MANAGERIAL ECONOMICS AND FINANCIAL ACCOUNTING

UNIT 6: Capital Budgeting

1. What is capital budgeting? Explain its nature & significance.

Capital: Capital is defined as wealth, which is created over a period of time through abstinence to spend.
These are different forms of capital: property, cash or tittles to wealth. It is the aggregate of funds used in the
short-run and long-run.

Need for capital: The business needs for capital are varied. They are:

1. To promote a business
2. To conduct business operations smoothly
3. To expand and diversify
4. To meet contingencies
5. To pay taxes
6. To pay dividends and interests
7. To replace the assets
8. To support welfare programmers
9. To wind up

Types of capital: Capital can broadly be divided into two types:

1. Fixed capital
2. Working capital

FIXED Capital: Fixed capital is that portion of capital which is invested in acquiring long-term assets such as
land and buildings, plant and machinery. Furniture and fixtures and so on.The following are the features of
fixed assets:

• Permanent in nature
• Profit generation
• Low liquidity
• Amount of fixed capital
• Utilize for promotion and expansion
Types of fixed assets:
Fixed assets can be divided into three types:
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1. Tangible fixed assets: These are physical items which can be seen and touched. Most of the common fixed
assets are land, buildings, machinery, motor vehicles, furniture and so on.
2. Intangible fixed assets: These do not have physical form. They cannot be seen or touched. But these are very
valuable to business. Examples are good will, brand names, trademarks, patents, copy rights and so on.
3. Financial fixed assets: These are investments in shares, foreign currency deposits, government bonds, shares
held by the business in other companies and so on .

WORKING CAPITAL: Working capital is the flesh and blood of the business. It is that portion of capital
that makes a company work. It is not just possible to carry on the business with only fixed assets; working
capital is also called as circulating capital.

Features of working capital:

1. Short life span

2. Smooth flow of operations
3. Liquidity
4. Amount of working capital
5. Utilized for payment of current expenses
Components of working capital:
From the accounting point of view, working capital is the difference between current assets and
current liabilities .
(Working capital=current assets-current liabilities)
CURRENT ASSESTS:
Cash is required to pay salaries, office expenses and to pay creditors for purchases stock of raw
materials in adequate quantities to ensure uninterrupted production stock of finished goods in sufficient
quantities to meet the demand from customers.
• Debtors, that is , the expenses paid in advance such as insurance, rent, salaries and so on.
• Bills receivables these are the bills of exchange received for the money lent or to be received for a short
period.
CURRENT LIABILITIES: Creditors, that is, the people from whom we purchase on credit basis.
• Accruals, that is, those expenses in respects of which, the liability has arisen. In other words, the expenses
have fallen due and hence to be incurred, such as interest, salaries, taxes and so on.
• Bills payable these are the bills of exchange against which money is to be paid within a short period.

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2. What is Capital Budgeting? Explain the Significance of Capital Budgeting?
Nature of Capital Budgeting:
Charles T Horngren defines capital budgeting as” the long-term planning to make and finance proposed
capital outlays”. The capital budgeting decisions involve long-term planning for selection and also financing
the investment proposals. Capital budgeting is the process of evaluating the relative worth of long-term
investment proposals on the basis of their respective profitability.
Significance of capital budget:
Capital budgeting decisions assume special significance for the following reasons:
1. SUBSTANTIAL CAPITAL OUTLAYS:
Capital budgeting decisions involve substantial capital outlays.
2. LONG TERM IMPLICATIONS:
Capital budgeting proposals are of the longer duration and hence have long-term
implications. For instance, the cash flows for next 5 to 15 years have to be forecast.
3. STRATEGIC IN NATURE:
Capital budgeting decision can affect the future of the company significantly as it constitutes
the strategic determinant for the success of a company.
4. IRREVERSIBLE:
Once the funds are committed to a particular project, we cannot take back the decision. If
the decision is to be reversed, we may have to lose a significant portion of the funds already committed. It
may involve loss of the time and efforts.
3. Why is capital budgeting necessary? Explain its Methods?
It is necessary to reduce costs or increase revenues to maximize profits. The company is said to be efficient
in its operations when it can be classified into the following types:
* Projects that reduces costs
* Project that increases revenues
Capital Budgeting Decisions:
The following are examples of certain investment or capital budgeting decisions:
❖ Constructors of a new building, or renovation of existing old buildings.
❖ Interior decoration of a given building
❖ Purchase of technology from a foreign country
❖ Building a production facility
❖ Buying a new delivery truck
❖ Sponsoring a local football- or cricket team for one or more number of years
❖ Building a bridge
❖ Buying an airline
❖ Making a new product/Starting as new business
Methods of capital budgeting:
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 Capital budgeting decisions are made under different criteria. How are these criteria determined? These
criteria differ in concepts. Some use thumb rules are some use logic and scientific approach. So, based on
these criteria, the methods of capital budgeting can be classified as:
a) Traditional method
• Payback period
• Accounting rate of return method
b) Discounted cash flow methods
• Internal rate of return(IRR) method
• Net present value(NPV) method
• Profitability method

PAY BACK METHOD:

Under payback method, the decision to accept or reject a proposal is based on its payback period. Payback
period refers to the period within the original cost of the project is recovered. It is calculated by dividing the
cost of the project by the annual cash inflows.
Payback period = Cost of the project
Annual cash inflows
The shorter the length of the payback period, the better is the project in terms of paying back. The original
investment particularly where the future is uncertain, the companies favor this method. The earlier the
original investment is recovered, the letter it is, in terms of safety and liquidity. Where the cash flows are
uniform throughout, they are said to even.
ADVANTAGES:

1. Easy to calculate and understand: Calculation of payback period does not involve any complicated formula.
It is easy to calculate and understand.
2. Liquidity is emphasized: It is emphasizes on the earlier cash flows which are more likely to be accurate than
later cash flow.
3. Reliable techniques in volatile business conditions: It is a reliable technique for project appraisal,
particularly in the areas of volatile business conditions such as change in technology, changing fashions or
customers tastes/preferences.
DISADVANTAGES:
1) Post-payback earnings ignored: This method ignores the earnings after the payback period. It ignores the
total life of the project and the total profitability of the investment.
2) Timing of cash flows ignored: This method does not consider the timing of cash flows. All the cash flows
are given equal weight age.
3) Liquidity is over emphasized: the liquidity of the proposal is over-emphasized by choosing only cash
inflows. Other factors such as cost of proposals or cost of capital are ignored.

ACCOUNTING RATE OF RETURN (ARR) METHOD:

Accounting rate of return refers to the ratio of annual profits after taxes to the average investment.
The average investment is equal to half of the original investment. Accounting rate of return is also called average
rate of return.
ARR= Average annual profits after taxes
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 Average investment
Where average investment is half of the capital outlay (that is, capital outlay divided by 2). Average capital
employed is calculated to the usual accounting convention that the original investment gets exhausted
steadily to zero over the life of the project.
ADVANTAGES:
❖ It is easy to understand and calculate
❖ It can be compared with the cut of return and hence the decision to accept or reject is made easier.
❖ It consider all cash inflows during the life of the project, not like payback method.
DISADVANTAGES:
❖ The concept of time value of money is ignored.
❖ Unless we have a cut-off point of return, accounting rate of return cannot be meaningful and effective.
❖ The average concept is not reliable, particularly in times of high or wild fluctuations in the returns.
Discounted cash flow methods:

Discounted cash flow methods are the improved methods over the traditional techniques. These consider the
time of value of money. They consider the whole earnings of the proposal and the cost of the project.
Because of these reasons, these methods are also called modern methods of investment appraisal. Discounted
cash flow methods can be

A. Internal rate of return (IRR) method

B. Net present value (NPV) method

Internal rate of return (IRR) method:

Internal rate of return is that rate of return at which the present value of expected cash flows of a project
exactly equals the original investment. In other words, it equates the present value of a given project with its
outlay. This is the cutoff point at which the income equals the expenditure or the investment breaks even.

At IRR, the net present value of a project is zero. The net present value refers to the excess of the present
value of future cash flows over and above the original investment. IRR is denoted by “r”. It is computed as
shown below

C= CF1 +CF2……………+…CF n

(1+r) (1+r)2 (1+r)n

IRR for Even cash flows Factor = Project Cost/ Annual cash flows

Uneven cash flows =L+ (P1 – I) / (P1-P2) * D

ADVANTAGES:

❖ IRR is based on time value of money

❖ It is based on the earnings of all the years of the project
❖ It is a valuable tool to compare the projects with different cash inflows and different life span
❖ It is independent of cost of capital
DISADVANTAGES:
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❖ It is difficult and tedious to calculate IRR by even trial and error.
❖ It is based on certain assumptions, one of which is that the intermediate cash inflows are reinvested at IRR.
Where the company has more than one project with different IRRS, these assumptions may not hold good.

Net present value method:Net present value refers to the excess of present value of future cash inflows over
and above the cost of original investment.

NPV= (PV cfat) minus (PVc)

Where PVcfat refers to the present value of future cash inflows after taxes.

PV c refers to present value of original investment or capital

NPV= Total Discounted cash Inflows – Initial investment
The concept of NPV is a logical extension to the concept of present value. Here the
decision is based on the size of net present value. The projects with higher NPVS are selected. If the NPV is
negative that means the project is not profitable .In otherworld’s the NPV should always be positive and
should be maximum. The present value factors are used here to determine the present value of the future cash
inflows.

PROFITABILITY INDEX
This is the ratio between the present value of cash inflows and the present value of cash outflows. It is used
to indicate the profitability at a glance.
Profitability index= Sum of present value of cash inflows/ sum of present value of cash outflows
4. What is time value of money?
The concept of the time value of money refers to the fact that the money received today in different in its
worth from the money receivable at some other time in future. For example if you offered a choice between
receiving 1000 today and receiving 1000 after one year, the obvious choice of any person would be to
receive 1000 today. It is better option as 1000 received today can be invested in a bank or other instrument
and the value of such investment one year later would be higher.
Example: original investment 2000,
(+) 10% interest for 1st year 200
Value at the end of first year 2200
Reasons for time value of money:
• Uncertainty
• Inflation
• Reinvestment opportunities
• Future value of money
• Preference of present consumption