2011

Assignment
Enrolment Number

Annamalai University
Director of Distance Education
MBA xxxxxxxxxxxxxxxxxx 1st year

Assignment Topic

1.2 Management Economics

Self Declaration
I declare that the assignment submitted by me is not a verbatim/photo
static copy from the websites/ books/ journals/manuscripts.

Signature of the student

Countersigned

Signature of the Faculty Concerned

Q 2. How to prepare a Capital Budget for yarn industry? - Explain

Before we prepare a capital budget for yarn industry, let us discuss about capital
budgeting and necessity of capital budgeting.

Introducing to Capital Budgeting

Capital budgeting involves and integrates the various elements of the firm,
marketing, finance, accounting, production engineering and purchase
departments. The effectiveness of the process of capital budgeting is dependent
on inputs from all major departments of the firm. The estimates for a project are
got from the various departments and they are drawn together in the form of
project evaluation. Top management sets the standards of acceptability and
ultimately makes the decision and the money spent on accept or reject the
project.

Capital budgeting is concerned with planning and control of capital expenditure. It

describes planning systematic program for investing money on fixed assets. The
most important decision which a management has to take is decision to invest i.e.
to incur expenditure now which will produce a stream of benefits over a period of
time. Investment decisions are different from operating decisions. In the case of
investment decisions, the time horizon over which benefits accrue is longer than
one year and the money spent is termed as capital expenditure. In the case of an
operating decision the time horizon is shorter than one year and the amount
spent is considered as a revenue expense.

Need for Capital Budgeting

1. The capital allocation is a basic business decision on which many others

depend and it is one of the firm’s fundamental decisions.
2. The kind of investment project which the firm is going to launch will
determine the nature of the firm’s future for better or worse, because the
type of the product of the firm plans to produce will determine whether it
will continue to grow.
3. The effect of investment decision extends beyond the current period and
its result is not immediately reported in the profit and loss account.
Therefore, its apparent right or wrong nature cannot be quickly found out.
4. It broadens the base on which profit will be earned through return on
capital employed. Rate of return is an important factor in assessment of
efficiency of the firm.
5. The investment decision extends to the future. There is much uncertainty
about the size of the future cash flow generated by an investment project.
6. Investment decisions are usually costly or impossible to reverse. Production
facilities and machinery are highly specialized and there may not be second
market for disposing them. Also, it is costly to disassemble production
equipment.

For those reasons the firm should have a procedure for analyzing and selecting
the most desirable investment project from various alternatives that are
available.

Capital budgeting is simply a plan for the investment of funds, whose benefits
will be received over a period of time. It formulates a basis on which to choose
among competing investment projects. It determines the relative benefit each
investment project may bring to the firm and the relative cost each may incur.
It is for this reason that the analysis at times referred to as a cost benefit
analysis. Budgeting is also known as investment decision making, equipment
replacement policy or the analysis of capital expenditure.

Capital budgeting decisions belong to the most important areas of managerial

decisions as they involve more extended estimation and prediction of things to
come requiring a high order of intellectual ability for their economics analysis.
Heavy spending on capital assets in the recent years has stimulated a genuine
interest among the economist, financial analysis and accounts in managerial
approaches to capital budgeting decision.
Criteria for Capital Budgeting Decisions
Potentially, there is a wide array of criteria for selecting projects. Some
shareholders may want the first to select projects that will show immediate
surges in cash inflows, other may want to emphasize long-term growth with
little importance on short term performance. Viewed in this way, it would be
quite difficult to satisfy the differing interests of all the shareholders.

Fortunately there is a solution. The goal of the firm is to maximize present

shareholder value. This goal implies that projects should be undertaken that
result in a positive net [present value, that is the present value of the expected
cash inflow less the present of the required capital expenditures. Using net
present value (NPV) as measure, capital budgeting involves selecting those
projects that increase the value of the firm because they have a positive NPV.
The timing and growth rate of the incoming cash flow is important only to the
extent of its impact on NPV. Using NVP as the criterion by which to select
projects assumes efficient capital markets so that the firm has access to
whatever capital is needed to pursue the positive NPV projects. In situation
where this is not the case, there may be capital rationing and capital budgeting
process becomes more complex.
Note that it is not the responsibility of the firm to decide whether to please
particular groups of shareholders who prefer longer or shorter term result.
Once the firm has selected the projects to maximize its net present value, it is
up to the individual shareholders to use the capital markets to borrow or lend
in order to move the exact timing of their own cash inflows forward or
backward. This idea is crucial in the principal-agent relationship that exists
between shareholders and corporate managers. Even though each may have
their own individual preferences, the common goal is that of maximizing the
present value of the corporation.

Method of Apprising Project Profitability

A firm always aims to maximize its profits. Therefore, selection of projects on
the basis of their profitability becomes the essential task in the decision
making process for investing funds. Therefore, the projects have to be
evaluated regarding their profitability and ranked. The firm has to write down
the list from low priority to high priority proposals. If the funds are limited the
most profitable projects have to be selected.

There are many methods that can be used to assess the investment
opportunities. Let us discuss about 1) Internal Rate of Return 2) Net Present
Value Method

Internal Rate of Return(IRR)

This method considers the time value of money. IRR is the rate at which the
present value of future cash flows from an investment project is equated with
the present value of the cash outflows of an investment. In other words, the
internal rate of return is the interest rate at which sums the net present value
of an investment projects to zero. IRR is determined solely by outlay and
proceeds associated with the project. It does not depend on any rate
determined by outside investment. The formula for IRR is

C = R1/(1+r1) + R2/(1+r2) + R3/1+r3) + ……..+ Rn(1+rn)

Where C = the amount of capital invested

R1 = Cash inflow in the first year

Rn = Cash inflow in the nth year

N = Life period of the project

Investment project would be accepted if the IRR is greater than the cut-off
rate. Investment project will be rejected if the rate of return is less than the
cut off rate. Alternative investment projects can be ranked in the order of IRR.
The weakness of this method is that it is cumbersome one involving
computational problems. This method may not solve problems under all
situations.

Net Present Value Method(NPV)

This method is concerned mainly with ascertaining the present worth of the
future earnings by the application of the appropriate rate of interest. This
method compares the present value of the future benefits with the present
value of the investment. This is done by discounting cash flows by an
appropriate rate of interest. When the present value of benefits does not
exceed the present value of investment, the proposal for investment should be
rejected. This method allows comparison of the project having different
service lives. The formula for finding out the total present value of all cash
inflows generating out of the investment is presented below.

NPV = R1/(1+i1) + R2/(1+i2)2 + R3/(1+i3)3…………… + Rn/(1+in)n

Where NPV denotes present value, i denotes rate of discount, R1, R2, R3 ………
Rn are the net cash flows from the project in the year 1,2,3 etc.

N = life of the asset. The project selection rule in this method is to accept the
project if the NPV is < 0

Net present value indices are calculated by dividing the net present value by
initial cost of the project and simplifying it by 100.

i.e. NPVI = NPV/initial cost x 100

Alternative project can be ranked in the order of NPVI

The demerits of this method are

1. it lacks simplicity
 2. it is based on the assumption that discount rate is known in calculating
the net present value.
3. this method may not offer proper help and guidance when projects with
different amount of investment are compared.

Scope of the Study

The efficient allocation of capital is the most important finical function in the
modern world.
The scope of the study is limited to prepare a capital budget for a yarn industry.

ABC yarn industry is considering investing in a project with the following cash
flows:

Time Actual Cash Flows

(Rs)
0 (100,000)
1 90000
2 80000
3 70000

An ABC yarn industry requires a minimum return of 40% under the present
conditions. Inflation is currently running at 30% a year, and this is expected to
continue indefinitely.

Let us take a look at ABC yarn industry’s required rate of return. if it invested
Rs 10,000 for one year on 1 January, then on 31 December it would require a
minimum return of Rs4000 . With the initial investment of Rs10,000, the total
value of the investment by 31st December must increase to Rs14,000. During
the year, the purchasing value of the dollar would fall due to inflation. we can
restate the amount received on 31 December is terms of the purchasing power
of the dollar at 1 January as follows:
Amount received on 31 December in terms of the value of the dollar at 1
January:

14,000 / ( 1.30)1 = 10,769

in terms of the value of the dollar at 1 January, ABC yarn industry would make
a profit of Rs 769 which represents a rate of return of 7.69% in “today’s
money” terms. This is known as the real rate of return. the required rate of
40% is a money rate of return (sometimes known as a nominal rate of return).
The money rate measures the return in terms of the dollar, which is falling in
value. the real rate measures the return in constant price level terms.

the two rates of return and the inflation rate are linked by equation:

(1 + 0.4) = (1 + 0.0769) * (1 + 0.3) = 1.4

if the cash flows are expressed in terms of actual dollars that will be
received or paid in the future, the money rate for discounting should be
used.

if the cash flows are expressed in terms of the value of the dollar at time 0
(i.e. in constant price level terms), the real rate of discounting should be
used.

In ABC yarn industry’s case, the cash flows are expressed in terms of the
actual dollars that will be received or paid at the relevant dates. Therefore,
we should discount them using the money rate of return.

Time Cash flow Discount factor PV

Rs 40% Rs
0 (150,000) 1.000 (100,000)
1 90,000 0.714 64,260
2 80,000 0.510 40,800
 3 70,000 0.364 25,480
30,540

The project has a positive net present value of Rs30,540, so ABC yarn
industry should go ahead with the project.

The future cash flows can be re-expressed in terms of the value of the
dollar at time 0 as follows, given inflation at 30% a year

Time Actual Cash flow Cash flow at time 0 price level

Rs Rs
0 (100,000) (100,000)
1 90,000 90,000 * 1 /(1.30)1 69,231
2 80,000 80,000 * 1 /(1.30)2 47,337
3
3 70,000 70,000 * 1 /(1.30) 31,862

The cash flows expressed in terms of the value of the dollar at time 0 can now
be discounted using the real value of 7.69%.

Time Cash flow Discount factor Pv

Rs 7.69% Rs
0 (100,000) 1.000 (100,000)
1 69,231 1 /(1.0769)1 64,246
2 47,337 1 /(1.0769)2 40,804
3 31,862 1 /(1.0769)3 25,490
30,540

The NPV is the same as before.