PADMASHRIANNASAHEBJADHAVBHARATIYA SAMAJUNNATIMANDAL‘S

B.N.N COLLEGE BHIWANDI

DIST.THANE 421305

UNIVERSITY OF MUMBAI

PROJECT ON

A Study Of Capital Budgeting

SUBMITTED BY

PARVATI ANANTA SHINDAE

ROLL NUMBER

29

IN PARTIAL FULFILLME N OFTHEREQUIREMENTT FOR

THE AWARD OF THE DEGREE OF

M.COM. (ADVANCE ACCOUNTANCY) (PART-2) (SEM-Ⅳ)

OF

UNIVERSITY OF MUMBAI

UNDER THE GUIDANCE OF

Prof.SONAM MORE

1
 CERTIFICATE

This is to certify tha PARVATI ANANTA SHINDEA (ROLL NO29 of

M.COM.PART 2 (ADVANCE ACCOUNTANCY) SEMESTER-Ⅳ (Academic Year2023-2024)has

successfully completed the project on

“A Study of CAPITAL BUDGETING”

Under the guidance of ―Prof.SONAM MORE partial fulfillment of the

requirement for the reward of the Degree of M.COM Part 2 (ADVANCE

ACCOUNTANCY)SEMESTER-Ⅳ

University of Mumbai for the Academic yea 2023-2024

SIGNATURE

Principal: Dr. Ashok.D.Wagh

Project Guide: Prof.SONAM MORE

External Examiner: Prof.

2
 DECLARATION

I the undersigned Miss / M PARVATI ANANTA SHINDEA here by,

declarethattheworkembodied inthisprojectworktitled,
“A Study of CAPITAL BUDGETING”,

forms my own contribution to the research work carried out under the

guidanceof PROF.SONAM MORE is a result of my own research work

and has not

been previously submitted to any other University for any other Degree/

Diploma to this or any other University.

I, here by further declare that all information of this document has been
obtained and presented in accordance with academic rules and ethical
conduct.

PARVATI ANANTA SHINDEA certified by

(Signature of student)

Prof. SONAM MORE Date:

Signatue

3
 ACKNOWLEDGEMENT

The project would not have been possible without the

support of many people. Firstly, I would like to thank God

almighty for his continuous blessingthat he has showered

on me all through my life. I would like to thank the

University of Mumbai, Prof. Dr. A. D. Wagh, and B.N.N.

For giving me a chance to work on such an

interestingtopic.

I express a deep sense of gratitude toward my project guide Prof.

SONAM MORE for his valuable guidance, motivation and insistence on

perfection. Working with such a scholarly person was a

pleasant and anenriching learning experience.

In a special way I would even like to thank my parents

for their continuous prayer to the almighty for my

success in life and for their kindblessing, continuous

support and motivation in every stage of my life.

Last, but not the least, I would like to thank the entire

teaching as well as officestaff at B.N.N COLLEGE for their

motivation, support and help rendered to

me in my academic journey and especially while working on project.

4
 INDEX

CAPITAL BUDGETING

Sr no. Tittle Page

1 Introduction 06

2 Nature 07
3 Technique 08-12
4 Process of capital budgeting 13-14
5 Example of capital budgeting 15-23
6 Capital investment 24-29
7 Project of cash flow 30-40

8 Basic principles of cash flow 41-52

9 Project selection under capital rationing 53-66

10 Conclusion and suggestion 67

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 CAPITAL BUDGETING

INTRODUCTION :
Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context,
capital expenditure is the spending of funds for large expenditures like purchasing fixed
assets and equipment, repairs to fixed assets or equipment, research and development,
expansion and the like. Budgeting is setting targets for projects to ensure maximum
profitability.

Capital budgeting is a process of evaluating investments and huge expenses in

An organization is often faced with the challenges of selecting between two
projects/investments or the buy vs replace decision. Ideally, an organization would like to
invest in all profitable projects but due to the limitation on the availability of capital an
organization has to choose between different projects/investments. Capital budgeting as a
concept affects our daily lives

Let’s look at an example- Your mobile phone has stopped working! Now, you have two
choices: Either buy a new one or get the same mobile repaired. Here, you may conclude that
the costs of repairing the mobile increases the life of the phone. However, there could be a
possibility that the cost to buy a new cell phone would be lesser than its repair costs. So, you
decide to replace your cell phone and you proceed to look at different phones that fit your
budget!

Capital budgeting in corporate finance, corporate planning and accounting is the planning
process used to determine whether an organization's long term capital investments such as
new machinery, replacement of machinery, new plants, new products, and research
development projects are worth the funding of cash through the firm's capitalization
structures (debt, equity or retained earnings). It is the process of allocating resources for
major capital, or investment, expenditures.An underlying goal, consistent with the overall
approach in corporate finance, is to increase the value of the firm to the shareholders.

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Nature of Capital Budgeting
It is a long-term investment decision.

It is irreversible in nature.

It requires a large amount of funds.

It is most critical and complicated decision for a finance manager.

It involves an element of risk as the investment is to be recovered in future.

Capital budgeting is the process by which investors determine the value of a potential
investment project.

The three most common approaches to project selection are payback period (PB), internal
rate of return (IRR), and net present value (NPV).

The payback period determines how long it would take a company to see enough in cash
flows to recover the original investment.

The internal rate of return is the expected return on a project—if the rate is higher than the
cost of capital, it's a good project.

The net present value shows how profitable a project will be versus alternatives and is
perhaps the most effective of the three methods

Every year, companies often communicate between departments and rely on finance
leadership to help prepare annual or long-term budgets. These budgets are often operational,
outlining how the company's revenue and expenses will shape up over the subsequent 12
months. However, another aspect to this financial plan is capital budgeting. Capital budgeting
is the long-term financial plan for larger financial outlays.
Capital budgeting relies on many of the same fundamental practices as any other form of
budgeting. However, there are several unique challenges to capital budgeting. First, capital
budgets are often exclusively cost centers; they do not incur revenue during the project and
must be funded from an outside source such as revenue from a different department. Second,
due to the long-term nature of capital budgets, there are more risks, uncertainty, and things
that can go wrong
Capital budgeting is often prepared for long-term endeavors, then re-assessed as the project
or undertaking is under way. Companies will often periodically reforecast their capital budget
as the project moves along. The importance in a capital budget is to proactively plan ahead
for large cash outflows that, once they start, should not stop unless the company is willing to
face major potential project delay costs or losses.

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 Capital budgeting is important because it creates accountability and measurability. Any
business that seeks to invest its resources in a project without understanding the risks and
returns involved would be held as irresponsible by its owners or shareholders. Furthermore, if
a business has no way of measuring the effectiveness of its investment decisions, chances are
the business would have little chance of surviving in the competitive marketplace.
Companies are often in a position where capital is limited and decisions are mutually
exclusive. Management usually must make decisions on where to allocate resources, capital,
and labor hours. Capital budgeting is important in this process, as it outlines the expectations
for a project. These expectations can be compared against other projects to decide which
one(s) is most suitable

Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a
measurable way for businesses to determine the long-term economic and financial
profitability of any investment project. While it may be easier for a company to forecast what
sales may be over the next 12 months, it may be more difficult to assess how a five-year, $1
billion manufacturing headquarter renovation will play out. Therefore, businesses need
capital budgeting to assess risks, plan
ahead, and predict challenges before they occur.

Techniques Used in Capital Budgeting:

There is no single method of capital budgeting; in fact, companies may find it helpful to
prepare a single capital budget using the variety of methods discussed below. This way, the
company can identify gaps in one analysis or consider implications across methods it would
not have otherwise thought about.

Discounted Cash Flow Analysis

Because a capital budget will often span many periods and potentially many years, companies
often use discounted cash flow techniques to not only assess cash flow timing but implications
of the dollar. As time passes, currencies often become devalued. A central concept in economics
facing inflation is that a dollar today is worth more a dollar tomorrow as a dollar today can be
used to generate revenue or income tomorrow.
Discounted cash flow also incorporates the inflows and outflows of a project. Most often,
companies may incur an initial cash outlay for a project (a one-time outflow). Other times,
there may be a series of outflows that represent periodic project payments. In either case,
companies may strive to calculate a target discount rate or specific net cash flow figure at the
end of a project.

Payback Analysis
Instead of strictly analyzing dollars and returns, payback methods of capital budgeting plan
around the timing of when certain benchmarks are achieved. For some companies, they want
to track when the company breaks even (or has paid for itself). For others, they're more
interested on the timing of when a capital endeavor earns a certain amount of profit.

8
For payback methods, capital budgeting entails needing to be especially careful in forecasting
cash flows. Any deviation in an estimate from one year to the next may substantially
influence when a company may hit a payback metric, so this method requires slightly more
care on timing. In addition, the payback method and discounted cash flow analysis method
may be combined if a company wants to combine capital budget methods.

Throughput Analysis
A dramatically different approach to capital budgeting is methods that involve throughput
analysis. Throughput methods often analyze revenue and expenses across an entire
organization, not just for specific projects. Throughput analysis through cost accounting can
also be used for operational or non-capital budgeting.

Throughput methods entail taking the revenue of a company and subtracting variable costs.
This method results in analyzing how much profit is earned from each sale that can be
attributable to fixed costs. Once a company has paid for all fixed costs, any throughput is kept
by the entity as equity.

Companies may be seeking to not only make a certain amount of profit but want to have a
target amount of capital available after variable costs. These funds can be swept to cover
operational expenses, and management may have a target of what capital budget endeavors
must contribute back to operations.

Metrics Used in Capital Budgeting

When a firm is presented with a capital budgeting decision, one of its first tasks is to
determine whether or not the project will prove to be profitable. The payback period (PB),
internal rate of return (IRR) and net present value (NPV) methods are the most common
approaches to project selection.

Although an ideal capital budgeting solution is such that all three metrics will indicate the
same decision, these approaches will often produce contradictory results. Depending on
management's preferences and selection criteria, more emphasis will be put on one approach
over another. Nonetheless, there are common advantages and disadvantages associated with
these widely used valuation methods

Payback Period
The payback period calculates the length of time required to recoup the original investment.
For example, if a capital budgeting project requires an initial cash outlay of $1 million, the
PB reveals how many years are required for the cash inflows to equate to the one million
dollar outflow. A short PB period is preferred
as it indicates that the project would "pay for itself" within a smaller time frame.

9
Payback periods are typically used when liquidity presents a major concern. If a company
only has a limited amount of funds, they might be able to only undertake one major project at
a time. Therefore, management will heavily focus on recovering their initial investment in
order to undertake subsequent projects.
Another major advantage of using the PB is that it is easy to calculate once the cash flow
forecasts have been established.
There are drawbacks to using the PB metric to determine capital budgeting decisions. Firstly,
the payback period does not account for the time value of money (TVM). Simply calculating
the PB provides a metric that places the same emphasis on payments received in year one and
year two.
Such an error violates one of the fundamental principles of finance. Luckily, this problem can
easily be amended by implementing a discounted payback period model. Basically, the
discounted PB period factors in TVM and allows one to determine how long it takes for the
investment to be recovered on a discounted cash flow basis.
Another drawback is that both payback periods and discounted payback periods ignore the
cash flows that occur towards the end of a project's life, such as the salvage value. Thus, the
PB is not a direct measure of profitabilities
There are other drawbacks to the payback method that include the possibility that cash
investments might be needed at different stages of the project. Also, the life of the asset that
was purchased should be considered. If the asset's life does not extend much beyond the
payback period, there might not be enough time to generate profits from the project.
Since the payback period does not reflect the added value of a capital budgeting decision, it is
usually considered the least relevant valuation approach. However, if liquidity is a vital
consideration, PB periods are of major importance.

Internal Rate of Return

The internal rate of return (or expected return on a project) is the discount rate that would
result in a net present value of zero. Since the NPV of a project is inversely correlated with
the discount rate—if the discount rate increases then future cash flows become more
uncertain and thus become worth less in value—the benchmark for IRR calculations is the
actual rate used by the firm to discount after-tax cash flows.

An IRR which is higher than the weighted average cost of capital suggests that the capital
project is a profitable endeavor and vice versa.

The IRR rule is as follows:

IRR > Cost of Capital = Accept Project

IRR < Cost of Capital = Reject Project

The primary advantage of implementing the internal rate of return as a decision-making tool
is that it provides a benchmark figure for every project that can be assessed in reference to a
company's capital structure. The IRR will usually produce the same types of decisions as net
present value models and allows firms to compare projects on the basis of returns on invested
capital.

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Despite that the IRR is easy to compute with either a financial calculator or software
packages, there are some downfalls to using this metric. Similar to the PB method, the IRR
does not give a true sense of the value that a project will add to a firm—it simply provides a
benchmark figure for what projects should be accepted based on the firm's cost of capital.

The internal rate of return does not allow for an appropriate comparison of mutually
exclusive projects; therefore managers might be able to determine that project A and project
B are both beneficial to the firm, but they would not be able to decide which one is better if
only one may be accepted.

The IRR is a useful valuation measure when analyzing individual capital budgeting projects,
not those which are mutually exclusive. It provides a better valuation alternative to the PB
method, yet falls short on several key requirements.

Net Present Value

The net present value approach is the most intuitive and accurate valuation approach to
capital budgeting problems. Discounting the after-tax cash flows by the weighted average
cost of capital allows managers to determine whether a project will be profitable or not. And
unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison
to alternatives.

The NPV rule states that all projects with a positive net present value should be accepted
while those that are negative should be rejected. If funds are limited and all positive NPV
projects cannot be initiated, those with the high discounted value should be accepted.

Some of the major advantages of the NPV approach include its overall usefulness and that the
NPV provides a direct measure of added profitability. It allows one to compare multiple
mutually exclusive projects simultaneously, and even though the discount rate is subject to
change, a sensitivity analysis of the NPV can typically signal any overwhelming potential
future concerns.
Although the NPV approach is subje
ct to fair criticisms that the value-added figure does not factor in the overall magnitude of the
project, the profitability index (PI), a metric derived from discounted cash flow calculations
can easily fix this concern.

The profitability index is calculated by dividing the present value of future cash flows by the
initial investment. A PI greater than 1 indicates that the NPV is positive while a PI of less
than 1 indicates a negative NPV. Weighted average cost of capital (WACC) may be hard to
calculate, but it's a solid way to measure investment quality.

Long-Term Effect on Profitability

Any organisation that wants to expand and prosper must have a long-term perspective
because a poor choice could harm the company's survival ability, eventually affecting capital
budgeting. Additionally, it affects the future costs & growth of the company. A corporation's
profitability is significantly impacted over the long duration by capital expenditures. There
are prospects of boosting an organisation's profitability if the expenses are made after a
budget has been adequately prepared.

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 Huge Investments
Any firm needs significant investment to expand because it has limited resources, so the
company must make a prudent choice when choosing an investment. The wrong choice may
significantly impact the purchase of an asset, the rebuilding or replacement of existing
equipment, or even the firm's sustainability

Cannot Undo Decisions

Most of the time, capital investment decisions are final; they require significant outlays of
money, and it might be challenging to find a market. The asset must be destroyed, and you
must take the losses if you want to stay with the business.

Expenditure Control
Capital budgeting is important for paying closer attention to expenditures and, if necessary,
performing R&D for investment activity. While this stage is critical in the capital budgeting
process, a good project might turn into a negative one if the expenses are not done in a
controlled manner and are not adequately monitored

Information Flow
The project's inception is only a notion; whether it is approved or disapproved will depend on
the various power levels and the situation. The capital budgeting process makes
communicating information to the right decision-makers easier so they can decide better for
the organisation's future.

Assistance in Investment Decision-Making

Long-term financial decisions take time because the results won't be seen for several years
after the decision is made. Risk involvement in uncertainty is defined. When choosing an
investment, management loses its freedom and liquidity of funds. It must be taken into
account while approving the proposal.

Maximising Wealth
Encourage the organisation to make long-term investments to protect the interests of the
organisation's shareholders. The shareholder will demonstrate their interest in the company if
the organisation makes planned investments in a specific activity. They can use it to
maximise the organisation's growth. Any organisational change is additionally tied to the
development, sales, and foreseeable profitability of the company and its assets based on
capital budgeting.

Uncertainty and Risk

When we invest in a particular project, we anticipate a specific return on our ongoing
financial commitment. Because there is a permanent commitment of funds, there is more
danger. Whether the investment is made in the present or future, numerous risks surround
capital budgeting decisions. The risk and uncertainty increase with the project's duration, and
predictions for costs, sales, and profits may change depending on the period.

Issues with Investment Decisions

Investment in long-term plans can be time-consuming and intricate. The management must
be aware of the complexity of linked activity since acquiring fixed assets is a continual
activity.

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 National Nature
Any project that is started creates new employment possibilities and promotes economic
growth and rising per capita income. These are the contributions the business makes when
choosing a new project.

1) There is a long duration between the initial investments and the expected returns.

2)The organizations usually estimate large profits.

3) The process involves high risks.

4) It is a fixed investment over the long run.

5) Investments made in a project determine the future financial condition of an organization.

6)All projects require significant amounts of funding.

7)The amount of investment made in the project determines the profitability of a company

Process of Capital Budgeting:

Identifying and generating projects
Investment proposals are the first step in capital budgeting. Taking up investments in a
business can be motivated by a number of reasons. There could be the addition or expansion
of a product line. An increase in production or a decrease in production costs could also be
suggested.

Evaluating the project

It mainly consists of selecting all criteria necessary for judging the need for a proposal. In
order to maximize market value, it has to match the company's mission. It is crucial to
consider the time value of money here.
In addition to estimating the benefits and costs, you should weigh the pros and cons
associated with the process. There could be a lot of risks involved with the total cash inflows
and outflows. This needs to be scrutinized thoroughly before moving ahead.

Selecting a Project
Since there is no ‘one-size-fits-all’ factor, there is no defined technique for selecting a
project. Every business has diverse requirements and therefore, the approval over a project
comes based on the objectives of the organization.
After the project has been finalized, the other components need to be attended to. These
include the acquisition of funds which can be explored by the finance department of the
company. The companies need to explore all the options before concluding and approving the
project. Besides, the factors like viability, profitability, and market conditions also play a
vital role in the selection of the project.

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Implementation
Once the project is implemented, now come the other critical elements such as completing it
in the stipulated time frame or reduction of costs. Hereafter, the management takes charge of
monitoring the impact of implementing the project.

Performance Review
This involves the process of analyzing and assessing the actual results over the estimated
outcomes. This step helps the management identify the flaws and eliminate them for future
proposals.

Factors Affecting Capital Budgeting

So far in the article, we have observed how measurability and accountability are two primary
aspects that achieve the center stage through capital budgeting. However, while on the path to
accomplish a competent capital budgeting process, you may come across various factors that
may affect it.

For a comparison of the six capital budgeting methods, two capital investments projects are
presented in Table 8 for analysis. The first is a $300,000 investment that returns $100,000 per
year for five years. The other is a $2 million investment that returns $600,000 per year for
five years.

Both projects have Payback Periods well within the five year time period. Project A has the
shortest Payback Period of three years and Project B is only slightly longer. When the cash
flows are discounted (10 percent) to compute a Discounted Payback Period, the time period
needed to repay the investment is longer. Project B now has a repayment period over four
years in length and comes close to consuming the entire cash flows from the five year time
period.
The Net Present Value of Project B is $275,000 compared to only $79,000 for Project A. If
only one investment project will be chosen and funds are unlimited, Project B is the preferred
investment because it will increase the value of the company by $275,000.

However, Project A provides more return per dollar of investment as shown with the
Profitability Index ($1.26 for Project A versus $1.14 for Project B). So if funds are limited,
Project A will be chosen.

Both projects have a high Internal Rate of Return (Project A has the highest). If only one
capital project is accepted, it’s Project A. Alternatively, the company may accept projects
based on a Threshold Rate of Return. This may involve accepting both or neither of the
projects depending on the size of the Threshold Rate of Return.

When the Modified Internal Rates of Return are computed, both rates of return are lower than
their corresponding Internal Rates of Return. However, the rates are above the Reinvestment
Rate of Return of 10 percent. As with the Internal Rate of Return, the Project with the higher
Modified Internal Rate of Return will be selected if only one project is accepted. Or the
modified rates may be compared to the company’s Threshold Rate of Return to determine
which projects will be accepted.

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Example of Capital Budgeting:

Capital budgeting for a small scale expansion involves three steps: recording the investment’s
cost, projecting the investment’s cash flows and comparing the projected earnings with
inflation rates and the time value of the investment.

For example, equipment that costs $15,000 and generates a $5,000 annual return would
appear to "pay back" on the investment in 3 years. However, if economists expect inflation to
rise 30 percent annually, then the estimated return value at the end of the first year ($20,000)
is actually worth $15,385 when you account for inflation ($20,000 divided by 1.3 equals
$15,385). The investment generates only $385 in real value after the first year.

Capital Budgeting is an interesting concept and a high in demand skill among organizations
globally. Learning capital budgeting requires professional guidance to cover the complexities
of the topic well. There are courses that are focused on cost accounting and budgeting and
cover the topic extensively. Pursuing a course in Management Accounting also trains the
candidate on capital budgeting. Below are two courses that can be pursued to learn capital
Budgeting in depth:

Capital budgeting makes decisions about the long-term investment of a company's capital
into operations. Planning the eventual returns on investments in machinery, real estate and
new technology are all examples of capital budgeting. Managers may adopt one of several
techniques for capital budgeting, but many small businesses rely on the simplest technique,
called "payback period," which simply measures the time needed for the investment to return
its value. As your business grows beyond the small business, starting-up phase, you may
want to consider adopting more-sophisticated methods of calculating investment returns.

The payback period computation does not account for the time value of money, which
calculates how much money will be worth in the future based on projected interest rates. The
money spent in capital budgeting is actually worth more in the future because your business
could have invested the money and received interest payments. Small businesses using
payback period computations should account for the time value of money in order to create a
more accurate representation of when investments become profitable.

Small businesses must also account for inflation when evaluating investment options through
capital budgeting. When inflation increases, the value of money falls. Projected returns are
not worth as much as they appear if inflation increases, so seemingly profitable investments
may only break even or perhaps lose money when you account for inflation. Most small
businesses have neither the staff or the accounting experience to be aware of these factors, so
their return projections are less accurate than larger businesses' projections.

Capital budgeting for a dairy farm expansion involves three steps: recording the investment's
cost, projecting the investment's cash flows and comparing the projected earnings with
inflation rates and the time value of the investment. For example, dairy equipment that costs
$10,000 and generates a $4,000 annual return would appear to "pay back" on the investment
in 2.5 years.

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However, if economists expect inflation to rise 30 percent annually, then the estimated return
value at the end of the first year ($14,000) is actually worth $10,769 when you account for
inflation ($14,000 divided by 1.3 equals $10,769). The investment generates only $769 in
real value after the first year.

With the help of capital budgeting, we can understand that some methods make decisions
easy; however, some methods do not arrive at a decision; it makes it difficult for an
organization to make decisions. The below example of the capital budgeting technique shows
us how an organization can decide by comparing future cash inflows and outflows of the
individual projects. The point to be remembered on capital budgeting is that it considers only
financial factors in investment, as explained in the below examples, and not a qualitative
factor.

Capital budgeting is making long-term investment decisions, such as replacing existing

machinery with a new one. It involves analyzing a project’s future cash inflows and outflows
and determining whether it is financially viable.
While capital budgeting considers only financial factors and not qualitative factors in
investment decisions, it is a critical process for companies that require substantial funds for
capital expenditures.
Capital budgeting techniques include the payback period, accounting rate of return, net
present value, and discounted payback period, which provides a quantitative analysis for
choosing the most profitable investment.

So how long will it take the company to recover invested money from the above table it
shows three years and some months. But this is not the right way to find out a payback period
of initial investment because the company’s base is profit. It is not a cash flow, so profit is
not the right criteria, so a company should use it here as cash flow. So profit is arrived after
deducting depreciation value, so to know the cash flows, we have to add depreciation in
profit. The depreciation value is $2,000, so net cash flows will be as listed in the below table.

So from Cash flow analysis,

the company will recover the initial investment within two years. So the payback period is
nothing but the time taken by cash inflows to recover the investment amount.

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 Calculate the Payback Period and Discounted Pay Back Period for the project, which costs
$270,000 and projects expected to generate $75,000 per year for the next five years? The
company required rate of return is 11 percent. Should the company go ahead and invest in a
project? The rate of return is 11%. Do we have to find it here, PB?DPB?Should the project be
purchased?

Solution:

After adding each year’s cash flows, the balance will come, as shown in the below table.

From the above table, positive balance is in between 3 and 4 years, so,

 PB= (Year – Last negative Balance)/Cash Flows

 PB=[3-(-45,000)]/75,000
 PB= 3.6 Years

Or

17
 PB= Initial Investment/Annual Cash Flows
 PB= 270,000/75,000
 PB= 3.6 Years.

The Discounted rate of return of 11% Present Value of Cash Flows are shown below.

 DPB= (Year – Last negative Balance)/Cash Flows

 DPB= [(4-(37,316.57)/44,508.85)
 DPB= 4.84 Years

So from both capital budgeting methods, it is clear that the company should go ahead and invest in
the project as though both methods will cover the initial investment before five years.

The accounting rate of Return technique of capital budgeting measures the annual average
rate of return over the assets life. Let’s see through this example below.
XYZ limited company planning to buy some new production equipment, which costs
$240,000, but the company has unequal net cash inflows during its life, as shown in the table,
and $30,000 residual value at the end of its life. Calculate the accounting rate of return?

18
 Solution:

First, calculate the Average Annual Cash Flows

 =Total cash Flows/Total Number of Year

 =360,000/6

Average Annual Cash Flows =$60,000

Calculate Annual Depreciation Expenses

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 =$240,000-$30,000/6

=210,000/6

Annual Depreciation Expenses =$35,000

Calculate ARR

 ARR=Average Annual net cash flows – Annual Depreciation Expenses/ Initial Investment
 ARR=$60,000- $35,000/$240,000
 ARR=$25,000/$240,000 × 100
 ARR=10.42%

Conclusion – If ARR is higher than the hurdle rate established by company management, it
will be considered, and vice versa, it will be rejected.
Example #4 (Net Present Value)

Met Life Hospital is planning to buy an attachment for its X-ray machine, The cost of the
attachment is $3,170, and life of 4 years, Salvage value is zero, and an increase in cash
inflows every year is $1,000. No investment is to be made unless having an annual of 10%.
Will MetLife Hospital invest in the attachment?

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Solution:

Total investment Recovered (NPV)= 3170

The above table shows that cash inflows of $1,000 for four years are sufficient to recover the
initial investment of $3,170 and provide exactly a 10% return on investment. So MetLife
Hospital can invest in X-ray attachment.

Example #5

ABC limited company is looking to invest in one of the project costs of $50,000 and cash
inflows and outflows of a project for five years, as shown in the below table. Calculate Net
Present Value and Internal Rate of Return of the Project. The interest rate is 5%.

21
Solution:

First, calculate net cash flows during that period by Cash inflows – Cash outflows, as shown
in the table below.

NPV= -50,000+15,000/(1+0.05)+12,000/(1+0.05)²+10,000/(1+0.05)³+ 10,000/(1+0.05)⁴+

14,000/1+0.05)5

NPV= -50,000+14,285.71+10,884.35+8,638.56+8,227.07+10,969.21

NPV= $3,004.84 (Fractional Rounding of)

Calculate IRR

22
 Internal Rate of Return = 7.21%
If you take IRR 7.21% the net present value will be zero.

Points to Remember

 If IRR is > than Discount (interest) rate, than NPV is > 0

 If IRR is < than Discount (interest) rate, than NPV is < 0
 If IRR is = to Discount (interest) rate, than NPV is = 0

Capital investments are long-term investments in which the assets involved have useful lives
of multiple years. For example, constructing a new production facility and investing in
machinery and equipment are capital investments. Capital budgeting is a method of
estimating the financial viability of a capital investment over the life of the investment.
Unlike some other types of investment analysis, capital budgeting focuses on cash flows
rather than profits. Capital budgeting involves identifying the cash in flows and cash out
flows rather than accounting revenues and expenses flowing from the investment. For
example, non-expense items like debt principal payments are included in capital budgeting
because they are cash flow transactions. Conversely, non-cash expenses like depreciation are
not included in capital budgeting (except to the extent they impact tax calculations for “after
tax” cash flows) because they are not cash transactions. Instead, the cash flow expenditures
associated with the actual purchase and/or financing of a capital asset are included in the
analysis.
Over the long run, capital budgeting and conventional profit-and-loss analysis will lend to
similar net values. However, capital budgeting methods include adjustments for the time
value of money (discussed in AgDM File C5-96, Understanding the Time Value of Money).
Capital investments create cash flows that are often spread over several years into the future.
To accurately assess the value of a capital investment, the timing of the future cash flows are
taken into account and converted to the current time period (present value).

23
Capital Investment:

Capital investment is the acquisition of physical assets by a company for use in furthering its
long-term business goals and objectives. Real estate, manufacturing plants, and machinery
are among the assets that are purchased as capital investments.

The capital used may come from a wide range of sources from traditional bank loans to
venture capital deals.

Capital investment is the expenditure of money to fund a company's long-term growth.

The term often refers to a company's acquisition of permanent fixed assets such as real estate
and equipment.
Capital assets are reported as non-current assets and most are depreciated.
The funds for capital investment can come from a number of sources, including cash on hand,
though big projects are most often financed through obtaining loans or issuing stock.
Examples of capital investments are land, buildings, machinery, equipment, or software.

An individual, a venture capital group or a financial institution may make a capital

investment in a business. The money can be provided as a loan or a share of the profits down
the road. In this sense of the word, capital means cash.
The executives of a company may make a capital investment in the business. They buy long-
term assets such as equipment that will help the company run more efficiently or grow faster.
In this sense, capital means physical assets.
In either case, the money for capital investment must come from somewhere. A new
company might seek capital investment from any number of sources, including venture
capital firms, angel investors, or traditional financial institutions. When a new company goes
public, it is acquiring capital investment on a large scale from many investors.

An established company might make a capital investment using its own cash reserves or seek
a loan from a bank. It might issue bonds or stock shares in order to finance capital
investment. There is no minimum or maximum capital investment. It can range from less than
$100,000 in seed financing for a start-up to hundreds of millions of dollars for massive
projects undertaken by companies in capital-intensive sectors such as mining, utilities, and
infrastructure.

A decision by a business to make a capital investment is a long-term growth strategy. A

company plans and implements capital investments in order to ensure future growth. Capital
investments generally are made to increase operational capacity, capture a larger share of the
market, and generate more revenue. The company may make a capital investment in the form
of an equity stake in another company's complementary operations for the same purposes.

In many cases, capital investments are a necessary and normal part of an industry. Consider
an oil-drilling company that relies on heavy machinery to extract raw materials to be
processed. As opposed to a law firm that will have low-to-no capital investment
requirements, capital-intensive businesses usually need specific assets in order to operate.

24
In addition, there are strategic components for a business to consider when deciding whether
or not to invest in a capital asset. For instance, consider how certain heavy machinery such as
a company vehicle could be leased. Should the company be willing to incur debt and tie up
capital, the company may spend less money in the long-term by incurring a capital
investment as opposed to a periodic "rental" expense.
Types of Capital Investments
Companies often acquire capital investments for diversification, modernization, or business
expansion. This may mean buying capital investments different from existing aspects of its
business or capital investments that simply do things better than before. Some specific types
of capital investments include:

Land: Companies may buy bare land to be used for development or expansion.
Buildings: Companies may buy existing buildings for manufacturing, storage, production, or
headquarter operations.
Assets Under Development: Companies may incur spending over time to assemble assets that
may be capitalized. For example, a company can build its own building; the accumulation of
charges may be considered a capital investment.
Furniture and Fixtures: Though furniture and fixtures may be more temporary in nature,
certain aspects of accounting rules result in some overlap between FFE and capital
investments.
Machines: Companies that invest in the production elements of making goods are making
capital investments.
Software Development or Computing Devices: Companies more frequently invest capital to
build software; these costs now commonly qualify for capitalization and amortization over
time.

The advantages of capital investments can vary depending on the specific situation. However,
most companies embark on capital investments for productivity. By investing in new
equipment or technology, companies can improve their efficiency, thus lower costs and
increasing output. These types of investments may also improve the quality of goods
produced.

Capital investments can also lead to cost savings over time. For example, a new piece of
equipment may be more energy-efficient than an older model, which can result in lower
utility bills. Similarly, new technology may streamline processes and reduce the need for
manual labor. Last, companies may decide the long-term discounted cashflow is favorable
when comparing the upfront investment of a capital investment compared to the long-term,
ongoing cash outlay of a recurring expense.

By investing in their long-term assets, companies can also gain a competitive advantage in
the market. This can make it more difficult for competitors to catch up, and can help the
company to maintain its market position over the long term. If a company is willing to take a
risk and incur a large investment to strengthen its business, this may create a barrier to entry
that competitor can not overcome or compete against.

25
Cons of Capital Investment
The preferred option for capital investment is always a company's own operating cash flow,
but that may not be sufficient to cover the anticipated costs. It is more likely the company
will resort to outside financing. Therefore, there is usually a little more risk to capital
investments. This is especially true for capital investments that are customized or hard to
liquidate; once the company has bought the capital investment, it may be hard to exit the
investment.

Capital investment is meant to benefit a company in the long run, but it nonetheless can have
short-term downsides. Capital investments tends to reduce earnings growth in the short term,
and that never pleases stockholders of a public company. This may be especially true for
capital investments that also incur operating costs (i.e. the acquisition of land will be
accompanied by a potentially hefty annual property tax assessment).

In addition, if a company does not have sufficient capital on hand to make a large investment,
there are downsides to each of its financing options. Issuing additional stock shares, which is
often the funding option for public companies, dilutes the value of its outstanding shares.
Existing shareholders generally dislike finding that their stake in the company has been
reduced. Alternatively, the total amount of debt a company has on the books is closely
watched by stockholders and analysts. The payments on that debt can stifle the company's
further growth.

Pros
May increase productivity if capital investment is more efficient than prior methods

May result in higher quality manufactured goods

May be cheaper in the long-run when compared against rented or monthly expensed solutions

May create a barrier to entry that yields a competitive advantage

Cons
May be too expensive for the company to outright purchase on their own.

May limit or restrict short-term profitability of the company

May be accompanied by additional operating expenses

May reduce the liquidity of the company should it be difficult to sell the capital asset

Accounting for Capital Investments

Accounting practices for capital investments involve recording the cost of the asset,
allocating the cost over its useful life, and carrying the investment as the difference between
cost and accumulated depreciation. The accounting treatment can vary depending on the type
of asset, as land is not depreciated but many other capital investments are depreciated.

26
The cost of the asset should be recorded in the company's accounting records. This can
include the purchase price of the asset as well as any additional costs related to the purchase
such as installation or transportation costs. Companies may record the fair market value for
certain capital investments under certain circumstances, but capital investments must initially
be recorded at cost.

If the asset has a cost that meets the company's capitalization policy, the cost of the asset will
be recorded as a capital asset on the balance sheet. This allows the company to spread the
cost of the asset over its useful life and to recognize the expense over time. This is the
primary difference between the assets mentioned earlier and normal operating costs, as
operating costs are expensed in the period they are incurred while capital investment costs are
spread over time.

The useful life of a capital investment is an estimate of the number of years that the asset will
be used by the company. The depreciation method used will depend on the asset and the
company's accounting policies, but commonly used methods include straight-line, declining
balance, and sum-of-the-years'-digits. Companies may also record impairments to reduce the
value of a capital investment should a loss be incurred. In addition, whereas operating
expenses may simply be stopped, companies have a series of entries to post when a capital
investment is disposed of.

Example of Capital Investment

As part of its year-end financial statements, Amazon.com reported the following assets it
owned for fiscal year 2021 and 2022.

Amazon, Balance Sheet

Amazon, Balance Sheet.
This format of the balance sheet is standard where assets are reported by liquidity starting
with the most liquid assets. Because capital investments are not liquid, they are often reported
lower in the list.

At year-end 2022, Amazon reported a net asset balance of $186.7 billion for property and
equipment. This figure is net because capital investments, aside from land, are often
depreciated and reported as their cost less any accumulated depreciation. Note that this
$186.7 billion is also being excluded from current assets. Because of the long-term nature of
capital investments, they are reported as noncurrent assets.

27
The advantages of capital investments can vary depending on the specific situation. However,
most companies embark on capital investments for productivity. By investing in new
equipment or technology, companies can improve their efficiency, thus lower costs and
increasing output. These types of investments may also improve the quality of goods
produced.

Capital investments can also lead to cost savings over time. For example, a new piece of
equipment may be more energy-efficient than an older model, which can result in lower
utility bills. Similarly, new technology may streamline processes and reduce the need for
manual labor. Last, companies may decide the long-term discounted cashflow is favorable
when comparing the upfront investment of a capital investment compared to the long-term,
ongoing cash outlay of a recurring expense.

By investing in their long-term assets, companies can also gain a competitive advantage in
the market. This can make it more difficult for competitors to catch up, and can help the
company to maintain its market position over the long term. If a company is willing to take a
risk and incur a large investment to strengthen its business, this may create a barrier to entry
that competitor can not overcome or compete against.

Cons of Capital Investment

The preferred option for capital investment is always a company's own operating cash flow,
but that may not be sufficient to cover the anticipated costs. It is more likely the company
will resort to outside financing. Therefore, there is usually a little more risk to capital
investments. This is especially true for capital investments that are customized or hard to
liquidate; once the company has bought the capital investment, it may be hard to exit the
investment.

Capital investment is meant to benefit a company in the long run, but it nonetheless can have
short-term downsides. Capital investments tends to reduce earnings growth in the short term,
and that never pleases stockholders of a public company. This may be especially true for
capital investments that also incur operating costs (i.e. the acquisition of land will be
accompanied by a potentially hefty annual property tax assessment).

In addition, if a company does not have sufficient capital on hand to make a large investment,
there are downsides to each of its financing options. Issuing additional stock shares, which is
often the funding option for public companies, dilutes the value of its outstanding shares.
Existing shareholders generally dislike finding that their stake in the company has been
reduced. Alternatively, the total amount of debt a company has on the books is closely
watched by stockholders and analysts. The payments on that debt can stifle the company's
further growth.

28
Pros
May increase productivity if capital investment is more efficient than prior methods

May result in higher quality manufactured goods

May be cheaper in the long-run when compared against rented or monthly expensed solutions

May create a barrier to entry that yields a competitive advantage

Cons
May be too expensive for the company to outright purchase on their own.

May limit or restrict short-term profitability of the company

May be accompanied by additional operating expenses

May reduce the liquidity of the company should it be difficult to sell the capital asset

Accounting for Capital Investments

Accounting practices for capital investments involve recording the cost of the asset,
allocating the cost over its useful life, and carrying the investment as the difference between
cost and accumulated depreciation. The accounting treatment can vary depending on the type
of asset, as land is not depreciated but many other capital investments are depreciated.

The cost of the asset should be recorded in the company's accounting records. This can
include the purchase price of the asset as well as any additional costs related to the purchase
such as installation or transportation costs. Companies may record the fair market value for
certain capital investments under certain circumstances, but capital investments must initially
be recorded at cost.

If the asset has a cost that meets the company's capitalization policy, the cost of the asset will
be recorded as a capital asset on the balance sheet. This allows the company to spread the
cost of the asset over its useful life and to recognize the expense over time. This is the
primary difference between the assets mentioned earlier and normal operating costs, as
operating costs are expensed in the period they are incurred while capital investment costs are
spread over time.

The useful life of a capital investment is an estimate of the number of years that the asset will
be used by the company. The depreciation method used will depend on the asset and the
company's accounting policies, but commonly used methods include straight-line, declining
balance, and sum-of-the-years'-digits. Companies may also record impairments to reduce the
value of a capital investment should a loss be incurred. In addition, whereas operating
expenses may simply be stopped, companies have a series of entries to post when a capital
investment is disposed of.

29
Project Of Cash Flows:

First things first, if you want to learn about cash flow projections, you need to know what
cash flow is.

Cash flow is the amount of money going in and out of your business. Healthy cash flow can
help lead your business on a path to success. But poor or negative cash flow can spell doom
for the future of your business.

If you want to predict your business’s cash flow, create a cash flow projection. A cash flow
projection estimates the money you expect to flow in and out of your business, including all
of your income and expenses.

Typically, most businesses’ cash flow projections cover a 12-month period. However, your
business can create a weekly, monthly, or semi-annual cash flow projection.

Advantages of projecting cash flow

Estimating anticipated cash flow projections can help boost your business’s success.

Projecting cash flows has many advantages. Some pros of creating a cash flow projection
include being able to:

Predict cash shortages and surpluses

See and compare business expenses and income for periods
Estimate effects of business change (e.g., hiring an employee)
Prove to lenders your ability to repay on time
Determine if you need to make adjustments (e.g., cutting expenses)
Cash flow projection isn’t for every business. Your projected cash flow analysis can be time-
consuming and costly if done wrong.

Keep in mind that cash flow predictions will likely never be perfect. However, you can use
your projected cash flow as a tool to help manage cash flow.

The bottom line is, your cash projections give you a clearer picture of where your business is
headed. And, it can show you where you need to make improvements and cut costs.

How to calculate projected cash flow

If you’re ready to start calculating projected cash flow for your business, start gathering some
historical accounting data.

You need to get reports detailing your business’s income and expenses from your accountant,
books, or accounting software. Depending on the timeframe you want to predict, you might
need to gather additional information.

Want to learn how to calculate cash flow projections? Use the projected cash flows steps
below.

30
1. Find your business’s cash for the beginning of the period
To calculate your cash from the beginning of the period, you need to subtract the previous
period’s expenses from income.

Cash at Beginning of Period = Previous Period’s Income – Previous Period’s Expenses

2. Estimate incoming cash for next period

Next, you need to predict how much cash will come into your business during the next
period.

Incoming cash includes things like revenue, sales made on credit, loans, and more.

You can forecast future cash by looking at trends from previous periods. Be sure to account
for any changes or factors that differ from previous periods (e.g., new products).

3. Estimate expenses for next period

Think about all the expenses you will pay next period. Consider things like raw materials,
rent, utilities, insurance, and other bills.

4. Subtract estimated expenses from income

To calculate your business’s cash flow, subtract your estimated expenses from your estimated
income.

Cash Flow = Estimated Income – Estimated Expenses

5. Add cash flow to opening balance

After you calculate cash flow, you need to add it to your opening balance. This will also give
you your closing balance. Your closing balance will carry over to act as your starting balance
for the next period.

Creating a projection of cash flow

If you want to create your own cash flow projection, start drafting out columns for your
future periods. Or, you can take advantage of a spreadsheet to organize your cash flow
statement projections.

You should include the following categories in your cash flow projection:

Opening balance
Cash in (e.g., sales)
Cash out (e.g., expenses)
Totals for cash in and cash out
Uses of cash (e.g., materials)
Total cash flow for the period
Closing balance
Periods (e.g., month of January)
After you lay out the sections on your cash flow projection report, plug in your projected cash
flow calculations.

31
Revisiting your cash flow projection
Cash flow projections are not set in stone. Revisit your projection from time to time to see
where you stand.

If you see major differences or flaws in your cash flow forecast, it may be time to crunch
more numbers and do some digging. Pinpointing issues with your projection early on can
prevent major inaccuracies in the future.

To ensure your projection stays as accurate as possible, consider variable expenses such as:

Months with three paychecks

Sales during peak seasons
Months when premiums are due (e.g., insurance)
Hiring additional workers
A good rule of thumb is to not project too far into the future. Too many variables can come
into play with your business (e.g., dip in the economy) and affect your future cash flow.

As mentioned, a standard time period for cash flow projection is 12 months. Try to limit your
cash flow projection time period to only a year in advance. That way, you can help prevent
unforeseen expenses and errors impacting your projection.

If you don’t have time to track financial forecasts, consider delegating projection updates to a
bookkeeper. Or, you can streamline the way you track cash flow with basic accounting
software.

Project cash flow refers to how cash flows in and out of an organization in regard to a
specific existing or potential project. Project cash flow includes revenue and costs for such a
project.

Below are some basic principles of project cash flow:

It is a crucial part of financial planning concerning a company’s current or potential projects

that don’t require a vendor or supplier.
Experts sometimes call project cash flow relevant cash flow, which refers to when a company
is still deciding whether a project is worth its time. In order to calculate the relevant cash flow
of a project, a company analyzes the cash inflows and outflows that would occur if it decided
to take on the project. When performing a project cash flow analysis, be sure to exclude all
ongoing and non-relevant costs, like office rent or regular salaries.
Your project cash flow forecast should include at least monthly increments in order to show
project-related costs and revenue, as well as when you will realize those costs and revenue.
As mentioned above, a project cash flow analysis is less important if you’re not using outside
vendors or suppliers — without external contracts, a project incurs no outside costs. Still,
even a project without contractors can benefit from a project cash flow analysis, as the
process can help your company quantify the resources it is using for the project.
Company leaders should approve a project cash flow and cost benefit analysis before a
company decides to take on a project.
Periodically, the project manager should compare a project’s cash flow projections with its
actual results. Then, you should adjust the plan accordingly.

32
Project Cash Flow Forecast
A project cash flow forecast includes cost estimates for a project, as well as a schedule of
when you will incur those costs. This forecast also displays the project’s revenue and a
schedule of when you will receive that revenue.

Here are some helpful recommendations for tracking project expenses:

Create a Forecast Calendar: Organize your forecast according to the various phases of a
project, and then fill in the particulars about your work breakdown structure (WBS) for each
phase. In addition, be sure to include project codes for each cost.
Include Payment Due Dates: Be sure to input the due dates for payments to suppliers or
vendors.

Use Supplier/Vendor Terms as a Guide: A supplier’s contract terms will clearly state a
payment due date. Use this information for your calendar.
Show the True Cost of a Project: You should also include a project’s payroll and other
estimated costs in order to obtain a more accurate picture of that project’s total cost.

Project Cash Flow Analysis

A project cash flow analysis allows you to look closely at the cash inflows and outflows
associated with an existing or potential project. The analysis also addresses opportunity costs
(i.e., the amount of money your company loses by embarking on a project).

Here are some details to consider when performing a project cash flow analysis:

Sunk Costs: These are costs that your company incurs whether you take on a project or not.
Sunk costs generally refer to the fixed costs you incur by running your business, such as rent,
overall payroll, research and development, and other expenses.

Initial Investments: These investments refer to the cash outlays for the equipment and other
assets that you need to execute a project.

Relevant Cash Flows: These are the revenue and costs that occur due to a project. They
include the following:

Incremental Cash Flows: These refer to all the cash inflows and outflows that result from a
project, including payments to suppliers and equipment leases.

Terminal Cash Flow: This term refers to proceeds from the equipment that you buy and use
specifically for a project.

Opportunity Costs: This refers to the amount of money your company loses by embarking on
a project. For example, participating in a year-long project might require an investment of
$50,000 for new equipment. If investing that money otherwise would net you $10,000, then
your opportunity costs include that $10,000.

33
Issues that a Project Cash Flow Analysis
A project cash flow analysis can highlight potential issues and give you time to deal with
them. Issues might include having too many bills due simultaneously or needing clients to
pay sooner.

Here are the major ways that a project cash flow analysis can help you adjust to potential
issues:

Change Your Inventory Buying Schedule: The analysis can help you spread out your
inventory purchases over a longer period of time, so you can avoid paying large amounts all
at once.

Stagger Other Purchases or Bill-Paying Requirements: A cash flow analysis allows you to
stagger other bills, so they are spread out over several months.

Stagger Other Large Payments: It also allows you to stagger other large payments that are
due (e.g., quarterly taxes or annual insurance).

Show You the Need for Upfront Payments from Clients: A cash flow analysis can indicate
when your project needs a larger down payment from a client. It can also show cases in
which subsequent payments should be due sooner. Barbee says that requiring down payments
or other types of upfront financial commitments is “a good way of setting your expectations
for a client.” How a client responds to such requirements can also reveal how serious and
committed they are. “If they don't want to put something down, that could be a red flag,” she
says.

Change Your Buying Terms: It can give you the opportunity to change the buying terms for
some materials, thereby spreading out payments over a longer term.
Alert You to the Need for a Loan: The analysis can show you when cash is low and give you
time to secure a loan on favorable terms.

Tips and Best Practices for Project-Based Cash Flow Analysis

Experts recommend a number of best practices for performing effective project cash flow
analyses, including making sure that you identify project-specific expenses and revenue.

Here are some best practices for creating a project-based cash flow analysis:
Identify and Separate the Variable Expenses Related to a Project: Many organizations aren't
careful enough about separating the expenses associated with a specific project.
"Organizations have a heavy predilection toward commingling the cost of goods with
overhead expenses,” says Barbee. When you commingle the two, you “can’t distinguish
between variable costs and fixed costs. You have to untangle those first.”
Ensure You Understand the Five Stages of Project Cost: For the purposes of a project cash
flow analysis, a cost is only a real cost when you’ve paid for it. There are four earlier stages
for that type of expense: when you’ve budgeted for the expense; when you’ve committed to
making the purchase; when you’ve actually made the purchase and had materials delivered to
you; and when you’ve been invoiced for the purchase.

34
Practice Incremental or Milestone Billing: This means invoicing clients for a portion of work
as you reach various project milestones. By doing this, you receive smaller, more frequent
payments throughout the project, thereby increasing your cash flow.

Practicing this type of billing also means identifying and tracking the hours your staff devotes
to a project. Even when your company doesn’t owe an outside supplier for project-related
work, you should still understand the hours your employees are spending on a project. Barbee
says that you should track those employee hours “even if you’re only charging a flat rate for a
project. That way, you can get the analytics.”
Assign Loans and Grants to a Project: You might get loans or government grants to do work
on a project. Make sure you assign that revenue, and any interest on the loans, to that
particular project’s revenues and costs.
Make an Accurate Estimate Regarding Expected Staff Hours: Bissett says company owners
or project managers with deep expertise in an industry can often perform certain tasks much
more quickly than other company staff can. Consequently, owners or project managers might
underestimate how long it will take their staff to complete such tasks for a client.

Managing finances is critical to execute any work. One must know what is available in hand,
how much is required to be spent, and the limitations. Efficient money management is the
key to succeed in every project delivery to meet the customer need and generate profit to the
organization.

The movement of finances in and out of any business is called cashflow. The money in the
form of income becomes a positive and that which is spent out as expenditure is called the
negative cashflow respectively. Cash flows are used not only to measure the present income
and expenses but also to measure the future potential of the financial resources for the
business.

It is used to evaluate the risks within a financial product such as evaluating default risk,
matching cash requirements or re-investment requirements, etc.

• It is used to determine the project's rate of return or value, the flow of money into and out of
the project is used in financial models to determine the net present value and the rate of return
respectively.

• It also helps in determining the problems with the organizational liquidity factor. The
liquidity is the amount of hot cash or the running money available for expenditure mainly
operational ones. Being profitable does not necessarily mean that there is liquidity; the
organization may fail due to a shortage of funds while being profitable.

• By accrual accounting standard the cashflow factor is used to evaluate the quality of the
income. If the income consists of large non-cash items it is called low-quality cashflow.

• Accrual accounting concepts do not represent the economic realities of the company. For
example, an organization may be notionally profitable but maybe generating less or little
operational cash. And therefore in such cases, the organization may be required to go in for
more debt by issuing shares or raising additional debt finance for raising the required
operational cash.

35
• However, it is a subjective term and used as per the person's requirements. It can be used for
measuring current income or to measure future profits. It can be represented as the total of all
money involved so far or the subset of those funds. Enroll for the PMP certification course at
StarAgile and become a certified project management executive.

Project cash flow is used to measure the outflow and inflow of money from the project to the
organizations. It is not easy to do budgeting with the cashflows, if you are not experienced
and do not have any knowledge of budgeting then the project is destined to be doomed. That
is the reason the project cash flows are an important subject and you must know how to work
on them. The inflow of cash is known as the revenue generated from the project. And the
outflow of the cash is called the project expenditure. Register for the PMP training at
StarAgile institute and learn the concepts of cash flow management in detail along with all
roles of a PM.

If the inflow is more than the outflow for the project then it is called the profit and this must
be the typical situation for any project. However, not all projects generate profits. The
viceversa is called the loss for the project. Sometimes over the period the cash outflow and
inflow are the same and this is the situation where the project has not attained any profit or
loss. However, it is just the experience gained which will help in generating profit in the
future project.

In this subheading let us discuss how the project flow analysis is done. The cashflow can be
of three types and is found in the different stages of the projects. They are operational
cashflow, financial cashflows, and investment cashflows.

• The operational cash flows are the ones that involve cash outflow/inflow in the form of day-
to-day operations such as expenditure for raw materials, labor salaries, energy consumptions,
etc.

• The financial cash outflow/inflow are the ones that are expenditure due to insurance of debt
to equity etc

• The investment cash outflow/inflow is the ones that are related to the procurement of assets
and capital expenditures such as building, equipment, tools, and machinery, etc.

The cash flows factors can be considered to calculate the parameters to measure
organizational performance. A business's statement of cashflows is the net flow for that
business or the organization. If the net flow increases then it is called positive net flow. If the
net flow decreases then it is called the negative net flow. It depends on the project's results to
have positive or negative cashflows. This net flow as discussed consists of three parameters
such as operating, investment, and financial cashflows. Learn effectively the project
management concepts and cash flow analysis by taking up the PMP course online at
StarAgile.

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Steps to Prepare Project on Cash Flow Statement
A projected cash flow statement is used in the project and is used to evaluate the cash
outflows and inflows for an economic entity to determine how much, when, and for how long
the cash deficits or surpluses will exist for that entity during the upcoming period.

Let us consider a template example on the cash flow sheet for a sample project.

The steps involved are

• Beginning of the cash balance---

• Total cash available---

• Total cash on the assets---

• Total cash on the operational items---

• Total cash on the payment of the term debt with interest---

• Other expenses and taxes---

• Total cash required---

A cash flow statement is one of the most important financial statements for a project or
business. The statement can be as simple as a one page analysis or may involve several
schedules that feed information into a central statement.
A cash flow statement is a listing of the flows of cash into and out of the business or project. Think
of it as your checking account at the bank. Deposits are the cash inflow and withdrawals
(checks) are the cash outflows. The balance in your checking account is your net cash flow at
a specific point in time.
A cash flow statement is a listing of cash flows that occurred during the past accounting
period. A projection of future flows of cash is called a cash flow budget. You can think of a
cash flow budget as a projection of the future deposits and withdrawals to your checking
account.
A cash flow statement is not only concerned with the amount of the cash flows but also the
timing of the flows. Many cash flows are constructed with multiple time periods. For
example, it may list monthly cash inflows and outflows over a year’s time. It not only
projects the cash balance remaining at the end of the year but also the cash balance for each
month.
Working capital is an important part of a cash flow analysis. It is defined as the amount of
money needed to facilitate business operations and transactions, and is calculated as current
assets (cash or near cash assets) less current liabilities (liabilities due during the upcoming
accounting period). Computing the amount of working capital gives you a quick analysis of
the liquidity of the business over the future accounting period. If working capital appears to
be sufficient, developing a cash flow budget may not be critical. But if working capital
appears to be insufficient, a cash flow budget may highlight liquidity problems that may
occur during the coming year.
Most statements are constructed so that you can identify each individual inflow or outflow
item with a place for a description of the item. Statements like Decision Tool Cash Flow

37
Budget (12 periods) provides a flexible tool for simple cash flow projections. A more
comprehensive tool for a Farm Cash Flow (Decision Tool) is also available. A more in-depth
discussion of creating a cash flow budget is Twelve Steps to Cash Flow Budgeting.
Some cash flow budgets are constructed so that you can monitor the accuracy of your
projections. These budgets allow you to make monthly cash flow projections for the coming
year and also enter actual inflows and outflows as you progress through the year. This will
allow you to compare your projections to your actual cash flows and make adjustments to the
projections for the remainder of the year.

Reasons for Creating a Cash Flow Budget

Think of cash as the ingredient that makes the business operate smoothly just as grease is the
ingredient that makes a machine function smoothly. Without adequate cash a business cannot
function because many of the transactions require cash to complete them.
By creating a cash flow budget you can project sources and applications of funds for the
upcoming time periods. You will identify any cash deficit periods in advance so you can take
corrective actions now to alleviate the deficit. This may involve shifting the timing of certain
transactions. It may also determine when money will be borrowed. If borrowing is involved,
it will also determine the amount of cash that needs to be borrowed.
Periods of excess cash can also be identified. This information can be used to direct excess
cash into interest bearing assets where additional revenue can be generated or to scheduled
loan payments.
Cash Flow is not Profitability
People often mistakenly believe that a cash flow statement will show the profitability of a
business or project. Although closely related, cash flow and profitability are different. A cash
flow statement lists cash inflows and cash outflows while the income statement lists income
and expenses. A cash flow statement shows liquidity while an income statement
shows profitability.
Many income items are also cash inflows. The sales of crops and livestock are usually both
income and cash inflows. The timing is also usually the same as long as a check is received

38
and deposited in your account at the time of the sale. Many expense items are also cash
outflow items. The purchase of livestock feed (cash method of accounting) is both an expense
and a cash outflow item. The timing is also the same if a check is written at the time of
purchase.
However, there are many cash items that are not income and expense items, and vice versa.
For example, the purchase of a tractor is a cash outflow if you pay cash at the time of
purchase as shown in the example in Table 1. If money is borrowed for the purchase using a
term loan, the down payment is a cash outflow at the time of purchase and the annual
principal and interest payments are cash outflows each year as shown in Table 2.
The tractor is a capital asset and has a life of more than one year. It is included as an expense
item in an income statement by the amount it declines in value due to wear and obsolescence.
This is called “depreciation”. The cost of depreciation is listed every year. In the tables below
a $70,000 tractor is depreciated over seven years at the rate of $10,000 per year.
Depreciation calculated for income tax purposes can be used. However, to more accurately
calculate net income, a realistic depreciation amount should be used to approximate the actual
decline in the value of the machine during the year.
In Table 2, where the purchase is financed, the amount of interest paid on the loan is included
as an expense, along with depreciation, because interest is the cost of borrowing money.
However, principal payments are not an expense but merely a cash transfer between you and
your lender.

39
A cash flow statement is only one of several financial statements that can be used to measure
the financial strength of a business. Other common statements include the balance sheet or
Net Worth Statement and the Income Statement, although there are several other statements
that may be included.

These statements fit together to form a comprehensive financial picture of the business. The
balance sheet or net worth statement shows the solvency of the business at a specific point in
time. Statements are often prepared at the beginning and ending of the accounting period (i.e.
January 1). The statement records the assets of the business and their value and the liabilities
or financial claims against the business, i.e. debts. The amount by which assets exceed
liabilities is the “net worth” of the business. The net worth reflects the current value of
investment in the business by the owners.

40
Basic Principles for Measuring Project Cash Flows:

1. Principle of Incremental Cash Flows

The cash flows of a project must be measured in incremental terms. To ascertain a project’s
incremental cash flows, one has to look at what happens to the cash flows of the firm with
the project and without the project. The difference between the two reflects the incremental
cash flows attributable to the project.

Project Cash Flow for year t = Cash flow for the firm with the project for year t – Cash
flow for the firm without the project for year t

In estimating the incremental cash flows of a project, the following guidelines must be borne
in mind:

Consider all incidental effects

Ignore sunk costs
Include opportunity costs
Question the allocation of overhead costs

2. Principle of Long Term Funds

A project may be evaluated from various points of view: total funds point of view, long term
funds point of view, and equity point of view. The measurement of cash flows as well as the
determination of the discount rate for evaluating the cash flows depends on the point of view
adopted. It is generally recommended that a project may be evaluated from the point of view
of long-term funds (which are provided by equity stockholders, preference stock-holders,
debenture holders, and term-lending institutions) because the principal focus of such
evaluation is normally on the profitability of long-term funds. This argument, though
plausible, cannot be regarded as unassailable. Nonetheless, we subscribed to the position that
it is quite reasonable to view a project from the long-term funds point of view. Hence for
determining the costs and benefits of an investment project we will raise the questions. What
is the sacrifice made by the suppliers of long term funds? What benefits accrue to the
suppliers of long-term funds? The sacrifice made by the suppliers of long-term funds is equal
to the outlays on fixed assets and net working capital (it may be recalled that net working
capital, which represents the difference between current assets and current liabilities, is
supported by long-term funds). The benefits accruing to the suppliers of long-term funds
consist of operational cash inflows after taxes and salvage value of fixed assets and net
working capital.

3. Principle of Financing Costs Exclusion

When cash flows relating to long-term are being defined, financing costs of long-term funds
[interest on long-term debt and equity dividend] should be excluded from the analysis. Why?
The weighted average cost of capital used for evaluating the cash flows takes into
account the cost of long-term funds. Put differently the interest and dividend payments are
reflected in the weighted average cost of capital Hence, if interest on long term debt and
dividend on equity capital are deducted in defining the cash flows, the cost of long-term
funds will be counted twice – an error that should be carefully guarded against.
Operationally, the exclusion of financing costs principle means that
The interest on long-term debt [referred to hereafter as just interest for the sake of simplicity]
is ignored while computing profits and taxes thereon and

41
The expected dividends are deemed irrelevant in cash flow analysis.
While dividends pose no difficulty as they come only from profit after taxes, interest needs
to be handled properly. Since interest is usually deducted in the process of arriving at profit
after tax, an amount equal to interest [1 -tax rate] should be added back to the figure of
profit after tax. Thus, whether the tax rate is applied directly to the profit before interest and
tax figure or whether the tax adjusted interest, which is simply interest [1-tax rate], is added
to profit after tax, we get the same result.

4. Principle of Post-tax
Tax payments like other payments must be properly deducted in deriving the cash flows. Put
differently cash flows must be defined in post-tax terms [It may be noted that the cost of
capital employed for evaluating the cash flow stream is also measured in post-tax terms].

Figure shows the estimated cash flows for a particular project. After an initial net investment
of $100,000, the project is expected to generate a stream of net cash inflows over its
anticipated 5-year life of $50,000 in year 1; $40,000 in year 2; $30,000 in year 3; $25,000 in
year 4; and $5,000 in year 5. This type of project is called a conventional or normal project.
Illustration of Estimated Cash Flows for a Normal Capital Investment Project

Nonnormal or nonconventional projects have cash flow patterns with either more than one or
no sign change. Table illustrates the cash flow patterns for three sample projects. Projects X
and Y can cause some analytical problems, as we shall see in the discussion of the internal
rate of return criterion in the following chapter. Project X might require that certain
equipment be shut down and rebuilt in year 3, and Project Y could be an investment in a
mining property, with the negative cash flow in year 5 representing abandonment costs
associated with closing down the mine after its mineral wealth has been depleted.

Finally, Project Z, which generates negative cash flows over the entire life of the investment,
such as an investment in pollution control equipment, can be difficult to evaluate using the
decision- making criteria developed in the next chapter.

Regardless of whether a project’s cash flows are expected to be normal or nonnormal, certain
basic principles should be applied during their estimation, including the following:

42
 Cash flows should be measured on an incremental basis. In other words, the cash flow
stream for a particular project should be estimated from the perspective of how the entire
cash flow stream of the firm will be affected if the project is adopted as compared with
how the stream will be affected if the project is not adopted. Therefore, all changes in the
firm’s revenue stream, cost stream, and tax stream that would result from the acceptance
of the project should be included in the analysis. In contrast, cash flows that would not be
changed by the investment should be disregarded.

 Cash flows should be measured on an after -tax basis. Because the initial investment
made on a project requires the outlay of after -tax cash dollars, the returns from the project
should be measured in the same units, namely, after-tax cash flows.

 All the indirect effects of a project should be included in the cash flow
calculations. For example, if a proposed plant expansion requires that working capital be
increased for the firm as a whole —perhaps in the form of larger cash balances,
inventories, or accounts receivable —the increase in working capital should be included in
A firm may also have to provide for further working capital increases as sales increase
over the life of the project. These additional working capital requirements should be
included in the yearly net cash flows as outflows.However, as the project winds down, net
working capital balances decline; these should be included as inflows when determining
yearly cash flows. Other indirect effects may occur when one division of a firm introduces
a new product that competes directly with a product produced by another division. The
first division may consider this product desirable, but when the impact on the second
division’s sales is considered, the project may be much less attractive.
For example, in the Ford capital expenditure decision discussed earlier in the chapter, the
company should consider the impact of the increased output of Volvos on the demand for
Ford’s other luxury -car brands —namely, Lincoln and Jaguar.

Sample Cash Flow Patterns for Nonnormal Projects

Sunk costs should not be considered when evaluating a project. A sunk cost is an outlay
that has already been made (or committed to be made).
Because sunk costs cannot be recovered, they should not be considered in the decision to
accept or reject a project. For example, in 2004, the Chemtron Corporation was considering
constructing a new chemical disposal facility. Two years earlier, the firm had hired the
R.O.E. Consulting Group to do an environmental impact analysis of the proposed site at a
cost of $500,000.

43
Because this $500,000 cost cannot be recovered whether the project is undertaken or not, it
should not be considered in the accept –reject analysis taking place in 2004. The only
relevant costs are the incremental outlays that will be made from this point forward if the
project is undertaken.

The value of resources used in a project should be measured in terms of their

opportunity

costs. Opportunity costs of resources (assets) are the cash flows those resources could
generate if they are not used in the project under consideration. For example, suppose that the
site Chemtron is considering to use for its disposal facility has been owned by the firm for
some time. The property originally cost $50,000, but a recent appraisal indicates that the
property could be sold for $1 million.

Because Chemtron must forgo the receipt of $1 million from the sale of the site if the
disposal facility is constructed, the appropriate opportunity cost of this piece of land is $1
million, not the original cost of $50,000. These five principles of cash flow estimation may be
applied to the specific problem of defining and calculating a project’s net investment and net
cash flows.

Cash flow is the movement of money into or out of a business, project, or financial product. It
is usually measured during a specified, limited period of time. Measurement of cash flow can
be used for calculating other parameters that give information on a company’s value and
situation Cash flow can be used, for example, for calculating parameters: it discloses cash
movements over the period. Cash inflows usually arise from one of three activities –
financing, operations or investing – although this also occurs as a result of donations or gifts
in the case of personal finance. Cash outflows result from expenses or investments. This
holds true for both business and personal finance. When beginning the capital-budgeting
analysis, it is important to determine a project’s cash flows. The cash flows of a project must
be measured in incremental terms

The basic principles of measuring project cash flasks are –

A principle of incremental cash flow,

A principle of the long-term fund,

A principle of financing cost exclusion,

A principle of post-tax.

44
Many firms have gone under because their owners failed to undertake any type of cashflow
forecasting exercise. Instead, they naively assumed that because they had orders in the
pipeline and some cash in the bank that there was cash to fulfil and deliver those orders and
release money for investment to pay off creditors.

This article summarises basic cashflow issues and actions owners of small businesses should
be aware of to improve their firm’s cashflow position.

Cashflow Management Basics

The main cash inflows of most small businesses are customers payments, bank loans,
shareholder investments and interest from savings.

The main cash outflows are buying stock and raw materials, general operating expenses,
payroll, business tax, creditor loan repayments and Directors’ dividends.

The surplus between the inflows and outflows represents the lifeblood and survival of any
small business. Therefore, budgeting and forecasting are absolutely critical to confidently
understand whether a cashflow surplus will exist at points in the future.

Cashflow forecasting
Forecasting cashflow should be fundamental to any small business. You don’t need to be an
Excel wizard to produce a cashflow forecast although using Excel or a suitable accounting-
based software package clearly helps.

By analysing your bank statement over a given period you can begin to identify cheques you
have written but have not yet cleared. Also, outstanding amounts which you have invoiced
but customers or trade creditors may not have settled as yet.

Ideally, it is sensible to plot all of your inflows and outflows over as long a period as
possible. Identify all of the direct debits, standing orders and other monthly outgoings such as
rent on your premises, loan repayments and wages.

All receipts and payments should be identified by date and with an opening and closing bank
balance over a fixed period.

The further forward you can plot in your calculations, the more clearly you can begin to see
the peaks and troughs in your cashflow forecast.

If your business is highly seasonal, calculate how much cash needs to be generated in high
season in order to sustain you through the low season.

Get your accountant or bookkeeper to double-check your assumptions and question whether
they are realistic. For instance,

45
Are you relying on a small number of large customers to pay invoices at certain dates?
Do you check your bank statements regularly to ensure invoices been settled on time?
Have you stayed in regular contact with your larger customers to ensure everything is fine at
their end and that they are able to pay their invoices on time?
Have you included all of your operating expenses in the cash outflows (it’s easy to forget lots
of smaller amounts)?
Cost cutting
In times of economic recession, many small firms are cutting costs drastically in order to
survive. A simple and obvious way to improve cashflow is to reduce business investment in
non-essential areas, but do realise that this may also reduce the company’s potential to grow
and expand.

Whether this longer-term sacrifice is worth the short-term gain will depend upon the owner’s
attitude towards risk and reward. Recruitment, advertising, pay increases, large investments
in property and machinery are usually the first things to be cut back during an economic
slowdown. Consider leasing expensive equipment like premises, computer equipment and
cars as opposed to buying these capital expenditure items.

Despite the decline in business loans available on the market, many larger trade suppliers
provide their own finance schemes to help alleviate the pain of upfront costs. Look closely at
the stock levels to see if there is scope for minimising cash tied up in stock sitting idly on the
shelf. Are there any sale or return deals to be had with new suppliers available? Is it possible
to negotiate with existing creditors such as loan companies, the taxman and trade creditors to
change the terms and conditions of your repayment profile?

Only by amending your own cashflow forecast with these cuts can you begin to see the
impact on future sales revenue and profitability. Identify items in the cashflow forecast which
are absolutely essential for business survival, compared to those that can be postponed or
eliminated if push came to shove.

During boom times most people’s mindset is one of relative comfort and security. However,
as business confidence evaporates owners of small firms are getting used to a different
mindset. One in which owners don’t really need corporate luxuries, flashy cars and gadgets.
Everybody is asking for a discount and expecting to receive value for money. So factor this
new mindset into your cashflow forecast as the pressure on your margins becomes more
acute.

It’s probable your customers will ask you for discounts and financial incentives to stop them
going to your competitors instead. Likewise, ask for discounts from your trade suppliers.
Simply be honest with your reasons for asking a discount. If you don’t ask you don’t get.

Credit Control & Debt Collection Practical Tips

There are many things businesses can do to improve their cashflow. Here are 10 general
credit control and debt collection tips that we know will help you get paid on time, every
time.

46
1. Credit check prospective customers using a credit checking service to ensure that any
potential prospect is creditworthy. Creditworthy customers are less likely to default on
business debts

2. Offer business customers discounts for early payment of invoices. For instance, a 10%
discount in exchange for settlement within seven days of the date of the invoice

3. Limit the amount of trade credit for each major customer or groups of customers

4. Provide different ways for customers to pay an invoice to make life easier. The hassle of
writing and posting a cheque can be removed by electronic means

5. Whenever you deal with new prospects or existing clients, point out to them your terms of
business. These include adding your payment terms to your standard terms and conditions of
trade, application forms, and order notes, statements of account, order acknowledgements,
dispatch notes, contractual documents, invoices and e-mails;

6. Send out comprehensive invoices on time and double-check all the invoice details are
correct

7. Make friends with the Purchase ledger Person who is responsible for paying your invoice,
particularly in larger organisations with hundreds of employees with multiple responsibilities.
Try and establish some rapport with them so they know who you are before you ring up out
of the blue at a future date and chase payment of an unpaid invoice

8. Consider using a factoring organisation to whom you can sell or ‘factor’ the value of
unpaid customer bills to a third-party institution (an invoice factoring company), in exchange
the majority of the unpaid business debt to be paid immediately to the company

9. Establish a written policy and procedure for the credit control process and stick to it

The term cash flow refers to the net amount of cash and cash equivalents being transferred in
and out of a company. Cash received represents inflows, while money spent represents
outflows.

A company’s ability to create value for shareholders is fundamentally determined by its

ability to generate positive cash flows or, more specifically, to maximize long-term free cash
flow (FCF). FCF is the cash generated by a company from its normal business operations
after subtracting any money spent on capital expenditures

Cash flow is the movement of money in and out of a company.

Cash received signifies inflows, and cash spent signifies outflows.
The cash flow statement is a financial statement that reports on a company's sources and
usage of cash over some time.

47
A company's cash flow is typically categorized as cash flows from operations, investing, and
financing.
There are several methods used to analyze a company's cash flow, including the debt service
coverage ratio, free cash flow, and unlevered cash flow.

Understanding Cash Flow

Cash flow is the amount of cash that comes in and goes out of a company. Businesses take in
money from sales as revenues and spend money on expenses. They may also receive income
from interest, investments, royalties, and licensing agreements and sell products on credit,
expecting to actually receive the cash owed at a late date.

Assessing the amounts, timing, and uncertainty of cash flows, along with where they
originate and where they go, is one of the most important objectives of financial reporting. It
is essential for assessing a company’s liquidity, flexibility, and overall financial performance.

Positive cash flow indicates that a company's liquid assets are increasing, enabling it to cover
obligations, reinvest in its business, return money to shareholders, pay expenses, and provide
a buffer against future financial challenges. Companies with strong financial flexibility can
take advantage of profitable investments. They also fare better in downturns, by avoiding the
costs of financial distress.

Cash flows can be analyzed using the cash flow statement, a standard financial statement that
reports on a company's sources and usage of cash over a specified time period. Corporate
management, analysts, and investors are able to use it to determine how well a company can
earn cash to pay its debts and manage its operating expenses. The cash flow statement is one
of the most important financial statements issued by a company, along with the balance sheet
and income statement

Special Considerations

As noted above, there are three critical parts of a company's financial statements:1

The balance sheet which gives a one-time snapshot of a company's assets and liabilities

The income statement, which indicates the business's profitability during a certain period

The cash flow statement, which acts as a corporate checkbook that reconciles the other two
statements. It records the company's cash transactions (the inflows and outflows) during the
given period. It shows whether all of the revenues booked on the income statement have been
collected.

But the cash flow does not necessarily show all the company's expenses. That's because not
all expenses the company accrues are paid right away. Although the company may
incur liabilities any payments toward these liabilities are not recorded as a cash outflow until
the transaction occurs.

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The first item to note on the cash flow statement is the bottom line item. This is likely to be
recorded as the net increase/decrease in cash and cash equivalents (CCE). The bottom line
reports the overall change in the company's cash and its equivalents (the assets that can be
immediately converted into cash) over the last period.

If you check under current assets on the balance sheet, that's where you'll find CCE. If you
take the difference between the current CCE and that of the previous year or the previous
quarter, you should have the same number as the number at the bottom of the statement of
cash flows.

Types of Cash Flow

Cash Flows From Operations (CFO)

Cash flow from operations (CFO), or operating cash flow, describes money flows involved
directly with the production and sale of goods from ordinary operations. CFO indicates
whether or not a company has enough funds coming in to pay its bills or operating expenses.
In other words, there must be more operating cash inflows than cash outflows for a company
to be financially viable in the long term.

Operating cash flow is calculated by taking cash received from sales and subtracting
operating expenses that were paid in cash for the period. Operating cash flow is recorded on a
company's cash flow statement, which is reported both on a quarterly and annual basis.
Operating cash flow indicates whether a company can generate enough cash flow to maintain
and expand operations, but it can also indicate when a company may need external financing
for capital expansion.

Note that CFO is useful in segregating sales from cash received. If, for example, a company
generated a large sale from a client, it would boost revenue and earnings. However, the
additional revenue doesn't necessarily improve cash flow if there is difficulty collecting the
payment from the customer.

Cash Flows From Investing (CFI)

Cash flow from investing (CFI) or investing cash flow reports how much cash has been
generated or spent from various investment-related activities in a specific period. Investing
activities include purchases of speculative assets, investments in securities, or the sale of
securities or assets.

49
Negative cash flow from investing activities might be due to significant amounts of cash
being invested in the long-term health of the company, such as research and development
(R&D), and is not always a warning sign

Cash Flows From Financing (CFF)

Cash flows from financing (CFF), or financing cash flow, shows the net flows of cash that are
used to fund the company and its capital. Financing activities include transactions involving
issuing debt, equity, and paying dividends. Cash flow from financing activities provide
investors with insight into a company’s financial strength and how well a company's capital
structure is managed

Cash Flow vs. Profit

Contrary to what you may think, cash flow isn't the same as profit. It isn't uncommon to have
these two terms confused because they seem very similar. Remember that cash flow is the
money that goes in and out of a business.

Profit, on the other hand, is specifically used to measure a company's financial success or
how much money it makes overall. This is the amount of money that is left after a company
pays off all its obligations. Profit is whatever is left after subtracting a company's expenses
from its revenues.

How to Analyze Cash Flows

Using the cash flow statement in conjunction with other financial statements can help
analysts and investors arrive at various metrics and ratios used to make informed decisions
and recommendations.

Free Cash Flow (FCF)

Analysts look at free cash flow (FCF) to understand the true cash generation capability of a
business. FCF is a really useful measure of financial performance and tells a better story than
net income because it shows what money the company has left over to expand the business or
return to shareholders, after paying dividends, buying back stock, or paying off debt

Free Cash Flow = Operating Cash Flow - CapitalEx

Unlevered Free Cash Flow (UFCF)

Use unlevered free cash flow (UFCF) for a measure of the gross FCF generated by a firm.
This is a company's cash flow excluding interest payments, and it shows how much cash is
available to the firm before taking financial obligations into account. The difference between
levered and unlevered FCF shows if the business is overextended or operating with a healthy
amount of debt

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The final line in the cash flow statement, "cash and cash equivalents at end of year," is the
same as "cash and cash equivalents," the first line under current assets in the balance sheet.
The first number in the cash flow statement, "consolidated net income," is the same as the
bottom line, "income from continuing operations" on the income statement.

Because the cash flow statement only counts liquid assets in the form of CCE, it makes
adjustments to operating income in order to arrive at the net change in cash. Depreciation and
amortization expense appear on the income statement in order to give a realistic picture of the
decreasing value of assets over their useful life. Operating cash flows, however, only consider
transactions that impact cash, so these adjustments are reversed.

The net change in assets not in cash, such as AR and inventories, are also eliminated from
operating income. For example, $368 million in net receivables are deducted from operating
income. From that, we can infer that there was a $368 million increase in receivables over the
prior year.

This increase would have shown up in operating income as additional revenue, but the cash
wasn't received yet by year-end. Thus, the increase in receivables needed to be reversed out
to show the net cash impact of sales during the year. The same elimination occurs for current
liabilities in order to arrive at the cash flow from operating activities figure.

Investments in property, plant, and equipment (PP&E) and acquisitions of other businesses
are accounted for in the cash flow from the investing activities section. Proceeds from issuing
long-term debt, debt repayments, and dividends paid out are accounted for in the cash flow
from financing activities section.

The main takeaway is that Walmart's cash flow was positive (an increase of $742 million).
That indicates that it has retained cash in the business and added to its reserves in order to
handle short-term liabilities and fluctuations in the future.

How Are Cash Flows Different Than Revenues?

Revenues refer to the income earned from selling goods and services. If an item is sold on
credit or via a subscription payment plan, money may not yet be received from those sales
and are booked as accounts receivable. But these do not represent actual cash flows into the
company at the time. Cash flows also track outflows as well as inflows and categorize them
with regard to the source or use.

What Are the 3 Categories of Cash Flows?

The three types of cash flows are operating cash flows, cash flows from investments, and
cash flows from financing.

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Operating cash flows are generated from the normal operations of a business, including
money taken in from sales and money spent on cost of goods sold (COGS), along with other
operational expenses such as overhead and salaries.

Cash flows from investments include money spent on purchasing securities to be held as
investments such as stocks or bonds in other companies or in Treasuries. Inflows are
generated by interest and dividends paid on these holdings.

Cash flows from financing are the costs of raising capital, such as shares or bonds that a
company issues or any loans it takes out

What Is Free Cash Flow and Why Is It Important?

Free cash flow is the cash left over after a company pays for its operating expenses and
CapEx. It is the money that remains after paying for items like payroll, rent, and taxes.
Companies are free to use FCF as they please

Knowing how to calculate FCF and analyze it helps a company with its cash management
and will provide investors with insight into a company's financials, helping them make better
investment decisions.

FCF is an important measurement since it shows how efficient a company is at generating

cash.

The cash flow statement complements the balance sheet and income statement and is a
mandatory part of a public company's financial reporting requirements since 1987

The price-to-cash flow (P/CF) ratio is a stock multiple that measures the value of a stock’s
price relative to its operating cash flow per share. This ratio uses operating cash flow, which
adds back non-cash expenses such as depreciation and amortization to net income.

P/CF is especially useful for valuing stocks that have positive cash flow but are not profitable
because of large non-cash charges.

Cash flow refers to money that goes in and out. Having a positive cash flow means there's
more money coming in while a negative cash flow indicates a higher degree of spending. The
latter isn't necessarily a bad thing because it may mean that you're investing your money in
growth. But if your spending becomes excessive, you won't have enough for a rainy day and
you won't be able to pay your suppliers or lenders. Whether you're running a business or a
household, it's important to keep on top of your cash flow.

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Project Selection Under Capital Rationing:

From the foregoing discussion it may be recalled that the profitability of a project can be
measured by any one of the DCF techniques (viz. IRR, NPV and PI), particularly the two
theoretically sound methods IRR and NPV. Practically, the firm may accept all those projects
which give a rate of return higher than the cost of capital or which have positive NPV. And,
in case of mutually exclusive projects, the projects having the highest NPV or giving the
highest rate of return may be accepted. In other words, a firm should accept that investment
proposal which increases maximum the firm’s value.

In actual practice, however, every firm prepares its annual capital expenditure budget which
depends on the availability of funds with the firm or other considerations. In that case, a firm
has to select not only the profitable investments opportunities but also it has to rank the
projects from the highest to lowest priority, i.e. a cut-off point is selected.

Naturally, the proposal which is above the cut-off point will be funded and which is below
the cut-off point will be rejected. It should be remembered that this cut-off point is
determined on the basis of the number of projects, funds available for financing capital
expenditure, and the objectives of the firm.

That is, in other words, question of Capital Rationing appears before us. It is normally
applied to situations where the supply of funds to a firm is limited in some way. It actually
encompasses many different situations ranging from that where the borrowing and lending
rates faced by the firms differ to that where the funds available for investment by the firm are
strictly limited.

In short, it rejects a situation where the firm is constrained, for external or self-imposed
reasons, to obtain necessary funds to invest in all profitable investment projects, i.e. a
situation where a constraint is placed on the total size of capital investment during a
particular period. In the circumstances the firm has to select a combination of investment
proposals which provides the highest NPV, subject to the budget constraint.

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Selection Process under Capital Rationing:

Needless to mention that under capital rationing a firm cannot accept all the projects even if
all of them are profitable. In order to select or reject the projects, a comparison must be made
among them.

Selection of project depends on two steps:

(i) Ranking the projects according to the Profitability Index (PI) or Net Present Value (NPV)
method;

(ii) Selecting projects in descending order of profitability (until the funds are exhausted).

The projects can be ranked by any one of the DCF techniques, viz., IRR, NPV and PI. But PI
method is found to be the more suitable and reliable measure of profitability since it
determines the relative profitability; while NPV method is an absolute measure of
profitability.

Illustration 1:

Funds available for capital expenditure in a year are estimated at Rs. 2,50,000 in a firm. The
profitability index (PI) with mutually exclusive investment proposals are:

Solution:

It has already been pointed out that the projects should be selected on the basis of
profitability under PI method and rank is assigned accordingly, subject to maximum
utilisation of available funds showing:

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From the above, it becomes clear that the first projects should be selected as the optimum mix
since they will completely utilise the available funds amounting to Rs. 2,50,000. Projects
P6 and P8 are not included in above as their PI is less than unity (1) and, hence, are to be
rejected.

Illustration 2:

The following investment proposals along with their profitability index (PI) are:

Here P1 ranks first. But it does not utilise fully the available funds. If P3 is selected alone, it
will be worse than P1. P3 cannot be selected since its total requirements become Rs. 1,00,000
(Rs. 60,000 + Rs. 40,000) which is more than the available funds, viz. Rs. 75,000. Therefore,
if P3 and P4 are selected available funds can completely be utilised.

As such, the mix (P3 and P4) will be the most profitable projects and they will maximise the
present value shown:

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Thus, the total NPV of proposal 3 is highest in comparison with Proposals 1 and 2. As such,
the firm, in this case, will be able to utilise its scarce resources for optimum use.

Project Indivisibility:

It has been highlighted above that selection of project must be in such a manner so as to
maximise profitability, subject to the budget ceiling. Naturally, if this is strictly followed,
then it is better to accept many lower order smaller projects (according to ranking) than to
accept a single large project.

Therefore, under capital rationing, a possibility of trade-off arises between the two types of
projects. In other words, if a single large project is accepted, a series of small projects are
rejected due to this indivisibility, i.e., a project is an entity to be accepted or rejected as a
whole. It should be remembered that the problem of indivisibility may prove to be serious
and make the entire selection process quite un-widely. The most efficient way for solving the
same is the integer programming.

Ranking-Error Problem:

We know that any one of the DCF techniques can be used for ranking. Since there are
different cash flow timings the three DCF techniques viz., IRR, NPV and PI present conflict
in ranking as to the project which is known as ‘Ranking-Error Problem’. The following
illustration will make the principle of ‘Ranking-Error Problem’ clear.

Illustration 3:

From the information presented below, rank the projects after applying IRR, NPV and

PI when each of them are as under:

56
From the above, it becomes clear that the those DCF criteria rank the different projects in
different ways. Needless to mention that if there are no limit of funds, all the projects
(excluding P2) could be accepted by all the criteria. But if capital is rationed, different
decisions are reached by each criterion.

That is, the IRR would suggest to accept projects P3 and P4 whereas the NPV would suggest
to accept projects P1 and P4 and the PI would suggest to accept projects P1 and P5,
respectively. Naturally, the question arises before us which one is the ‘Correct Criterion’?
The problem arises due to the differing timing of the cash flow. However, the problem can be
tackled if a common reinvestment rate is considered.’

Capital Rationing Using Graph:

Sometimes funds for investment are strictly limited in the current period. After that the same
are freely available at the prevailing rate of interest. Of course, if there is any liquidity crisis
in a firm it will find out some financing sources even if the rate of interest becomes very high
although the financing sources are limited. The effect of limits on funds can be portrayed
with the help of a diagram (Fig. 11.4), where amount of capital in a period is shown on the
horizontal axis whereas (average) cost of capital is shown on the vertical axis.

57
The supply of capital at different costs of capital/prices is shown by AA curve. The
increasing slope of the said curve (AA) reflects the higher marginal cost of each extra
increment of funds. Curve BB represents the usual demand curve for funds. Here projects are
ranked inversely in order to diminish profitability.

As such, any point on this line shows the funds which are needed to finance those projects
which have positive (+) NPV. (Where discounted at the cost of capital shown horizontally
opposite on the Y axis i.e. OD funds will be demanded when average cost of finance is OG).
Under the situation the firm will try to utilize that amount of funds which are indicated by the
intersection of the demand curve (BB) and supply curve (AA).

In the present case, the firm must raise OD funds and finance those projects which are
represented by the BH segment of BB. It will give the greatest increment in net present
worth. That is, such project to the left of H has a positive (+) NPV of discounted at OG and,
at this rate of interest, the marginal project has a zero (O) NPV.

Therefore, from the above, it may be stated that the marginal project which is accepted
simply covers its cost and all other projects which are accepted, yield a return over, and
above their financing which are indicated by the area covered by the line GHB in the
diagram.

If, on the other hand, investments cannot exceed, say, OC, the shareholders (equity) will
forgo the NPV from those projects represented by EC. In that case, cost to equity
shareholders is represented in Fig. 11.4 by the area covered by EFH which reveals the excess
returns over the average cost of capital.

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Capital Rationing:

Capital rationing refers to a situation where the firm is constrained for external, or self
imposed, reasons to obtain necessary funds to invest in all investment projects with positive
net present value (NPV). Under capital rationing, the management has not simply to
determine the profitable investment opportunities, but it has also to decide to obtain that
combination of the profitable projects which yields highest net present value (NPV) within
the available funds. Capital rationing is the process through which companies decide how to
allocate their capital among different projects, given that their resources are not limitless. The
main goal is to maximize the return on their investment. Capital rationing is a strategy used
by companies or investors to limit the number of projects they take on at a time. If there is a
pool of available investments that are all expected to be profitable, capital rationing helps the
investor or business owner choose the most profitable ones to pursue.

Companies that employ a capital rationing strategy typically produce a relatively higher
return on investment (ROI). This is simply because the company invests its resources where
it identifies the highest profit potential.

Why capital rationing?

Capital rationing may rise due to external factors or internal constraints imposed by the
management. Thus there are two types of capital rationing.

External capital rationing

Internal capital rationing

External capital rationing

External capital rationing mainly occurs on account of the imperfections in capital markets.
Imperfections may be caused by deficiencies in market information, or by rigidities of
attitude that hamper the free flow of capital. The net present value (NPV) rule will not work
if shareholders do not have access to the capital markets. Imperfections in capital markets
alone do not invalidate use of the net present value (NPV) rule. In reality, we will have very
few situations where capital markets do not exist for shareholders.

Internal capital rationing

Internal capital rationing is caused by self imposed restrictions by the management. Various
types of constraints may be imposed. For example, it may be decide not to obtain additional
funds by incurring debt. This may be a part of the firm‘s conservative financial policy.

Capital rationing is a process that companies use to decide which investment opportunities
make the most sense for them to pursue.

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The typical goal of capital rationing is to direct a company’s limited capital resources to the
projects that are likely to be the most profitable.

Hard capital rationing refers to restraints put on a company by outside entities, such as banks
or other lenders.

Soft capital rationing results from a company’s own policies relating to how it wants to use
its capital.

Understanding Capital Rationing

Businesses typically face many different investment opportunities but lack the resources to
pursue them all. Capital rationing is a way of allocating their available funds in a logical
manner.

A company will typically attempt to devote its resources to the combination of projects that
offers the highest total net present value (NPV).

Companies may also use capital rationing strategically, forgoing immediate profit to invest in
projects that hold out greater long-term potential for the business as it positions itself for the
future.

Two Types of Capital Rationing

There are two primary types of capital rationing, referred to as hard and soft:

1) Hard capital rationing: occurs based on external factors. For example, the company may
be finding it difficult to raise additional capital, either through equity or debt. Or, its lenders
may impose rules on how it can use its capital. These situations will limit the company’s
ability to invest in future projects and may even mean that it must reduce spending on current
ones.

2) Soft capital rationing: also known as internal rationing, is based on the internal policies of
the company. A fiscally conservative company, for example, may require a particularly high
projected return on its capital before it will get involved in a project—in effect, self-imposing
capital rationing.

Examples of Capital Rationing:

Suppose that based on its borrowing costs and other factors, ABC Corp. has set 10% as the
minimum rate of return it wants from its capital investments. This is sometimes referred to as
a hurdle rate.

As ABC weighs its various investment opportunities, it will look at both their likely return
and the amount of capital they require, ranking them according to what’s known as a
profitability index.

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For example, if one project is expected to return 17% and another 15%, then ABC may fund
the 17% project first and fund the 15% one only to the extent that it has capital left over. If it
still has capital available, it might then consider projects returning 14% or 13% until its
capital has been fully allocated. It would be unlikely to fund a project returning below its
hurdle rate unless it has other reasons for doing so, such as to comply with government
requirements

A company might also choose to hold onto its capital if it either can’t find enough attractive
investment opportunities or foresees difficult times ahead and wants to keep funds in reserve.

What is the cost of borrowing?

The cost of borrowing is often expressed in terms of an effective annual interest rate, which
takes into account both the simple interest rate that a lender charges and the effect of
compounding. A company’s cost of borrowing is based in part on its likelihood of defaulting
on the debt

Businesses can raise capital in several ways. They can borrow money through loans or by
issuing bonds, known as debt capital. They can also raise equity capital by selling shares in
the business. And they can generate their own capital in the form of retained earnings, which
represents income they still have left over after meeting their other obligations, such as
stockholder dividends.

Companies are limited in how much capital they have available to invest in new projects at
any given time. Capital rationing is a way for them to decide how to allocate their capital
among those projects. The goal is typically to maximize the return on their investment,
although long-term strategy and other factors can also come into play.

Capital rationing is about putting restrictions on investments and projects taken on by a

business. To illustrate this better, let’s consider the following example:

Construction is looking at five possible projects to invest in, as shown below:

To determine which project offers the greatest potential profitability, we compute each
project using the following formula:

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 Profitability = NPV / Investment Capital

Based on the table above, we can conclude that projects 1 and 2 offer the greatest potential
profit. Therefore, VV Construction will likely invest in those two projects.

Suppose there is a company named Yuva Constructions Ltd (‘YCL’). YCL is engaged in the
business of construction of buildings for residential and commercial purposes. It has secured
the required preliminary permissions and approvals from the state government for
constructing three projects – Project A, B, and C.

YCL has a total budget of $10 billion. Project A, B, and C are expected to yield total value
(present value of cash flows) of $7 billion, $8 billion, and $6 billion respectively viz a viz the
initial investment required for each is $5 billion, $6 billion and $5 billion respectively. Apply
the capital rationing and find the optimal combination.

Solution:

First, let’s tabulate the information provided to us for ease of reference.

 Now, YCL has $10 billion. To maximize the investors’ wealth, it will have to accept projects
to receive the highest amount of profits within the limited budget of $10 million.
Accordingly, it will have to find out the expected rate of return for all the projects and then
rank them according to profitability index.

The below table thoroughly explains the same.

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 Based on the ranks, YCL must select Project A and B, as they have the highest profitability.
However, the total initial investment required if it chooses Project A and B would exceed the
available funding, i.e., it will require $11 billion ($5 billion + $6 billion) compared to the
available $10 billion.
 In such a situation, it will have to discard one project and move to the next ranking project
which suits its investment needs. Thus, YCL will have the option to go ahead with Project A
and C, which will entail an investment well within the available capital of $10 billion and
will have to forego investing in Project B.

Fallout of Capital Rationing

• Capital rationing limits the amount to be spent on capital expenditure decisions.

• It usually results in an investment policy that isless than optimal

.•It may lead to the acceptance of several small investment projects rather than afew large
investment projects.•It does not reckon intermediate cash inflows expected to be provided by
aninvestment project

Capital Rationing :Ranking method

• Under this method, the available projects are ranked according to a chosencriterion (like
NPV, IRR, PI, etc.)

.•The project for which the value of the chosen criterion is the highest (say highestNPV or
highest IRR etc) is assigned the top rank and the project with the nexthighest value of the
chosen criterion follows with rank-2 and so on.

• After the projects are ranked, the projects are chosen starting from the top. Thisis a simple
method of capital rationing.However, this method suffers deficiency

• Project Indivisibility:. Since some projects are indivisible in nature, this methodof choosing
the projects to match the capital expenditure budget maysometimes give erroneous results.

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Capital Rationing Used? – Benefits

Capital rationing is used by many investors and companies in order to ensure that only the
most feasible investments are made. It helps ensure that businesses will invest only in those
projects that offer the highest returns. It may appear that all investments with high projected
returns should be taken. However, there are times when funds are low or when a company or
an individual investor merely want to improve their cash flows before making any more
investments. It may also be the case that the investor has reason to believe that they can make
the investment under more favorable terms by waiting a bit longer before pursuing it. For
example, the company’s management may expect a significant drop in interest rates within
the next six months, which would make for less expensive financing costs.

Limited Numbers of Projects are Easier to Manage

When a company invests in a large number of projects simultaneously, the sharing of funds
means less capital available for each individual project. This typically translates to more time
and effort being required to monitor and manage each project. Also, allocating limited
resources across several projects may actually threaten the success of the projects, if, for
example, the projected budget for one or more projects turns out to have significantly
underestimated costs. Wise capital rationing can help a company avoid such problems.

Capital Rationing Offers Increased Investment Flexibility

Investment opportunities are constantly changing. Portfolio managers usually keep a

significant portion of available investment funds in the form of cash. Maintaining a ready
supply of excess cash, first of all, provides greater financial stability and makes it easier for
investors to adjust to sudden adverse circumstances that may arise.

Keeping some excess cash in reserve accomplishes something else as well. It ensures that if a
particularly attractive unseen golden opportunity should suddenly arise, the investor has
funds available to take immediate advantage of the situation. The ability to act quickly may
be the difference between a good investment opportunity and a great one.

Potential Disadvantages of Capital Rationing

Capital rationing also comes with its own set of potential disadvantages, including the
following:

1. High capital requirements

Because only the most profitable investments are taken on under a capital rationing scenario,
rationing can also spell high capital requirements.

2. Goes against the efficient capital markets theory

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Instead of investing in all projects that offer high profits, capital rationing only allows for
selecting the projects with the highest estimated returns on investment. But the efficient
markets theory holds that it is virtually impossible, over time, to continually select superior
investments that significantly outperform others. Capital rationing may, in fact, expose an
investor to greater risk by failing to hold a diversified investment portfolio. Some of the
limitations are as follows.

It focuses on investing in fewer projects, which keeps the balance shareholder funds idle.

The concept of capital rationing is based on the assumption that the project will yield a
particular return. Any miscalculation of the same would result in the project generating lesser
profits.

Projects that are selected may be of smaller duration, which would lead to discarding certain
long-term projects, which may be healthy for the company’s stability.

The evaluation process ignores any intermediate cash flows that the project may have and the
time value associated with such cash flows.

Assumptions

Some of the assumptions are as follows.

The primary assumption is that there is a restriction imposed, either through internal forces or
external, on capital funding.

The other assumption followed here is that there are several projects to be undertaken by the
company or investors. Selecting certain projects will help optimize returns for the investment
made.

Lastly, the concept of capital rationing is based on the assumption that the expected rate of
return of proposed projects to be undertaken shall be achieved as expected, thus ignoring
practical factors such as economics, politics, policies, and such.

Causes

The increased cost of capital for higher capital/funding requirements.

Higher debt in books of the company.

Any internal management restriction.

Lack of human resources or knowledge for undertaking all the projects.

Benefits

The use of capital rationing does come with its shares of advantages and benefits for the
users. Some of the benefits are as follows.

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Any restriction on the use of available resources, in our case money, will utilize the resource
in the best optimal manner.

The company’s management or investors would not invest in any project coming their way
without getting into detailed analysis. This ensures there is no wastage or unnecessary use of
free funds available.

The investors would receive the highest or maximum returns on their investments by
following the optimal utilization process.

It may entail investing in only a few projects, which would help the management put in lesser
efforts in managing the affairs of the projects and yield better results.

The company or the investor will have funds available even after investing in the projects,
thus ensuring there is no cash crunch.

Limitations

Some of the limitations are as follows.

It focuses on investing in fewer projects, which keeps the balance shareholder funds idle.

The concept of capital rationing is based on the assumption that the project will yield a
particular return. Any miscalculation of the same would result in the project generating lesser
profits.

Projects that are selected may be of smaller duration, which would lead to discarding certain
long-term projects, which may be healthy for the company’s stability.

The evaluation process ignores any intermediate cash flows that the project may have and the
time value associated with such cash flows.

Capital rationing is a process of selecting a project mix that will provide the maximum profit
by investing the limited capital available in various projects. The process is followed after
considering the restrictions in place, whether internal or external forces, for the investments
to be made.

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Conclusion and Suggestion:
Capital budgeting is the process a business undertakes to evaluate potential major projects or
investments. Construction of a new plant or a big investment in an outside venture are
examples of projects that would require capital budgeting before they are approved or
rejected.

The capital Budgeting process generally helps the company in taking two types of decisions:
Investment decisions and financing decisions

Aliy investment decision whether strategic or tactical should be discussed and finalised at the
level of the mills itself. The management of

the mill at different levels should have a thorough understanding of the investment decisions.
This would facilitate the management to effectively monitor and control the implementation
of the investment decision.A standing committee, representing the different cadres of
management and a few workers, may be constituted to decide the various issues related to
capitalexpenditure decision. The committee may seek the advice and support of the
professional bodies like SITRA and SIMA whenever necessary for scientific formulation of
project proposals.The proposals are formulated without properly assessing the future
prospects. The assumptions on which the projections made are also unrealistic.Hence proper
care should be taken while assessing the future prospects andmaking assumptions.The mills
follow a crude method of appraising the proposals. The mills may very well evaluate the
projects using discounted cashflow techniques alongwith traditional methods as the mills
have necessary data for employingdiscounted or time adjusted methods.Implementation
should be carefully monitored by the personnel in the millat different level, to see that the
projects are executed within the timeframe andfinancial budget. This requires periodic review
of the project implementation andinitiation of corrective measures as and when required.

The performance of the capital budgeting decision is not evaluated by the cooperative
spinning mills. One reason is failure on the part of the mills to develop indicators both-
qualitative and quantitative. Research may be attempted to develop qualitative and
quantitative indicators for evaluating the performance of investments.As there are more
external controls on investments by cooperatives ther could be more time lag in finalising
investment decisions in cooperatives. Under inflationary situation this time lag will mean
cost-overrun. This is an important issue which needs further probing.

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