Dr.
Akhilesh Das Gupta Institute of Technology & Management
BBA Department
Name of Faculty: Mr. Sachin Jindal
Subject Code: BBA
Subject Title: Financial Management
Notes
Unit-III
Meaning of Capital Budgeting: Capital Budgeting refers to the planning
process which is used for decision making of the long term investment. It helps
in deciding whether the projects are fruitful for the business and will provide
the required returns in the future years. It is important because capital
expenditure requires a huge amount of funds. So before making such
expenditures in the capital, the companies need to assure themselves that the
spending will bring profits to the business. Investments in heavy machinery or
big constructions are examples of capital budgeting.
Capital budgeting process is a decision-making process where a company
plans and determines any long-term Cap-ex whose returns in terms of cash
flows are expected to be received beyond a year. Investment decisions may
include any of the below:
Expansion
Acquisition
Replacement
New Product
R&D
Major Advertisement Campaign
Welfare investment
Features of Capital Budgeting
Capital Budgeting is characterized by the following features:
There is a long duration between the initial investments and the expected
returns.
The organizations usually estimate large profits.
The process involves high risks.
It is a fixed investment over the long run.
Investments made in a project determine the future financial condition of an
organization.
All projects require significant amounts of funding.
The amount of investment made in the project determines the profitability of
a company.
Objectives of Capital Budgeting
The following points present the objectives of the capital budgeting:
Capital Expenditure Control: Organizations need to estimate the cost of
investment as it allows them to control and manage the required capital
expenditures.
Selecting Profitable Projects: The company will have to select the most
appropriate project from the multiple possibilities in front of it.
Identification of Source of funds: The businesses need to locate and
select the most viable and apt source of funds for long-term capital
investment. It needs to compare the various costs like the costs of
borrowing and the cost of expected profits.
Limitations of Capital Budgeting
Although capital budgeting provides a lot of insight into the future prospects of a
business, it cannot be termed a flawless method after all. In this section, we learn
about some of the limitations of capital budgeting.
Cash Flow
It is a simple technique that determines if an enhanced value of a project justifies
the required investment. The primary reason to implement capital budgeting is to
achieve forecasting revenue a project may possibly generate. The problem could be
the estimate itself. All the upfront costs or the future revenue are all only estimates
at this point. An overestimation or an underestimation could ultimately be
detrimental to the performance of the business.
Time Horizon
Usually, capital budgeting as a process works across for long spans of years. While
the shorter duration forecasts may be estimated, the longer ones are bound to be
miscalculated. Therefore, an expanded time horizon could be a potential problem
while computing figures with capital budgeting.
Besides, there could be additional factors such as competition or legal or
technological innovations that could be problematic.
Time Value
The payback period method of capital budgeting holds a lot of relevance, especially
for small businesses. It is a simple method that only requires the business to repay
in the predecided timeframe. However, the problem it poses is that it does not count
in the time value of money. This is to say that equal amounts (of money) have
different values at different points in time.
Discount Rates
The accounting for the time value of money is done either by borrowing money,
paying interest, or using one’s own money. The knowledge of discount rates is
essential. The proper estimation and calculation of which could be a cumbersome
task.
Even if this is achieved, there are other fluctuations like the varying interest rates
that could hamper future cash flows. Therefore, this is a factor that adds up to the
list of limitations of capital budgeting.
Methods of Capital Budgeting
There are five major techniques used for capital budgeting decision analysis
to select the viable investment are as below:
#1 – Payback Period
Payback Period is the number of years it takes to recover the investment’s
initial cost – the cash outflow –. The shorter the payback period, the better it is.
Features:
Provides a crude measure of liquidity
Provides some information on the risk of the investment
Simple to calculate
#2-Discounted Payback Period
Features:
It considers the time value of money
Considers the risk involved in the project cash flows by using the cost of
capital
#3-Net Present Value Method
NPV is the sum of the present values of all the expected cash flows in case a
project is undertaken.
NPV = Total Present Value- CF0
where,
CF0 = Initial Investment
PV = Annual Cash Inflow * PV of Rs 1
K = Required Rate of Return
This method of capital budgeting analysis considers the time value of money
Considers all the cash flows of the project
Considers the risk involved in the project cash flows by using the cost of capital
Indicates whether the investment will increase the project’s or the company’s
value
#4- Internal Rate of Return (IRR)
IRR is the discount rate when the present value of the expected incremental
cash inflows equals the project’s initial cost.
i.e. when PV(Inflows) = PV(Outflows)
Features:
It considers the time value of money
Considers all the cash flows of the project
Considers the risk involved in the project cash flows by using the cost of capital
Indicates whether the investment will increase the project’s or the company’s
value
#5- Profitability Index
Profitability Index is the Present Value of a Project’s future cash flows divided
by the initial cash outlay.
PI = PV of Future Cash Flow / CF0
Where,
CF0 is the initial investment
This ratio is also known as Profit Investment Ratio (PIR) or Value Investment
Ratio (VIR).
Features:
It considers the time value of money
Considers all the cash flows of the project
Considers the risk involved in the project cash flows by using the cost of capital
Indicates whether the investment will increase the project’s or the company’s
value
Useful in ranking and selecting projects when capital is rationed
Types of Capital Budgeting Decisions
Accept-Reject Decision. .
Mutually Exclusive Project Decision. .
Capital Rationing Decision.
1. Accept-Reject Decision: This is a fundamental decision in capital budgeting.
If the project is accepted, the firm would invest in it; if the proposal is rejected,
the firm does not invest in it. In general, all those proposals which yield a rate of
return greater than a certain required rate of return or cost of capital are
accepted and the rest are rejected. By applying this criterion, all independent
projects are accepted. Independent projects are the projects that do not compete
with one another in such a way that the acceptance of one precludes the
possibility of acceptance of another. Under the accept-reject decision, all
independent projects that satisfy the minimum investment criterion should be
implemented.
2. Mutually Exclusive Project Decision: Mutually Exclusive Projects are those
which compete with other projects in such a way that the acceptance of one will
exclude the acceptance of the other projects. The alternatives are mutually
exclusive and only one may be chosen. Suppose a company is intending to buy
a new folding machine. There are three competing brands, each with a different
initial investment and operating costs. The three machines represent mutually
exclusive alternatives, as only one of these can be selected. Moreover, the
mutually exclusive project decisions are not independent of the accept-reject
decisions. The project should also be acceptable under the latter decision. Thus,
mutually exclusive projects acquire significance when more than one proposal
is acceptable under the accept-reject decision.
3. Capital Rationing Decision: In a situation where the firm has unlimited
funds, all independent investment proposals yielding returns greater than some
pre-determined level are accepted. However, this situation does not prevail in
most of the business forms in actual practice. They have a fixed capital budget.
A large number of investment proposals compete for these limited funds. The
firm must, therefore, ration them. The firm allocates funds to projects in a
manner that it maximises long-run returns. Thus, capital rationing refers to a
situation in which a firm has more acceptable investments than it can finance. It
is concerned with the selection of a group of Investment proposals out of many
investment proposals acceptable under the accept-reject decision. Capital
rationing employs ranking of acceptable Investment projects. These projects can
be ranked on the basis of a pre-determined criterion such as the rate of return.
The projects are ranked in descending order of the rate of return.
Process of Capital Budgeting
The process of Capital Budgeting involves the following points:
1. Identifying and generating projects
Investment proposals are the first step in capital budgeting. Taking up
investments in a business can be motivated by a number of reasons. There could
be the addition or expansion of a product line. An increase in production or a
decrease in production costs could also be suggested.
2. Evaluating the project
It mainly consists of selecting all criteria necessary for judging the need for a
proposal. In order to maximize market value, it has to match the company's
mission. It is crucial to consider the time value of money here.
In addition to estimating the benefits and costs, you should weigh the pros and
cons associated with the process. There could be a lot of risks involved with the
total cash inflows and outflows. This needs to be scrutinized thoroughly before
moving ahead.
3. Selecting a Project
Since there is no ‘one-size-fits-all’ factor, there is no defined technique for
selecting a project. Every business has diverse requirements and therefore, the
approval over a project comes based on the objectives of the organization.
After the project has been finalized, the other components need to be attended
to. These include the acquisition of funds which can be explored by the finance
department of the company. The companies need to explore all the options
before concluding and approving the project. Besides, the factors like viability,
profitability, and market conditions also play a vital role in the selection of the
project.
4. Implementation
Once the project is implemented, now come the other critical elements such as
completing it in the stipulated time frame or reduction of costs. Hereafter, the
management takes charge of monitoring the impact of implementing the project.
5. Performance Review
This involves the process of analyzing and assessing the actual results over the
estimated outcomes. This step helps the management identify the flaws and
eliminate them for future proposals.
