Capital Budgeting

Report on Capital Budgeting

Abstract

This report deals with

• The nature of capital investment appraisal

• The techniques available for evaluating capital investments

• The limitations of these techniques

• The capital budgeting practices in select countries

Introduction:

Some of the major responsibilities of top management are in the area of long range planning. Allocating resources to competing uses is one of the most important decisions a manager has to make. Executives are constantly faced with such questions as:

 Which projects should a firm accept?

 How should the productivity of capital be measured?

 Should the company take care of investments that reduce costs or that maintain profits or that add to profits?

 What happens to the risk complexion and competitive position of the firm if the investment under consideration is accepted as opposed to not choosing it?

A typical capital budgeting decision involves commitment of large, initial cash outlay with the benefits spread out in time. The time to recoup initial investment could be long. This makes it imperative for the firm to carefully plan its investments to attain the corporate objectives. Capital Investments are typically irreversible in nature or costly to get out. Unwarranted investments can jeopardize the financial well being of the firm. Capital Budgeting deals with investment in real assets. A project requires a large, up front capital investment; generates cash flows for a specified period of time at the end of which the project can be liquidated. The liquidation value of assets at the end of the project life is called Salvage value. It should be noted that the term initial investment is a misnomer. The term is used even when the investment is spread over a number of years. It is indeed the case in many real life situations. A project is shown as a time line diagram below.

Time 0 1 2 N

___________________________________________________

Cash flow I CF1 CF2 вЂ¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦Ð²Ð‚¦.. CFn

+ Salvage value.

Classification of Investments

Investments can be classified on several bases like importance, size, functional activity, cost reducing Vs revenue increasing, profit maintaining vs profit adding etc. The most appropriate way of classification is on the basis of relationship between investments. The possible relationship between investments can be plotted on a continuum as shown below

Prerequisite Independent Mutually

Exclusive

Complement Substitute

At one end of the spectrum, one investment might be a prerequisite for the other. At the other end we have investments that are complete substitutes. Accepting one will result in automatic rejection of the other. Two investments are said to be independent if the cash flows from one investment would be the same regardless of whether the second investment is undertaken or not. Thus, buying a Lathe for the machine shop and computerizing administration are independent investments. If the cash flows from one investment are affected by the decision to undertake another investment, they are said to be dependent. Dependence can be of four types. If the decision to undertake the second investment increases the benefit expected from the first (or decrease cost), then the second investment is said to be a complement of the first. Ex: Providing entertainment to visitors in a large clothing shop or manufacturing a primary input if it leads to cost advantage. If the decision to undertake the second investment decreases the benefit from the first investment (or increase costs), the second investment is said to be a substitute of the first. For example, making aircoolers and fans for the same market may lead to product cannibalization and erode profitability. In the extreme case, the benefits from the first may totally disappear if the second investment is accepted or it may be technically impossible to undertake both. Such investments are called mutually exclusive investments. For example, it is not possible to build one plant in two locations. Accepting one will result in automatic rejection of the other.

Techniques for Evaluating Capital Investments

Companies spend a great deal of time and money on new investments. Executives need measures of productivity of capital, which can be applied to distinguish good ones from bad ones. There are broadly two types of measures вЂ" some based on accounting income and some based on cash flows. The cash flow based measures can be further categorized as those that consider time value of money and those that don’t. Cash flow based measures that consider time value of money are called Discounted Cash Flow (DCF) techniques.

Return on Investment ROI is essentially a single period measure. Income is computed for a specified period and then divided by the average book value of assets of the same year

ROI= [EBIT (1- T) / Av. B.V of investment]

Where

EBIT= Earnings Before Interest