EEFA Unit 06 CAPITAL BUDGETING - Vidyarthiplus
Transcript of EEFA Unit 06 CAPITAL BUDGETING - Vidyarthiplus
Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT
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Introduction Every organization, irrespective of its nature (profit-making or otherwise) or
size (big or small), in course of time of its functioning, usually acquires, upgrades,
replaces the assets such as land and buildings, plant and machinery and so on. For
each of these, there are two or more choices, alternatives, which need to be carefully
evaluated on the basis of their costs and revenues, before investment..
A mini - steel plant is considering building a new arc furnace; an insurance company
is planning to install a computer system for information processing; the Government
of India is thinking of an ambitious plan to link Ganges and Cauvery rivers; Gautam,
a graduate student, is planning to buy a moped. - all these situations involve a capital
expenditure decision. Essentially, each of them represents a scheme for investing
resources which can be analyzed and appraised reasonably independently. The basic
characteristic of a capital expenditure (also referred to as a capital investment or
capital project or just a capital project) is that it typically involves a current outlay
(or current and future outlays) of funds in the expectation of a stream of benefits
extending far into future.
Capital budgeting Thus to improve the quality of the decisions, understanding the principles of
investment in capital budgeting is essential.
Capital budgeting is defined as " the long term planning to make and finance
proposed capital outlays".
The capital budgeting decisions involve long term planning for selection and
financing theinvestment proposal. Capital budgeting is the process of evaluating the
relative worth of long term investment proposals on the basis of respective
profitability.
Capital budgets are different from operating budgets from time to time from
point of view. operating budgets (such as sales budget, purchase budget or
overheads budget) show the firm's planned operations or resource allocations for a
given period in future, normally one year. on the other hand, capital budgets are
made for long term period , say three years or beyond.
Long term investment proposals involve large cash outlays. this require
careful analysis of cash outflows and inflows associated with each of these
proposals.
Capital Expenditures Importance and Difficulties
Importance Capital expenditure decisions often represent the most important decisions taken by
a firm. Their importance stems from three interrelated reasons:
1) Long-Term Effects - The consequences of capital expenditure decisions
extend far into the future. The scope of current manufacturing activities of a firm is
governed largely by capital expenditures in the past. Likewise current capital
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Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT
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expenditure decisions provides the framework for future activities. Capital
investment decisions have an enormous bearing on the basic character of a firm.
2) A reversibility - The market for used capital equipment in general is
ill-organised. Further, for some types of capital equipments, custom-made to meet
specific requirement .the market may virtually be non-existent. Once such an
equipment is acquired, reversal of decision may mean scrapping the capital
equipment. Thus, a wrong capital investment decision, often cannot be reversed
without incurring a substantial loss.
3) Substantial Outlays Capital expenditures usually involve substantial
outlays. An integrated steel plants for example involves an outlay of several
thousand millions. Capital costs tend to increase with advanced technology.
Difficulties While capital expenditure decisions are extremely important, they also pose
difficulties which stem from three principal sources:
Measurement Problems - Identifying and measuring the costs and benefits of a
capital expenditure proposal tends to be difficult. This is more so when a capital
expenditure has a bearing on some other activities of the firm (like cutting into the
sales of any existing product) or has some intangible consequences (like improving
the morale of workers).
Uncertainty - A capital expenditure decision involves costs and benefits that
extend far into the future. It is impossible to predict exactly what will happen in
future. Hence, there is usually a great deal of uncertainty characterizing the costs and
benefits of a capital expenditure decision.
Temporal Spread - The costs and benefits associated with a capital expenditure
decision are spread out over a long period of time, usually 10-20 years for industrial
projects and 20-50 year for inf'ra-structtual projects. Such a temporal spread creates
some problems in estimating discount rates and establishing equivalences.
Phases of Capital Budgeting - Capital budgeting is a complex process, divided
into five broad phases: - planning; analysis; selection; implementation; review
-
The solid arrows reflect
the main sequence:; planning
precedes analysis; analysis
precedes selection; and so on.
The dashed arrows indicate that
the phases of capital budgeting
are not related in a simple,
sequential manner. Instead, there
are several feedback loops
reflecting the iterative nature of
the process.
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Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT
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A. Planning The planning phase of a firm's capital budgeting process is concerned with the
articulation of its broad investment strategy and the generation and preliminary
screening of project proposals, The investment strategy of the firm delineates the
broad areas or types of investments the firm plans to undertake. This provides the
framework which shapes, guides, and circumscribes the identification of individual
project opportunities.
Once a project proposal is identified, it needs to be examined. To begin with, a
preliminary project analysis is done. A prelude to the full blown feasibility study,
this exercise is meant to assess
(i) Whether the project is prima facie worthwhile to justify a feasibility study
(ii) What aspects of the project are critical to its viability and hence warrant an
in-depth investigation.
B. Analysis If the preliminary screening suggests that the project is prima facie worthwhile, a
detailed analysis of the marketing, technical, financial economics and ecological
aspects is under taken. the questions and issues raised in such a detailed analysis are
described in the following section.
The focus of the phase of capital budgeting is on gathering, preparing, and
summarizing relevant information about various project proposals which are being
considered for inclusion in the capital budget. Based on the information developed
in this analysis, the stream of costs and benefits associated with the project can be
defined.
C. Selection Selection follows, and often overlaps, analysis. It addresses the question-is the
project worthwhile? A wide range of appraisal criteria have been suggested to judge
the worthwhileness of a project. They are divided into two broad categories, viz.,
non-discounting criteria and discounting criteria.
The principal non-discounting criteria are the payback period and the accounting
rate of return.
The key discounting criteria are the net present value, the internal rate of ream, and
the benefit cost ratio.
The selection rules associated with these criteria are as follows:
Criterion Accept Reject
Payback period (PBP) PBP < target period PBP > target period
Accounting rate of return (.ARR) ARR > target rate ARR < target rate
Net present value (NPV) NPV > 0 NPV < 0
Internal rate of return (IRR) IRR > cost of capital IRR < cost of capital
Benefit cost ratio (BCR) BCR > 1 BCR < 1
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Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT
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Capital
rationing
Where the given projects are equally viable, and all of these are
necessary for the survival of the firm, but not have enough resources
to finance all these projects, based on the priorities, the company
has to allocate funds for each of the project
To apply the various appraisal criteria suitable cut-off values (hurdle rate, target rate,
and cost of capital) have to be specified. These are essentially a function of the mix
of financing and the level of project risk. While the former can be defined with
relative ease, the latter truly tests the ability of the project evaluator. Indeed, despite
a wide range of tools .and techniques for risk analysis (sensitivity analysis, scenario
analysis, Monte Carlo simulation, decision tree analysis, portfolio theory, capital
asset pricing model, and so on), risk analysis remains the most irritable part of the
project evaluation exercise.
D. lmplemenlailon The implementation phase for an industrial project, which involves
setting up of manufacturing facilities, consists of several stages:
(i) project and engineering designs,
(ii) negotiations and contracting,
(iii) construction,
(iv) training,
(v) plant commissioning.
What is done in these stages is briefly described below: Stage Concerned with
Engineering and project designs Site probing and prospecting,
preparation of blueprints, and plant
designs plant engineering selection of
specific machineries and equipment.
Negotiations and contracting Negotiating and drawing up of legal
contracts with respect to project
financing, acquisition of technology,
construction of building and civil works
provision of utilities, supply of
machinery and equipment, marketing
arrangements, etc.
Construction Site preparation, construction of
buildings and civil works, erection and
installation of machinery and equipment.
Training Training of engineers technicians and
workers. (This can proceed
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Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT
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simultaneously along with the
construction work.)
Plant commissioning Start up of the plant. ( This is a brief but
commissioning technically crucial stage
in the project development cycle)
Translating an investment proposal into a concrete project is a complex,
time-consuming, and risk-fraught task. Delays in implementation, which are
common, can lead to substantial cost overruns.
For expeditious implementation at a reasonable cost, the following are helpful.
1. Adequate Formulation of projects : - A major reason for the delay is an
inadequate formulation of projects. Put differently, if necessary homework in terms
of preliminary studies and comprehensive and detailed formulation of the project is
not done, many surprises and shocks are likely to spring on the way. Hence, the need
for adequate formulation of the project cannot be over-emphasized.
2. Use of the Principle of Responsibility Accounting - Assigning specific
responsibilities to project managers for completing the project within the defined
time-frame and cost limits is helpful in expeditious execution and cost control.
3. Use of Network Techniques - For project planning and control two basic
techniques are available- PERT (Program Evaluation Review Technique) and CPM
(Critical Path Method). These techniques have, of late, merged and are being
referred to by a common terminology, that is network techniques. With the help of
these techniques, monitoring becomes easier.
E. Review
Once the project is commissioned the review phase has to be set in motion.
Performance review should be done periodically to compare actual performance
with projected pedormonce.
A feedback device, it is useful in several ways:
(i) It throws light on how realistic were the assumptions underlying the project;
(ii) It provides a documented logo of experience that is highly valuable in future
decision making;
(iii) It suggests corrective action to be taken in the light of actual performance;
(iv) It helps in uncovering judgmental biases;
(v) It induces a desired caution among project sponsors.
Levels of Decision Making In addition to looking at the various phases of capital budgeting, researchers have
also examined different levels of decision maldng. Gordon Miller, Mintzberg ,
forexample, defined three levels of decision making:: - operating, administrative,
and strategic.
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Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT
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The key characteristics of decisins at these levels are described below:
Characteristics Operating
decisions
Administrative
decisions
Strategic
decisions
Where is the decision taken Lower level
management
Middle level
management
Top level
management
How structured fs the decision Routine Semi-structured Unstructured
What is the level of resource
commitment
Minor
resource
commitment
Moderate
resource
commitment
Major
resource
commitment
What is the tithe horizon Short-term Medium-term Long-term
The three levels (operating, administrative, and strategic) of decision making can be
readily applied to capital budgeting decisions.
Examples are given below:
1. Operating capital budgeting decision - Minor office equipmen
2. Administrative capital budgeting decision - Balancing equipment
3. Strategic capital budgeting decision - Diversification project
Steps to be considered for evaluating capital budgets - a) Generating investment proposals
b) estimating cash flows for the proposals
c) Evaluating cash flows
d) Selection of project based on an acceptance criterion
e) Monitoring and re-evaluating, on a continuous basis, the investment projects,
once they are accepted
Complications underlying Capital Budgeting Decisions: - Varying cash flos at different points of time - the future cash flows (both inflows
and outflows) are to be estimated ,which is uncertain, and hence a specialized task
Time value factor - cash inflows occurring at different points of time have to be
compared with the corresponding cash outflows using the concept of time value of
money.
Estimation of cash flows Cash Inflow refers to cash receipts and does not refer to future income. It may be
calculated for a particular project or asset or for the whole business for one year or
several years.
Format for computing cash inflows
Yr Cash
revenue
Cash
expenses
Cash
flow
before
taxes
(CFBT)
Depre-
ciation
Taxable
income
Taxes Cash flow
after taxes
(CFAT)
Cash
Inflows
A B C D=(B-C) E F=(D-E) G H=(F-G) I=H+E
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Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT
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Cash Outflow - refers to the amount of cash going out of business. it may be
calculated for a particular project or asset or for the whole businessfor one year or
series of years. it constitutes the sum of al the outflows (including the cost of the
asset and installation) and amounts introduced or withdrawn periodically.
Methods of capital budgeting
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Limitations of capital budgeting -
A. Uncertainty in the future - all data used in the evaluation of proposals are
purely estimated. the data is error-prone more with the human judgement; bias or
discretion in the identification of cash flows
B. Qualitative factors ignored - factors considered are in term money, can be
quantified, but factors such as improved morale of employees as a result of
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implementation of proposals are not focussed. Other factor in the business
environment such as social economic conditions and so on, are not reflected here.
C. Volatile business conditions - the factors influencing business decisions include
� Technologicall advancement,
� government policies(such as fiscal policy, monetary policy),
� Sales forecast,
� Attitude of management (conservative or progressive),
� Estimated cash flow,
� Discount factors and rate of return.
Any change in one or more of these factors is going to affect the capital budgeting.
D. Unrealistic assumptions - they are:
� there is no risk and uncertainity in the business environment, which is untrue
and future of the business is full of uncertainity and different management
techniques are applied to minimise the risk
� the cash flows are received in lumpsum at the end of the given period
� the key variables such as sales revenue, costs, price or investments and so on
are taken based on past data, particularly in times of rising prices, these seldom holds
god for future.
� the cost of capital and discount rate are one and the same.
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