MIST

Capital Budgeting Handout: 2001

CAPITAL BUDGETING: An overview

All expenses of a firm are made to realize some future benefits.

When the time horizon for such expenditure is relatively short in

nature (in general less than 1 year) the expenditure is termed as

current expenditure. However, when an expeditor is made for a

purpose so that the benefit from which will be derived for a

number of years to come, it is called a capital expenditure. In order

to make a correct decision with regard to capital expenditure,

capital budgeting is done. Capital budgeting is the process of

identification of opportunities, estimation of cash flow to be

generated by the project, evaluating and selecting from among

the alternative courses of actions using the appropriate selection

criteria and implementing the investment project with proper

follow-up. Thus the capital budgeting is a process, which has the

following different steps:

Identification of the Opportunities: The first action required for

capital budgeting process will be to identify the appropriate

opportunities or requirements to make a capital investment. These

opportunities or requirements can emerge from any of the

following reasons:

i) Expansion of capacity : When a firm's existing production

capacity is fully utilized or about to be utilized, the firm should

go for expansion of its capacity so that it can retain its

customers.

ii) Growth potentials : A growth opportunities occur when a firm

seeks to (a) diversify its existing product line through

development of new product markets or (b) enhance the

existing market to newer dimension.

iii) Replacement of machinery : When a firm’s existing

machinery become old or obsolete or the firm wants to balance

the capacities of different segments of the production facilities

replacement needs appear. Most often these are more or less

systematic investment decision.

iv) Exploratory investments : When a firm identifies mineral or

other natural resource reserve exploratory investment

opportunity appears.

v) Research and development : The giant business firms can

afford to have research and development wings. These R&D

results in new product ideas or technologies or brings changes

in existing production system or product characteristics. Such

developments result in capital investment decision.

vi) Mandatory Investment : When a firm is obliged to make some

investment required by govt. For social benefit for employee

benefit, the firm is bound to make the investment. These

include environment protection laws and laws relating to

employee safety etc.

IDENTIFICATION OF ALTERNATIVES: In order to make

correct decision, the sound capital budgeting process requires

decisions from among the best alternative within the opportunity set

available. Therefore when an opportunity or requirements appear or

identified, the capital budgeting team must also find out all the

possible ways to explore or exploit it. Therefore, a systematic

appraisal must be made using appropriate selection or appraisal

technique.

CRITERIA for SELECTION OF APPROPRIATE

TECHNIQUE: In capital budgeting process, usage of most

appropriate selection criteria or technique is also important. There

are different techniques and one can find the right one depending

on one’s knowledge base as well as upon the importance of the

project. It is always wise to select appropriate appraisal techniques

for capital investment decision. In order to be appropriate, the

following factors should be given consideration:

a) Realism: The criteria should be realistic given the

investment opportunities and volume of benefits and cost

involved.

b) Cost-effective : Whatever technique the appraisal team

seeks to use, it must be cost-effective for the purpose it is

being used.

c) Flexibility: The technique must be flexible enough to

accommodate all the changing situations prevailing in the

firm or in the market.

ESTIMATION of CASHFLOW: Cash-flow estimation is another

crucial step in capital budgeting process. The successful capital

budgeting depends significantly upon proper estimation of cash

flow. The details of cash-flow estimation are given in the latter

part of the handout.

IMPLEMENTATION AND FOLLOWUP: Once the right

project is selected, the investment should be made. After the

investment, the finance manager may find that, actual situation is

not as it was expected and hence appropriate action will be

required in those situations. Modified project can be launched or

the project can be abandoned. The experience will give the finance

manager a good feed back for future actions.

IMPORTANCE OF CAPITAL BUDGETING:

Capital budgeting is one of the most important functions of the

finance manager. Failure to perform capital budgeting activities

properly can affect not only the value maximization objective of

the firm but can endanger the very survival of the firm. Especially

when the capital investment project is relatively too big for the

firm, it can cause the firm loose its own existence. For the

following reasons, capital budgeting is considered as very much

crucial for every firm:

a) Volume: Most of the capital budgeting decisions involve

significant volume of funds. Some time such funds

requirements can be as big as the overall size of the firm. The

bigger the size of the project the more important it is for the

firm.

b) Time: Capital budgeting involves commitment of funds for a

long time. Thus the funds remain tied up and causes

inflexibility in the management’s’ decision making process.

c) Strategic Importance: AS the capital budgeting process opens

the firm’s future toward expansion or growth paths, so it has

significant strategic importance. If the firm fails to attain its

strategic advantage through capital budgeting process, the firm

can loose its position to its competitors.

5) Cost of Capital: In most of the capital budgeting decisions,

funds are accumulated through issuance of long term financing

securities. Consequently it is related to capital structure and cost

of capital issues. Failing in proper financing plan will affect

cost of capital and ultimately the value of the firm.

Considering all these issues, it can be concluded that, capital

budgeting is very much crucial for every firm.

Estimation of CASHFLOW: Cashflow estimation is another

important issue in capital budgeting process. In general the

following factors are considered in estimating cash flow:

1) Incremental Cash flow: The cash flow for capital budgeting

shall be the incremental cash flow only. That is - the cash flow

incidental to the particular project and not one, which would

have taken place even if the project were not accepted, should

be considered for this purpose. Thus the following factors can

be worth mentioning here:

(a) Differential cash-flow or the cash flow directly incidental to

the project will be considered:

(b) Sunk cost or the cash flow which has already been

committed and can not be recovered in any form even if the

current project is not under taken, is called sunk cost. Sunk cost

should not be considered in estimating cash flow.

(c) Opportunity cost or value of the facilities, which will be

used, for the project but was in existence before the project was

undertaken, should be considered at their fair market value. For

example, a factory building abandoned in any previous

occasion is going to be used for the current project. If any

alternative use for the same is identified, the income lost from

that use must be considered as the cost of the current project.

(d) Cannibalization is the affect of the new product upon the

cash flow of any existing product of the firm. The cash flow for

cannibalization should be considered as a cash lost in

estimating cash flow for the firm or of the project.

(e) Additional Working Capital required for the new project

should be included in the estimated cash outlay for the project.

At the end of project life such investment on working capital

should be considered as cash recovered from operation.

(f) Depreciation is a non-cash expense or a charge in the

income statement. The depreciation charge should be made to

estimate taxable income. After deducting the tax from EBT, the

depreciation should be added back to estimate net cash flow

from the project.

2) Inflation: Inflation is another important issue for which care

must be taken during the time of estimating cash flow. In fact, the

cash flow should be either in real terms or at constant price or

appropriately adjusted for inflation. In the case of cash flow at

constant price or inflation free price, the cost of capital should also

be a real cost of capital that is a cost of capital, which does not

consider inflation premium. On the other hand if we want to

estimate inflation adjusted cash flow, proper measures should be

taken to estimate expected inflation and apply it properly. The

inflation rate may not be the same for all the inputs. Consequently,

appropriate inflation rate for the different inputs is applied. There

should not be any inflation adjustment on depreciation as it is a

mere allocation from previously incurred cash outlay.

3) Risk: Risk or uncertainty about the future is a natural

phenomenon. The longer the life of the project the greater will be

the degree of uncertainty about future cash flow. Therefore, the

future cash flow should be estimated by taking appropriate

measures to find the certainty equivalence of future cash flow.

CLASSIFICATION OF CAPITAL INVESTMENT

PROJECTS:

Capital investment projects can be classified into different types

namely as follows;

i By Size: In this category big medium small projects subject

to the size of the firm.

ii By type of benefit; A firm can derive benefit in different

form like cost reduction, market expansion etc.

iii By degree of dependence: The projects can have different

types of interrelationship. For example some projects may be

required in association with other project(s) and are known

as complementary projects ( ink and pen projects). There are

some projects, where acceptance of one necessitates rejection

of the others. These types of projects are called mutually

exclusive projects (e.g. a basket ball court and a swimming

pool in a single small piece of land). Some projects are

considered to be substitute when acceptance of one project

can serve the same purpose served by another project or

product (Diet Coke is a substitute of Classic Coke). When

acceptance of one project is no way related to the acceptance

or other decision factors of any other project, then the two

projects are said to be independent of each other.

iv By type of cash flow: In general it is assumed that the

capital projects will require some initial cash outlay and than

there will be cash inflow from the project. This known as

typical or traditional or conventional project cash flow. A

cash flow is considered as non-conventional when there is

multiple net cash outflow during the life of the project. In

other words when the cash flow pattern changes its signs

more than one time, it is a non-conventional cash flow.