MCom I Semester Managerial Economics Capital Budgeting Study Material Notes

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MCom I Semester Managerial Economics Capital Budgeting Study Material Notes

MCom I Semester Managerial Economics Capital Budgeting Study Material Notes: Need of Captial Budgeting Meaning and Definition of Capital Budgeting Importance of Capital Budgeting Urgency Methods Pay Back Period Method Various Methods of Appraising Various Alternation Proposals of Capital  Investments Unadjusted Rate of Return Method Net Present Value Method Present Value of Discounted Cash Flow Method Or time Adjusted rate of return Method :

MCom I Semester Managerial Economics Capital Budgeting Study Material Notes
MCom I Semester Managerial Economics Capital Budgeting Study Material Notes

MCom I Semester Managerial Economics Profit Study Material notes

CAPITAL BUDGETING

MEANING AND DEFINITION OF CAPITAL BUDGETING

Capital Budgeting means preparing a systematic and scientific outline of the investment of available capital. In Capital Budgeting, all the expenses providing long-term profit are regulated and controlled. Some definitions of Capital Budgeting are as follows–

Charles T Horngren, “Capital Budgeting is long-term planning for making and financing proposed capital outlays.”

E E. Nemmers. “Capital Budgeting Or Capital Management may be defined as the process of determining which investment of allocation of long-term funds are to be made by an enterprise.”

NEED OF CAPITAL BUDGETING

1 Control on Capital Investment

2. Efficient Management of Capital Expenditure

3. Forecasting of Profit

4. Control on Uncertainty and Risk

IMPORTANCE OF CAPITAL BUDGETING

The importance of Capital Budgeting can be explained as follows

(1) Capital Budgeting helps in the proper investment of long-term assets.

(2) Capital Budgeting is helpful in preparing a stable policy for depreciation and replacement of assets.

(3) Capital Budgeting helps in making capital expenditure more profitable.

(4) Capital Budgeting provides necessary information for Cash Budget.

(5) Capital Budgeting helps in preparing the best Plan of Modernisation.

(6) Capital Budgeting develops a number of alternatives for investments.

(7) Capital Budgeting helps in the development of methods and measures to minimise cost.

(8) Capital Budgeting stresses upon minimising cost and maxmising production. Thus, it helps in maximising the sales revenue and profit of an enterprise.

Conclusion. Thus, it may be concluded that Capital Budgeting means the process of preparing long-term plans for determining the allocation of long-term funds. It is the planning of making and financing long-term capital outlays.

VARIOUS METHODS OF APPRAISING VARIOUS ALTERNATIVE PROPOSALS OF CAPITAL INVESTMENTS

There are six methods of evaluating different alternative capital investment proposals-(1) Urgency Methods; (II) Pay-back Period Method; (III) Unadjusted Rate of Return Method; (IV) Present Value Or Discounted Cash-flow Method; (V) Method of Present Value Or Discounted Cash-inflow Method: (VI) Present Value Index Or Profitability Index Method. Details in these regards are as follows–

URGENCY METHODS

Under this method of Capital Budgeting, capital projects are selected on the basis of urgency of their need. If, for any reason, it is more urgent to take up a particular project, it is taken up at the first. Thus, this method is not based upon calculation and statistical techniques. It considers only the urgency of need of a proposal.

Advantages or Urgency Method-(i) This method is very simple. (ii) This method is logical also because it takes into consideration the factor of urgency which can never be ignored.

Disadvantages of Urgency Method–(i) This method is not based upon scientific calculations and statistical techniques. Therefore, the results of this method are not much reliable. (ii) This method cannot be and should not be used for the projects having long-term effect. (iii) This method may cause manipulation also because the executives may select a capital proposal which is unworthy on the basis of urgency.

[IIJ PAY-BACK PERIOD METHOD

“Within four years, truck will be my own.

” “Within three years, I shall be the owner of my taxi.”

These are the statements which give an impression of a period and this period is called the Pay-back Period. It is the period within which original cost of a project can be recovered through additional savings mobilising from the project. It is the period in which the cost of a project can be recovered through savings of the project (Savings after the payment of taxes but before providing depreciation). Under this method of Capital Budgeting, Pay-back Period is calculated for all the projects minimum Pay-back Period is Pay-back Period is selected. Period under this method all the projects under consideration and the project with Fay-back Period is consideration and the project with minimum k Period is selected. There are two methods of calculating Pay-back

1 In case of Even Net Cash-inflow. If the rate of cash-inflow is equal in all the years, Pay-back Period can be calculated with the help of following formula

Original Cost of Investment Pay-back Period=

Annual Net Cash-inflow

Example. Original Cost of a project is Rs. 20,000. Life of Project is 10 years. Scrap Value is nil. Project is expected to produce a Net Cash-inflow of Rs. 4,000 per year throughout this life. In this case, Pay-back Period can be calculated as follows

20,000 Pay-back Period = = 5 years

4,000

2. In case of Unven not Cash-inflows. If the amount of cash-inflows mobilising from a project is not equal, Pay-back Period is calculated in the form of comulative cash inflows. In this case, cumulative cash-inflows are calculated for all the projects. The period in which the amount of cumulative cash-inflows and the amount of original cost of a project are equal, is regarded as Pay-back Period for the project.

Example. Original Cost of a project is Rs. 25,000. Useful Life of the Project is five years and Scrap Value is nil. The project is expected to earn Net Cash-inflows as follows—I year=Rs. 4,000, II year = Rs. 6,000, III year =Rs. 7,000, IV year=Rs. 8,000 and V year=Rs. 10,000. In this case, the amount of Cumulative Cash-inflows will be as follows-I year = Rs. 4,000, II year=Rs. 10,000, III year=Rs. 17,000, IV year=Rs. 25,000 and V year=Rs. 35,000. As at the end of IV year, the amount of Cumulative Cash-inflows and the amount of Original Investment of Project are equal, Pay-back Period of this project will be four years.

Advantages of Pay-back Period Method –Important advantages of Pay-back Period Method are as follows

(1) This method is very easy to understand and to implement.

(2) This method is quite logical.

(3) This method helps in reducing business uncertainties and risk by determining pay-back period of a project.

(4) This method is very suitable for the enterprises which depend upon borrowed capital for financing a project.

(5) This method is very suitable for the enterprises in which the rate of technical developments is very high.

(6) This method stresses upon earliest recovery of the cost of project which is very rational for the business and industrial enterprises.

Disadvantages of Pay-back Period Method – Though there are several advantages of this method, yet it is not free from limitations and disadvantages. Important disadvantages of this method are as follows

(1) This method stresses only upon the recovery of the amount of investment. It ignores profitability of the project. Therefore, this method is incomplete.

(2) This method does not consider the whole life of projects.

(3) This method does not consider the changes in the value of money taking place during the Pay-back Period.

(4) This method ignores scrap value of assets.

(5) This method does not help in calculating the rate of return of the projects.

(6) Results of this method may be mis-leading. For example, there are two projects under consideration out of which one project is expected to earn high returns in initial years but these returns will decrease in later years and the second project is expected to earn low returns in initial years but these returns will go on increasing in later years, with the result that total cash-inflows of second project will be more than that of second project but under this method, first project will be selected.

III) UNADJUSTED RATE OF RETURN METHOD

Under Unadjusted Rate of Return Method of Capital Budgeting, a rate of return on the amount of capital invested is calculated in respect of every project under consideration. Such rate of return is calculated on the basis of net income of every project. On this basis, the project with highest rate of return is selected. Present value of the receipt of income over different years is not considered under this method. As most of the data used in calculating rate of return are obtained from financial statements, this method is known as ‘Financial Statement Method’ also. Formula for calculating the Rate of Return under this method are as followsRate of Return Average Rannual Net Income (Savings)

Average Investment Average Annual Cash-inflows – Annual Depreciation. Or. =

– x 100 Average Investment Here, Average Investment

= (Initial Investment + Salvage Value)/2

Advantages of Unadjusted Rate of Return Method – Important advantages of this method of Capital Budgeting are as under

(1) This method is very easy and simple.

(2) This method is logical also because it takes into consideration total annual net income of a project.

(3) This method is based upon profitability and not only upon Pay-back Period.

(4) This method considers average investment.

(5) Under this method. net income is calculated after providing for depreciation.

Disadvantages of Unadjusted Rate of Return Method-Though there are several advantages of this method, yet it is not free from disadvantages. Important disadvantages of this method are as under

(1) This method does not consider fair rate of return on investment.

(2) An important limitation of this method is that this method ignores time factor.

(3) This method does not consider cost of capital.

(4) Another serious limitation of this method is that there is no standard formula for calculating the rate of return under this method because the concept of net income is used by different scholars in different senses.

[IV] PRESENT VALUE OR DISCOUNTED CASH-FLOW METHOD OR TIME ADJUSTED RATE OF RETURN METHOD

This method is based upon the assumption that the value of one rupee which is received today is more than the rupee which is received tomorrow. This method considers that the value of capital invested in a project goes on reducing alongwith time. Similarly, the value of cash-inflows received from a project at different times is not equal. The value of cash-inflows received in later years. For this reason, under this method, the value of cash-inflows received at different times is adjusted on the basis of present value factors. Under this method also, a rate of return is calculated for all the projects under consideration and the project with highest rate of return is selected. This rate of return is adjusted on the basis of time of receipt of cash-inflows. Therefore, this method is known as ‘Time Adjusted Rate of Return Method’ also. Procedure of calculating rate of return under this method is as under

(1) Average Annual Cash-flow is calculated with the help of following formula Average Annual Cash-flow Total Cash-flow during effective life of Project + Scrap Value

Life of Project in Years

(2) Present Value Factor is calculated with the help of following formula Present Value Factor =

Investment of the Project

Average Annual Cash-flow

(3) This Present Value Factor is seen in cumulative present value table (Table ‘B’) in the line of life project. If this P.V. factor is not available in the table, two nearest factors are determined. A rate is given at the top of every P.V. Factor. These are called expected rate of return.

(4) If the cash-inflows of a project are equal in all the years and the project has no scrap value. Actual rate of return of the project will be between these two rates.

(5) If the cash-inflows of a project are not equal, trial and error method is adopted to calculate actual rate of return of the project. Under this method, present value of cash-inflows is calculated at different rates and the rate at which total present value of cash inflows is nearest to the cost of investment of project, is considered as the actual time adjusted rate of return of the project.

Advantages of Time Adjusted Rate of Return Method-Time Adjusted Rate of Return Method is an important method of Capital Budgeting. Important advantages of this method are as follows

(1) This method is based upon logical and scientific calculations.

(2) This method considers present value of cash-inflows of a project. Thus, this method adjusts all cash-inflows of a project on the basis of time of their receipt.

(3) This method considers the profitability of a project.

(4) This method takes into account the whole life of a project.

Disadvantages of Time Adjusted Rate of Return Method-Though there are several advantages of this method, yet it is not free from disadvantages. Main disadvantages of this method are as under

(1) It is very difficult to calculate rate of return under this method.

(2) Exact rate of return cannot be calculated under this method. It can be calculate only the nearest rate of return of a project.

(3) This method does not consider fair rate of return.

TVNET PRESENT VALUE METHOD

(A) Calculation of Total Present Value :

This is considered to be the most important and popular method of Capital Budgeting. This method of Capital Budgeting is considered to be most scientific also. Under this method, a minimum rate of return is determined for evaluating different capital projects. Present value of total cash-inflows of a project is calculated with he help of pre-determined rate of return. This method is very suitable when the cost of investment of all the projects is almost equal. There can be two situations of cash-inflows under Net Present Value Method

1 In Cash of Even Cash-inflows-If cash-inflows of a project are equal throught its life, total present of all the cash-inflows of a project is calculated of the basis of present value factor. This present value factor is determined from cumulative present value table (Table ‘B’) with the help of life of project and pre-determined minimum rate of return. Amount of annual cash-inflow is

Multiplied by this P.V. Factor and the result is total present value of all cash-inflows of the project.

2. In Cash of Uneven Cash-inflows-If the cash-inflows of a project are not equal over its life, the method of calculating present value differs. In this case, the present value of cash-inflows is calculated separately and then all the present values are added. Present value factor is calculated on the basis of present value table (Table ‘A’). Mathematically, it can be presented as follows

P.V.=CxF Whereas,

P.V. = Present Value

C = Annual Cash-inflow

F = Present Value Factor

(B) Calculation of Net Present Value :

In both the cases, total present value of cash-inflows of a project is calculated, cost of investment of the project is deducted from this value and the balance is called net present value of the project. Mathematically, it can be presented as followsNet Present Value (N.P.V.) = Total Present Value of Cash-inflows of a Project- Cost

of Investment of the Project. Advantages of Net Present Value Method-Important Advantages of Net Present Value Method are as follows

(1) This method is most scientific and logical.

(2) This method is the only method which considers the fair rate of return.

(3) This method adjusts cash-inflows of a project according to the time of their receipt.

(4) This method is based upon the profitability of project.

(5) This method is commonly adopted by the business and industrial enterprises to evaluate the profitability of different capital proposals.

Disadvantages of Net Present Value Method –The only disadvantages of this method is that it is difficult to follow and understand.

[IV] PRESENT VALUE INDEX OR PROFITABILITY INDEX METHOD

When there is a significant difference in the cost of investment of alternative projects, it is better to evaluate them on the basis of Present Value Index Method Or Profitability Inex Method. This method is not a new method in itself. It is the expansion of Net Present Value Method only. Under this method, present value of cash-inflows of a project is calculated in the same manner as it is calculated under net present value method. After this, total present value of a project is divided by the cost of its investment to calculate present value index. Mathematically, it can be presented as follows

Advantages of Present Value Index Method. Important Advantages of Present Value Index Method are as follows

(1) This method is very scientific and logical.

(2) This method considers the fair rate of return.

(3) This method is based upon the real profitability of the project.

(4) This method is very suitable when there is a significant difference in the cost of investment of alternative proposals.

Disadvantages of Present Value Index Method. Disadvantages of Present Value Index Method are as follows

(1) This method is not in accordance with accounting principles and concepts.

(2) This method is comparatively difficult to understand and follow.

(3) It is very difficult to estimate the effective life of a project.

(4) Some critics of the opinion say that this method causes more uncertainty because this method is based upon the estimates of cash-inflows and cash-inflows of a project can never be estimated with certainty.

FACTORS AFFECTING DECISIONS RELATING TO INVESTMENT

There are many considerations that affect the decisions of an enterprise relating to the investment. These factors are as follows

1 Specific Importance of Project. From practical point of view a number of investment decisions are taken considering the specific importance of a project. For example, if the competitors of an enterprise install a new plant with the object of improving the quality of their product, the enterprise will also have to consider the installation of the same plant so that it face the competition successfully, even if the installation of new plant is not so profitable.

2. Investment Capacity. Investment capacity of the enterprise is one of the most important factors affecting its investment decisions. If the investment capacity of an enterprise is low, the enterprise will have to select the proposal, the Pay-back Period of which is minimum, even if it is less profitable.

3. Availability of Additional Funds. Investment Capacity of an Prise in a particular project depends to a large extent upon its available also. If it is possible for an enterprise to collect additional funds for its ure requirements, the enterprise may select to investment total amount or major amount of its present funds in a project. If, on the other hand, it is not possible for a enterprise to collect additional funds for its future requirements, the enterprise cannot afford to invest the whole amount of its present funds in a project because it will have to save some funds for its future requirements also.

4. Degree of Certainty of Net Income. Degree of certainty of net income is also an important factor affecting the decisions relating to investment. For example, there are two investment proposals before an enterprise. Out of these, first alternative is expected to earn a certain rate of return for a certain number of years, though the rate is comparatively low and the second proposal is expected to earn a higher rate of return but there is no certainty of it. In this case, an enterprise will prefer the first alternative.

5. Quick Return of the Cost of Investment. Time of return of the cost of investment is also an important factor to be considered by an enterprise while taking investment decisions. An enterprise should invest in the project, the cost of which can be recovered in minimum time because it minimizes the degree of risk.

6. Profitability. Profitability of a project is the most important factor affecting the investment decisions of an enterprise. Main aim of every enterprise is to earn maximum profit. Keeping this view in mind, an enterprise should select the investment proposal offering highest rate of return.

7. Nature of Stability. Nature of Stability, in this context, means the regular market demand of the product or products manufactured by the plant which is proposed to be purchased in the project. From this point of view, life of plant should be maximum and the risk of obsolescence should be minimum. It is also necessary that there should be hope of regular market demand of the product or products to be produced by the proposed plant.

8. Goodwill Creating Factor. Sometimes, a project is accepted because it is expected to increase the goodwill of the enterprise, even if this projects is not profitable or less profitable for the enterprise. Such an investment proposal does not provide any direct benefit to the enterprise but it increases the goodwill of the enterprise. It also helps in boosting the morale of its employees. Beautiful decoration of factory and office building may be the example of such an investment

Conclusion-When an enterprise wants to make an investment, there can be a number of alternatives before the enterprise. An enterprise has to select the best possible alternative from among these alternatives. Such a decision should be taken only after considering all the relevent factors. Important factors affecting investment decisions of an enterprise are as follows–specific importance of project, investment capacity, availability of additional funds, degree of certainty of income, quick return of the cost of investment, profitability, nature of stability, goodwill creating factor.

FACTORS TO BE CONSIDERED IN ESTABLISHMENT OF AN INDUSTRIAL ENTERPRISE

The success of an enterprise depends to a large extent upon its establishment. If an enterprise is established after considering all the relevant factors, the enterprise will the successful. There is a large number of factors which should be considered in the establishment of an industrial enterprise. Important factors affecting the establishment of a Paper Mill in private sector with an investment of Rs. 1 crore are as follows

1 Selection of Location. Most important factor affecting the establishment of an enterprise is the location at which the enterprise is going to be established. A paper mill should be established at the place where the required raw materials are easily available.

2. Distance from Market. Distance from Market bears a direct relationship with the cost of production because distance from market increases the cost of transportation. Therefore, it should be well considered that the enterprise should be located near to the market. In addition to this, adequate transportation facilities should be available in the area.

3. Behaviour of Competitors. Every enterprise has to work in atmosphere of competition. Therefore, the behaviour and strategies of competitors should be duly considered before establishing an enterprise so that the enterprise may face the competition successfully.

4. Opportunity Cost of Investment. Opportunity cost is also an important factor to be considered while establishing a new enterprise. Here, the paper mill is to be established with an investment of Rs. 1 crore. Therefore, it is necessary that the factor of opportunity cost of Rs. 1 crore should duly be considered.

5. Percentage of Investment in Fixed Assets. An enterprise has to decide the ratio of investment between fixed assets and current assets. Therefore, before establishing paper mill with an investment of Rs. 1 crore, it is necessary to decide the percentage of investment in fixed assets. So far as it is possible, the percentage of investment in fixed assets should be minimum.

6. Certainty of Income. Certaincy of income is the base of investment in an industrial enterprise. It assures the recovery of invested capital. In this case, certainty of income should be estimated properly before investing the amount of Rs. 1 crore in paper mill.

7. Government Policy. Government policy plays an important role in the success and growth of an industrial enterprise. Therefore, taxation policy, licencing policy and distribution policy of Government should be thoroughly and carefully studied before establishing a paper mill with an investment of Rs. 1 crore. In addition to this, it should also be assured that there are no restrictions of Government against the interest of paper mill.

8. Other Factor. Following factors should also be considered before investing Rs. 1 crore in Paper Mill —

(i) What are the possibilities of profit in future in paper mill?

(ii) Whether adequate labour force is available at the place at which paper mill is going to be established or not?

(iii) What are the possibilities of obsolescence of the technology used in paper mill?

(iv) Whether adequate sources of collecting working capital are available or not?

(v) What is the demand of paper in market ?

Conclusion—There are a number of factors which should be considered before establishing a paper mill with an investment of Rs. 1 crore. If all the factors are properly considered, the enterprise is expected to be successful.

Capital Budgeting Study Material
Capital Budgeting Study Material
Capital Budgeting Study Material
Capital Budgeting Study Material
Capital Budgeting Study Material
Capital Budgeting Study Material
Capital Budgeting Study Material
Capital Budgeting Study Material

Whether the proposal requested by accepted by the Company? Give the reasons is support of your answer.

[Ans. Proposal should be accepted because the Rate of Return (Discounted Cash-flow) exceeds 10% and Pay-back Period is less than 5 years.]

8. M/s Manjul & Company has a proposal to make a Capital Investment of Rs. 6,00,000 which is estimated to produce the following profit figures after depreciation over 5 years on straight-line basis :

I Profit Rs
II 1,50,000
III 1,50,000
IV 1,20,000
V 90,000
VI 15,000

 

To undertake this programme, the company will have to issue Debentures at 10 percent p.a. Over the part of few years the Company’s profit have been of the order of 20 percent on the shareholder’s equity. You are required to prepare a report for the management indicating profitability or otherwise of the proposal. Ignore taxation. (Ans. Rate of Return 35% which is more than the cost of debentures debt (10%). Therefore, the management is advised to accept this proposal.]

Capital Budgeting Study Material

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