known as the capital budgeting or capital expenditure decisions.
A capital budgeting decision may be defined as the
firm’s decision to invest its current funds most efficiently in the long – term assets in anticipation of an expected flow of benefits. The firm’s investment decision would generally include:
• Expansion of existing business
• New business • Acquisition • Modernization • Replacement of the long term assets • Sale of division or business (disinvestment) Importance of Capital Budgeting • Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion. • Capital budgeting involves commitment of large amount of funds. • Capital decisions are required to assessment of future events which are uncertain.
• Capital budgeting decisions are irreversible.
• Capital budgeting ensures the selection of right source of finance at the right time. Objectives of Capital Budgeting
• To ensure the selection of the possible
profitable capital projects
• To ensure the effective control of capital
expenditure
• To ensure maximization of profit by allocating
the available funds Principles of Capital Budgeting Decisions A capital budgeting decision involves the following principles or factors:
• Creative search for profitable opportunities
• Evaluation of various proposals in order of priority
having regard to the amount available for investment.
• A careful estimate of the amount to be invested
• A careful estimate of revenues to be earned and costs
to be incurred in future in respect of the project under consideration. • A listing and consideration of non-monetary factors influencing the decisions.
• Evaluation of actual results achieved against those
budget.
• Care should be taken to consider working capital
requirements.
• It should recognize the fact that bigger benefits are
preferable to smaller ones and early benefits are preferable to latter benefits. Capital Budgeting Process The following procedure may be considered in the process of capital budgeting decisions: • Identification of profitable investment proposals.
• Screening and selection of right proposals.
• Evaluation of measures of investment worth on the basis of
profitability and uncertainty or risk.
• Final approval and preparation of capital expenditure budget.
• Implementing proposal, i.e., project execution.
• Review the performance of projects.
Types of Capital Expenditure (1) Capital expenditure increases revenue. (2) Capital expenditure reduces costs.
Capital Expenditure Increases Revenue:
• It is the expenditure which brings more revenue to the firm either by expanding the existing production facilities or development of new production line.
Capital Expenditure Reduces Costs:
• Such a capital expenditure reduces the cost of present product and thereby increases the profitability of existing operations. It can be done by replacement of old machine by a new one. Types of Capital Budgeting Proposals
Capital expenditure proposals may be classified into:
(1) Independent Proposals
(2) Dependent Proposals or Contingent Proposals
(3) Mutually Exclusive Proposals
Independent Proposals • An independent project is one where the decision to accept or reject the project has no effect on any other projects being considered by the company.
• The cash flows of an independent project have no effect on
the cash flows of other projects or divisions of the business.
• Independent proposals do not depend upon each other.
Independent investments serve different purposes and do not compete with each other.
For example the decision to replace a company's computer
system would be considered independent of a decision to build a new factory. Dependent Proposals or Contingent Proposals
Contingent investments are dependent projects; the
choice of one investment necessitates under taking one or more other investment.
For example: Construction of new building on
account of installation of new plant and machinery. Mutually Exclusive Investments
• Mutually exclusive investments serve the same purpose
and compete with each other.
• If one investment is undertaken, others will have to be
excluded.
• In mutually exclusive projects, the cash flows of one
project can have an impact on the cash flows of another. Investment Evaluation Criteria Three steps are involved in the evaluation of an investment:
Estimation of the cash flow
Estimation of the required rate of return
Application of a investment decision rule for
making the choice Investment Decision Rule The investment decision rules may be referred to as capital budgeting techniques, or investment criteria.
• Appraisal technique should be sound.
• The essential property of a sound technique is that it should maximise the shareholders’ wealth. Other properties of the sound technique are:
It should consider all cash flows to determine the true
profitability of the project
It should provide for an objective way of separating good
projects from bad projects
It should help ranking of projects according to their true
profitability
It should recognize the fact that bigger cash flows are
preferable to smaller ones and early cash flows are preferable to later ones.
It should help to choose among mutually exclusive projects
that projects which maximise the shareholders’ wealth. Methods of Evaluating Capital Investment Proposals 1. Traditional Methods (1) Pay-back period method or Payout method. (2) Improvement of Traditional Approach to Pay-back Period Method. (a) Post Pay-back profitability Method. (b) Discounted Pay-back Period Method. (c) Reciprocal Pay-back Period Method..
(3) Rate of Return Method or Accounting Rate of Return Method [ARR]
Time Adjusted Method or Discounted Cash Flow Method
(1)Net Present Value Method [NPV] (2)Internal Rate of Return Method [IRR] (3)Profitability Index Method [PI]