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Capital Budg
Capital Budg
Most small to medium sized companies have no idea how to approach capital investments. They treat it as if it were an operating budget decision rather than a long-term, strategic decision that will impact their cash flow, efficiency of their daily operations, income statement, and taxable income for years to come. They need your help understanding the importance of and then making the right capital budgeting decisions. Capital budgeting decisions relate to decisions on whether or not a client should invest in a longterm project, capital facilities and/or capital equipment/machinery. Capital budget decisions have a major effect on a firm's operations for years to come, and the smaller a firm is, the greater the potential impact, since the investment being made could represent a substantial percent of the firm's assets.
Capital investment (or, expenditure) decisions are more commonly referred to as capital budgeting decisions since they involve resource allocation, particularly for the production of future goods and services, and the determination of cash out-flows and cash-inflows, which need to be planned and budgeted over a long period of time. It is important that you get involved right from the start to guide them through this process since this is a very complicated accounting issue.
The phases of the capital budgeting process include: Description of the need or opportunity; Identification of alternatives; Evaluation of the options and the relevant cash flows of each; Selection of best alternative; and Conducting a post-completion audit of the projects.
that can look at the project/these issues impartially. Estimation bias can be dangerous. The objective is to evaluate (predict) how well each capital asset alternative will do and to determine if the net benefits to the firm are consistent with the required capital allocation, given the scarcity of resources most firms are faced with.
The firm should also make a subjective decision as to its preferences in terms of characteristics of projects in addition to the regular selection criteria it has set. For example, does the firm prefer: Projects with small initial investments? Earlier cash flows? Or, perhaps, shorter payback times? New projects or expansion of the existing operations? Domestic projects or foreign operations? If the firm is risk neutral, would the prospects of additional potential cash flows in riskier investments make a capital project more attractive?
Sensitivity Analysis considers what will happen if key assumptions change and identifies the range of change within which the project will remain profitable; Simple Profitability Analysis assesses risk by calculating an expected value for future cash flows based on their probability of success to future cash flows; Decision-tree Analysis builds on Simple Profitability Analysis by graphically outlining potential scenarios and then calculating each scenario's expected profitability based on the projects cash flow/net income; this technique allows managers to visualize the project and make more informed decisions, although decision trees can become very complicated considering all the scenarios that should be considered (e.g., inflation, regulation, interest rates, etc.); Monte Carlo Simulations use econometric/statistical probability analyses to calculate risk; and, EVA, which is growing in popularity, is a performance measure that adjusts residual income for "accounting distortions" that decrease short-term income but have long-term effects on shareholder wealth (e.g., marketing programs and R&D would be capitalized rather than expensed under EVA).
Once the risk has been assessed, which valuation method should the firm/you use for a project? The answer depends on considerations such the nature of the investment (the timing of its cash flows, for instance), uncertainty about the economy and the time value of money if it is a very long term capital project.
The Payback Period Method, which favors earlier cash flows and selects projects based on the
time it takes to recover the firm's investment; weaknesses in this method include the facts it does not consider cash flows after the payback period and it does not consider the time values of money; a common practice is to use this method to select from projects with similar rates of return that have been evaluated using a discounted cash flow (DCF) method (e.g., this is often referred to as the Payback Method based on Discounted Cash Flows or Break-Even Time Method); The Accounting Rate of Return (ARR) Method, which uses accounting income/GAAP information, is calculated as the average annual income divided by the initial or average investment; the projected return is normally compared to a target ARR based on the firm's cost of capital, the company's past performance and/or the riskiness of the project; The Net Present Value(NPV) Method, which is based on the time value of money and is a popular DCF method; the NPV Method discounts future cash flows (both in- and out-flows) using a minimum acceptable cost of capital (usually based on the weighted average cost of capital or WACC, adjusted for perceived risk) that is referred to as the "hurdle rate"; the NPV is as the difference between the present value of net cash inflows and cash outflows, and a $0 answer implies that the project is profitable and that the firm recovered its cost of capital; and, The Internal Rate of Return (IRR) Method, which is based on the time value of money, calculates the interest rate that equates the present value of cash outflows and cash inflows; this calculated rate of return is then compared to the required rate of return, or hurdle rate, to determine the viability of the capital projects.
projects. One final word regarding implementation of this control mechanism; successful post-completion auditing processes require that upper management understand that the purpose of the audit is to learn from past experiences,. Managers should not be penalized for the decisions they made but should, instead, be given the opportunity to learn from them.
What are the objectives of capital budgeting? Financial theory, in general, rests on the principle that the aim financial management should be to make the most of the present wealth of the firms equity shareholders. For a firm whose equity shares are dynamically traded on the stock market, the assets of the equity shareholders is replicated in the market price of the equity shares. Therefore the aim of financial management for such firms should be to maximize the market price of equity shares. The search of the welfare of equity shareholders is reasonable on the grounds that it donates to a competent allocation of capital in the economy. The bases for allotment of savings in the economy are anticipated return and risk. As equity share prices are based on expected return and risk, hard work to maximize equity share prices would end in an efficient allotment of resources. A different justification may be given for the aim of shareholder wealth maximization. Equity shareholders give the project (risk) capital required to begin a business firm and employ the management of the firm not directly through the board of directors. Therefore it behaves on corporate management to encourage the interests of equity shareholders. In a case where a public sector firm the equity stock of which, being fully owned by the government, is not traded on the stock market, the goal of financial management should be to maximized and the present value of the stream of equity returns an appropriate discount rate has to be applied. A like observation may be made with respect to other companies whose equity shares are not traded or very poorly traded.
Situational Analysis & Specification of objectives Collection Of Secondary Information Conduct Of Market Survey Characterisation Of Market Demand Forecasting Market Planning
Who are the buyers? What is the total current demand of the product? How is demand distributed temporally(pattern of salesper year) and geographically? What is the break up of demand? What price customer is willing to pay? How can potential customers be convinced to buy theproduct? What are the prospects of immediate sale?
Secondary Data Collection: Census of India National survey reports Plan reports Indian year book Statistical year book Annual surveys of industries The stock exchange directory The monthly bulletin of RBI
Conducting market survey: Defining the target population Selecting sample schemes and sample size Developing the questionnaire Recruiting & training the field investigators Obtaining information questionnaire
Scrutinizing the information collected Analysis of the data Interpretation of the data
Characterisation of market: Effective Demand in the past & present Breakdown of demand Price Methods of distribution & sales promotion Consumers Supply & competition Government policies
Demand Forcasting Qualitative Methods Time Series Projection Method Casuals Methods Market planning Pricing Distribution Promotion service