affects the financial health of the firm for a long period of time. The wrong and hasty decisions of the firm will not only result into heavy capital losses in time to come but may also account for the financial failure of the firm. Irreversible decisions: It is also important to note that the major part of a capital investment project is irreversible in the sense that once such project is undertaken, it becomes difficult to take investment decisions of a different nature for a short period. Prudent decisions are an essential part of capital budgeting. Proper procedures are needed for screening such investment projects. Long term implications: One of the most important reasons for capital budgeting decisions is that they have long term implications for a firm. The effects of a capital budgeting decision extend into the future and have to be put up with for a longer period than the consequences of current operating expenditure. Complex decisions: Decisions relating to capital budgeting are among the difficult and at the same time, the most critical. Moreover its very difficult to quantify all the benefits or costs relating to a particular investment decision, as these are largely dependent on economic, political, social and technological factors. Sales forecast: Investments in fixed assets is related with implied forecast of future sales. For example, investment in machinery will help the firm to meet the demand in the future by forecasting sales. Cash forecast: Capital investment requires substantially large amount of funds. This fund can only be arranged by making serious efforts to ensure their availability at the right time. It facilitates cash forecast to plan the investment proposals carefully, so that the firm can meet its long term obligations without any delay and difficulty. Over and undercapacity : Investment decisions based on sophisticated techniques, managerial skill and experience will usually improve the timing and quality of asset acquisition. If done poorly, it can cost the firm large sums of money because of overcapacity or undercapacity or both. Social importance: From macro point of view, individual investment decisions should have a substantial impact on the society because it determines employment, economic activities and economic growth. Impact on other financial decisions: Financing decisions and dividend decisions are some areas of financial management where capital budgeting decisions have remarkable impact. Decision in respect of a profitable investment project not only justifies the appropriate financing decisions but it has impact on the dividend decisions of the firm too. Wealth maximization to the share holders: Most of the firms are suffering from financial failure because they do not have proper balance among investment projects because either they have too much or too little capital equipment in comparison to their needs. Therefore management facilitates

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the wealth maximization of shareholders by avoiding over-investment and under-investment in fixed assets. Thus decisions in respect of capital budgeting should be taken very carefully so that the future plans of the firm are not affected adversely.

TYPES OF CAPITAL BUDGETING DECISIONS:There are many ways to classify the capital budgeting decision. Generally capital investment decisions are classified in two ways. One way is to classify them on the basis of the firms existence. Another way is to classify them on the basis of decision situation. 1. On the basis of firms existence: The capital budgeting decisions are taken by both newly incorporated firms as well as existing firms. The new firms may be required to take decision in respect of selection of a plant to be installed. The existing firm may be required to take decisions to meet the requirement of new environment or to face the challenges of competition. These decisions may be classified as follows: Replacement and Modernization decisions: These decisions aim to improve operating efficiency and reduce cost. Generally all types of plant and machinery require replacement either because economic life of plant or machinery is over or because it has become technologically outdated. The former decision is known as replacement decisions and the later is known as modernization decisions. Expansion decisions: Existing successful firms may experience growth in demand of their product line. If such firms experience shortage or delay in the delivery of their products due to inadequate production facilities, they can consider proposal to add capacity to existing product line. Diversification decisions: These decisions require evaluation of proposals to diversify into new product lines, new markets etc. for reducing the risk of failure by dealing in different products or by operating in several markets. 2. On the basis of decision situation: The capital budgeting decisions on the basis of decision situation are classified as follows: Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or more alternative proposals are such that the acceptance of one proposal will exclude the acceptance of the other alternative proposals. For instance, a firm may be considering proposal to install a semi-automatic or highly automatic machine. If the firm installs a semiautomatic machine, it excludes the acceptance of proposal to install highly automatic machine. Accept-reject decisions: The accept-reject decisions occur when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. Contingent decisions: The contingent decisions are dependable proposals. The investment in one proposal requires investment in one or more other proposals. For example, if a company accepts a proposal to set up a factory in a remote area, it may also have to invest in infrastructure etc.

CAPITAL BUDGETING PROCESS:The extent to which the capital budgeting process needs to be formalized and systematic procedures established depends on the size of the organization; the composition of the firms existing assets and managements desire to change that composition; timing of expenditures associated with the projects that are finally accepted. Planning: The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firms fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase. Evaluation: This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be one that enables the manager to make the best decision in the light of prevailing circumstances. Selection: Considering the returns and risks associated with the individual projects as well as the cost of capital to the organization, the organization will choose among projects so as to maximize shareholders wealth. Implementation: When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project. Control: The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits. Review: When a project terminates, or even before, the organization should review the entire project to explain its success or failure. This phase may have implication for firms planning and evaluating procedures. Further, the review may produce ideas for new proposals to be undertaken in the future.

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.

PROJECT CASH FLOWS:One of the most important tasks in capital budgeting is estimating future cash flows for a project. The final decision we make at the end of the capital budgeting process is no better than the accuracy of our cash-flow estimates. The project cash flow stream consists of cash inflows and cash outflows. The costs are denoted as cash outflows whereas the benefits are denoted as cash inflows. Cash flows can be calculated as follows:Initial cash flow: Cost of new assets + Installation/Set up Costs +(-) Increase (Decrease) in Net Working Capital level (-) Net Proceeds from sale of old asset (if it is a replacement situation) +/(-) Taxes (tax saving) due to sale of old assets (if it is a replacement situation) = INITIAL CASH OUTFLOW. Interim Incremental cash flows: Net increase (decrease) in operating revenue +(-) Net increase (decrease) in operating expenses excluding depreciation = Net change in income before taxes. +(-) Net decrease (increase) in taxes = Net change in income after taxes. +(-) Net increase (decrease) in tax depreciation charges = INCREMENTAL NET CASH FLOW FOR THE PERIOD. Terminal-Year Incremental Net cash flow: Incremental Net cash flow for the period +(-) Final salvage value (disposal cost) of asset -(+) Taxes (tax saving) due to sale or disposal of assets +(-) Decreased (increased) level of Net Working Capital = TERMINAL-YEAR INCREMENTAL NET CASH FLOW.

SOME IMPORTANT TERMS: Payback period: Payback

period of an investment is the expected number of years required to recover a projects cost. inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two weaknesses of the IRR. The MIRR correctly assumes reinvestment at the projects cost of capital and avoids the problem of multiple IRRs. However, the MIRR is not used as widely as the IRR in practice. method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project.

Net Present Value (NPV): The difference between the present value of cash Internal Rate Of Return (IRR):

Modified IRR (MIRR):

Profitability Index (PI): The profitability Index or PI,

CONCLUSION:-

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

REFERENCES Financial Management by Majumdar, Nisha, Ali Financial Management for IPCC issued by ICAI www.wikipedia.org
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