CASH MANAGEMENT MODELS

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NATURE, SIGNIFICANCE, METHODS WITH MERITS AND DEMAERITS

Nature of Capital Budgeting

(a) Capital expenditure plans involve a huge investment in fixed assets. (b) Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss. (c) Preparation of coital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects. It may be asserted here that decision regarding capital investment should be taken very carefully so that the future plans of the company are not affected adversely.  Significance of Capital Budgeting The need of capital budgeting can be emphasised taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, long-term implications for the firm, irreversible decisions and complicates of the decision making. Its importance can be illustrated well on the following other grounds:- (1) Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results. (2) Comparative Study of Alternative Projects Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each projects is estimated. (3) Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assets-acquisition and improvement in quality of assets purchased. It is due to ht nature of demand and supply of capital goods. The demand of capital goods does not arise until sales impinge on productive capacity and such situation occur only intermittently. On the other hand, supply of capital goods with their availability is one of the functions of capital budgeting. (4) Cash Forecast. Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast. (5) Worth-Maximization of Shareholders. The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity share-holders. (6) Other Factors. The following other factors can also be considered for its significance:- (a) It assist in formulating a sound depreciation and assets replacement policy. (b) It may be useful n considering methods of coast reduction. A reduction campaign may necessitate the consideration of purchasing most up-to—date and modern equipment. (c) The feasibility of replacing manual work by machinery may be seen from the capital forecast be comparing the manual cost an the capital cost. (d) The capital cost of improving working conditions or safety can be obtained through capital expenditure forecasting. (e) It facilitates the management in making of the long-term plans an assists in the formulation of general policy. (f) It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation, insure and there fixed assets Methods of evaluating capital expenditure proposals Which method is appropriate for the particular purpose of the firm will depend upon the circumstances but one thing is very clear that management has to select the most profitable proposal out of the various proposals under consideration with the management. The most commonly used methods are given below:- 1. Degree of Urgency Method 2. Pay back Period Method 3. Unadjusted Rate of Return Method 4. Present Value Method     (a) Time Adjusted Rate of Return Method     (b) Net Present Value Method Pay-Back Method It represents the number of years required to recover the original cash outlay invested in a project. It is based on the principle that every capital expenditure pays itself back over a number of years. It attempts to measure the period of time, it takes for the original cost of a project to be recovered from the additional earnings of the project. It means where the total earnings (or net cash inflow) from investment equals the total outlay, that period is the pay-back period. The standard recoupment period is fixed the management taking into account number of considerations. In making a comparison between two or more projects, the project having the lesser number of pay-back years within the standard recoupment limit will be accepted. Suppose, if an investment earns Rs. 5000 cash proceeds in each of the first two years of its use, the pay-back period will be two years. For this purpose, net cash inflow shall be calculated first in the following manner:- Cash inflow from sales revenue                        .............................................. Less operating expenses including depreciation ............................................                                                                           _____________________         Net income (before tax)                         ............................................... Less-Income tax                                            ...............................................                                                                       _______________________          Net income (after tax)                           ............................................... Add depreciation                                           ...............................................                                                                         ______________________           Net cash inflows                                  ...............................................                                                                        ______________________ Note:- As because depreciation does not affect the cash inflow, it shall not be taken into consideration in calculating net cash inflow. But it is an admissible deduction under income tax act. It has been deducted from the gross sale revenue and added in the Net-income (after tax).              Merits of Pay-back Method The merits of this method are as follows: (1) It is easy to calculate an simple to understand. It is an improvement over the criterion of urgency. (2) It is preferred by executives who like snap answers for the selection of the proposal. (3) It is useful where the firm is suffering from cash deficiency. The management may like to use pay-back method to emphasis those proposals which produce an early return of liquid funds. In other words, it stresses the liquidity objective. (4) Industries which are subject to uncertainty, instability or rapid technological charges may adopt the pay-back method for a simple reason that the future uncertainty does not permit  projection of annual cash inflows beyond a limited period.  in this way, it reduces teh possibility of loss through obsolescence. (5) It is a handy device for evaluating investment proposals, where precision in estimates of profitability is not important.  Limitations of Pay-back Method (1) It completely ignores the annual cash inflows after the pay-back period. (2) The method considers only the period of a pay back. It does not consider the pattern of cash inflows, i.e., the magnitude and timing of cash inflows. For example, if two projects involve equal cash outlay and yield equal cash inflows over equal time periods, it means both proposals are equally good. But the proposal with larger cash inflows in earlier years shall be preferred over the proposal which generated larger cash inflows in later years. (3) It overlooks the cost of capital; i.e., interest factor which is a important consideration in making sound investment decisions. (4) The methods is delicate and rigid. A slight change in operation cost will affect the cash inflows and as such pay-back period shall also be affected. (5) It over-emphasises the importance of liquidity as a goal of capital expenditure decisions. The profitability of t project is completely ignored. Undermining the importune of profitability can in no way be justified. Despite its weaknesses, the method is very popular in American and British industries for selecting investment proposals. Degree of Urgency Method Urgency plays an important role under this method. Some projects need immediate attention while others may be postponed for some time in order to avoid disruption in the working. The project that cannot be postponed are undertaken first. For example, if there is a break down production process due to loss of any component of the machinery which require immediate replacement in order to avoid disruption in production, shall be given firs priority over all other projects pending consideration with the management without any delay on the part of the management. In this way, urgency is the sole criterion for investing t funds in the project. It may, however, be possible that investment under this method is uneconomic. Evaluation. The method is very simple in principle as well as in practice. No technique is needed. Te project that seems urgent may be undertaken first. But the method is not a scientific method for evaluating the economic worth of t project. The main defects under this method may be enumerated as below:- (1) Under this method, no methodical analysis is applied. The action may be correct but in most cases by coincidence. In case where projected outlay is large and far reaching g in effect, urgency cannot be a convincing influence. (2) What is urgent and what is not is the sole decision of the top management. Each departmental incharge persuades the top management to assign first priority for the department project. The decisions are taken not on economic considerations but on the basis of 'power of persuasion' of the individual concern. Unadjusted Rate of Return Method Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out. The Accounting rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation.                                                                       Average income Accounting Rate of Return   (ARR) =       ______________                                                                    Average investment There are two variants of the accounting rate of return (a) Original Investment Method, and 9b) Average Investment Method. (a) Original Investment Method. Under this method average annual earnings or profits over the life of the project are divided by the total outlay of capital project, i.e., the original investment. Thus ARR under this method is the ratio between average annual profits and original investment established. We can express the ARR in the following way.                        Average annual profits over the life of the project ARR=          ____________________________________________                                                   Original Investment (b) Average Investment Method. Under average investment method, average annual earnings are divided by the average amount of investment. Average investment is calculated, by dividing the original investment by two or by a figure representing the mid-point between the original outlay and the salvage of the investment. Generally accounting rate of return method is represented by the average investment method. Rate of return. Rate of Return, as the term is used in our foregoing discussion, may be calculated by taking (a) income before taxes and depreciation, (b) income before tax and after depreciation. (c) income before depreciation an after tax, and (d) income after tax an depreciation, as the numerator. The use of different concepts of income or earnings as well as of investment is made. Original investment or average investment will give different measures of the accounting rate of return. Merits of Accounting Rate of Return Method (1) It is very simple to understand and use. (2) Rate of return may readily be calculated with the help of accounting data. (3) They system gives due weightage to the profitability of the project if based on average rate of Return. Projects having higher rat of Return will be accepted and are comparable with the returns on similar investment derived by other firm. (4) It takes investments and the total earnings from the project during its life time. Demerits of Return Method (1) It uses accounting profits and not the cash-inflows in appraising the projects. (2) It ignores the time-value of money which is an important factor in capital expenditure decisions. Profits occurring in different periods are valued equally. (3) It considers only the rat of return an not the length of project lives. (4) The method ignores the fact that profits can be reinvested. (5) The method does not determine the fair rate of return on investment. It is left at the discretion of the management. So, use of arbitrary rate of return cause serious distortion in the selection of capital projects. (6) The method has different variants, each of which produces a different rate of return for one proposal due to the diverse version of the concepts of investment and earnings. It is clear form the above discussion that the system is not much useful except in evaluating the long-term capital proposals.  Present Value Method The method is also known as 'Time adjusted rate of return' or 'internal rate of Return' Method or Discounted cash-flow method In recent years, the method has been recognised as the most meaningful technique for financial decisions regarding future commitments and projects. Postini Alternative The method is based on the assumption that future rupee value cannot be taken as equivalent to the rupee value in the present. When we compare the returns or cash inflows with the amount of investment or cash outflows, both must be stated on a present value basis if the time value of money is to be given due importance. The problem of difference in time (when cash outflows and inflows take place) can be resolved by converting the future amounts to their present values to make them comparable. The discounted cash flow rate of return or internal rt of return of n investment is the rate of interest (discount at which the present value of cash inflows and the present value of cash outflows become equal). The present value of future cash inflows can be calculated with help of following formula:              S P = ________         (1 + i )n Here P = Present value of future cash inflows S = Future value of a sum of money i = Rate of Return or required earning rate n = Number of year This method can be examined under two heads. (a) Net Present value method, and (b) Internal rate of return method. (a) Net Present Value Method. The net present value method also known as discounted benefit cost ratio. Excess present value method or Net gain method takes account of all income whenever received. Under this method, a required rate of return is assumed, and a comparison is made between the present value of cash inflows at different times and the original investment in order to determine the prospective profitability. This method is based on the basic principle if the present value of cash inflows discounted at a specified rate of return equals of exceeds the amount of investment proposal should be accepted. This discounted rate is also known a the 'required earning ratio'. Present value tables are generally used in order to make the calculations prompt and to know the present value of the cash inflows at required earning ration corresponding to different periods. We can, however, use the following formula to know the present value of Re. 1 to be received after a specified period at a given rate of discount.                              S               PV=  ________                          (1 + i )n Where         PV = Present Value                     r = rate of discount Example. Let us suppose an investment proposal requires an initial outlay of Rs. 40000 with an expected cash-inflow of Rs. 1,000 per year for five years. Should the proposal be accepted if the rate of discount is (a) 15 % or (b) 6% ? We can find the present value of cash inflows with the help of present value tables as follows @ 15 % and 6 % :- Year (1) Cash inflows (2) Present Value of Re 1 @ 15 % (3) Total Present Value @ 15 %(2) X (3) Present Value of Re 1 @ 6% (5) Total Present value @ 6% (2) X (5) 1. 2. 3. 4. 5. 1,000 1,000 1,000 1,000 1,000 .870 .756 .658 .572 .497 870 756 658 572 497 _________ 3353 ________ .943 .890 .840 .792 .747 943 890 840 792 747 ________ 4212 ________ The method is regarded as superior to other methods of investment appraisal in several ways:- (1) The method takes into account the entire economic life of the project investment and income. (2) It gives due weight age to time factor of financing. Hence valuable in long term capital decisions. In the words of Charles Horngren, 'Because the discounted cash flow method explicitly and routinely weighs the time value of money, it is the best method, to use for long-range decisions.' (3) it produces a measure which is precisely comparably among projects, regardless of the character and time shape of their receipts an outlays. (4) This approach provides for uncertainty and risk by recognizing the time factor. It measures the profitability of capital expenditure by reducing the earnings to the present value. (5) It is the best method of evaluating project where the cash flows are uneven. Cash inflows and outflows are directly considered under this method while they re averaged under other methods. As the total present value of Rs. 3353 at a discount rat of 15 % is less than Rs. 4000 (the initial investment) the proposal cannot be accepted, if we ignore the other non-quantitative considerations. But the present value of Rs. 4212 at a discount rate of 6 % exceeds the initial investment of Rs. 4,000, the proposal can be acceptable. The above example shows an even cash inflows every year. But if cash inflows is uneven, the procedure to calculate the present values is somewhat difficult. For example, if we expect cash flows at - Re. 1 one year after, Rs. 3 two years after. Rs. 4 three years after the present value at 15 % discount tat would be:-    PV of Re. 1 to be received at the end of one year – 1 (.870) = .870    PV of Re. 3 to be received at the end of one year – 2 (.756) = 1.512    PV of Re. 4 to be received at the end of one year – 3 (.658) = 1.974                                                                                                ________ Present value of series                                                                 4.356                                                                                              _________ (b) Internal Rate of Return Method. This method is popularly known as 'time adjusted rate of return method', 'discounted cash flow rate of return method', 'yield rate method', 'investor's method', or 'Marginal efficiency of capital' method. In present value method the required earning rate is selected in advance. But under internal rate of return method, rate of interest or discount is calculated. Internal rate of return is the rate of interest or discount at which the present value of expected cash flows is equal to t total investment outlay. According to the National Association of Accountants, America “Time adjusted rate of Return is the maximum rte of interest that could be paid for the capital employed over the life of an investment without loss on the project. “ This rate is usually found by trial and error method. First we select an arbitrary rate of interest and find the present value of cash flows during the life of investment at tat selected rate. Then we compare present value with the cost of investment. If the present value if higher or lower than the cost of investment, w try another rate and repeat the process. If present value is higher than the cost, we shall try a higher rat of interest or vice-versa. This procedure continues till the present values and the cost of investment (total outlay in project) are equal or nearly equal. The rate at which present value and cot of investment are equal. The at is called internal rate of return. Demerits or Limitations of Discounted Cash Flow Method (1) It involves a good amount of calculations hence it is difficult and complicated. But the supporters of this method rebute the argument and assert that difficulty of the method is unfamiliarity rather than its complexity. (2) It does not correspond to accounting concepts for recording costs and revenues with the consequence that special analysis is necessary for the study of capital investment. (3) The selection of cash inflows is based o sales forecasts which is in itself an indeterminable element. (4) The economic life of an investment is very difficult to forecast exactly. (5) The method considers discount on expected rate of return but the determine action of rate of return is in itself a problem. Despite the above defects, the method provides an opportunity for making valid comparisons between long-term competitive capital projects.

capital budgeting meaning

Meaning of Capital Budgeting

The word investment refers to the expenditure which is required to be made in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm. What is capital expenditure, is a very difficult question to answer. The terms capital expenditure are associated with accounting. Normally capital expenditure is one which is intended to benefit future period i.e., in more than one year as opposed to revenue expenditure, the benefit of which is supposed to be exhausted within the year concerned.

procedure of capital budgeting

Procedure of Capital Budgeting

in capital budgeting process, main points to be borne in mind how much money will be needed of implementing immediate plans, how much money is available for its completion and how are the available funds going to be assigned tote various capital projects under consideration. The financial policy and risk policy of the management should be clear in mind before proceeding to the capital budgeting process. The following procedure may be adopted in preparing capital budget :- (1) Organisation of Investment Proposal. The first step in capital budgeting process is the conception of a profit making idea. The proposals may come from rank and file worker of any department or from any line officer. The department head collects all the investment proposals and reviews them in the light of financial and risk policies of the organisation in order to send them to the capital expenditure planning committee for consideration. (2) Screening the Proposals. In large organisations, a capital expenditure planning committee is established for the screening of various proposals received by it from the heads of various departments and the line officers of the company. The committee screens the various proposals within the long-range policy-frame work of the organisation. It is to be ascertained by the committee whether the proposals are within the selection criterion of the firm, or they do no lead to department imbalances or they are profitable. (3) Evaluation of Projects. The next step in capital budgeting process is to evaluate the different proposals in term of the cost of capital, the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation techniques:- (a) Degree of Urgency Method (b) Pay-back Method (c) Return on investment Method (d) Discounted Cash Flow Method. (4) Establishing Priorities. After proper screening of the proposals, uneconomic or unprofitable proposals are dropped. The profitable projects or in other words accepted projects are then put in priority. It facilitates their acquisition or construction according to the sources available and avoids unnecessary and costly delays and serious cot-overruns. Generally, priority is fixed in the following order. (a) Current and incomplete projects are given first priority. (b) Safety projects ad projects necessary to carry on the legislative requirements. (c) Projects of maintaining the present efficiency of the firm. (d) Projects for supplementing the income (e) Projects for the expansion of new product. (5) Final Approval. Proposals finally recommended by the committee are sent to the top management along with the detailed report, both o the capital expenditure and of sources of funds to meet them. The management affirms its final seal to proposals taking in view the urgency, profitability of the projects and the available financial resources. Projects are then sent to the budget committee for incorporating them in the capital budget. (6) Evaluation. Last but not the least important step in the capital budgeting process is an evaluation of the programme after it has been fully implemented. Budget proposals and the net investment in the projects are compared periodically and on the basis of such evaluation, the budget figures may be reviewer and presented in a more realistic way.

working capital

working capital from Ravneet Kaur

financial management notes

Financialmanagement notes-anirudh from Ravneet Kaur

Dividend and its theories,how it will be paid

DEFINING DIVIDEND POLICY

Brealey et al defined dividend policy as “ the trade off between retaining earnings on the one hand and paying out cash and issuing new shares on the other.” Brealey et al (1986:417)

DIVIDEND CONTROVERSY

Over the last century, three schools of thought have emerged over dividend policy.

•      One faction sees dividends as attractive and as a positive influence on stock prices.

•      A second bloc believes that stock prices are not related to dividend payout levels.

•      The third group of theories maintains that firm dividend policy is irrelevant in stock price valuation.

The question is If dividends are so irrelevant as is being purported by Modigliani and Miller "Why do corporations pay dividends?" and also, "Why do investors pay attention to dividends?" Black [1976]

Theories of Dividend Policy

Irrelevance Theory

Modigliani and Miller researched and produced a paper stating that dividends were irrelevant to share value. They were of the view that the determinants of value of a share are the availability of projects with positive NPV’s rather than pattern of dividends paid out by a company to its shareholders

According to them under ideal conditions, the value of the firm is unaffected by dividend policy

Argument against MM preposition

1. If dividends are so irrelevant "Why do corporations pay dividends?" and also, "Why do investors pay attention to dividends?" Black [1976]

Argument for MM preposition

1. Dividend policy makes no difference because it has no effect on either stock prices or the cost of equity - Black and Scholes (1974),

Bird-in-hand theory

This theory states that dividends are more predictable than capital gains because managers can stabilize dividends, but cannot control stock price.

Therefore, dividend payments are safe cash in hand while the alternative capital gains are at best cash in the bush.

Tax Preference Theory

The theory argued taxes are paid on dividends in the year they are received while taxes on capital gains do not have to be paid until the stock is sold. Again taxes on capital gains may be less than on dividends, which are considered ordinary income. Thus depending on the tax situation of the investor, investors will prefer that companies retain the earnings and promote capital appreciation

THE CLIENTELE EFFECT

—  Some shareholders may prefer stocks that do not pay dividends.

—  Other shareholders may prefer stocks that pay a regular dividend.

—  Investors will form their well-diversified portfolios of stocks to have the desired dividend policy.

—  All clienteles would prefer not to be constantly rebalancing their portfolios as firm switch policies. Rebalancing is expensive due to transactions costs.

Main Factors Determining Dividend Policy

Dividend turn to be lower when there are more investment opportunities as the theory suggests. However, many businesses tend to base their dividend on the profit or earnings of the most recent year

How dividends are paid

Cash dividend

These are payment of cash by the firm to share holders

Stock dividends

This is the distribution of additional shares to share holders e.g., right issues

Dividend payout ratio:  this is the fraction of earnings paid out as dividends

Legal limitations on dividend

State laws- help to protect creditors against excessive payment of dividend

placing of limits on dividend payments

Stock repurchases

Some firms buys back from its share holders

Ex-dividend date – This is the date that determines whether a shareholder is entitled to dividend payment

 

Scrip Dividend

This is when a company allows it share holders to take their dividend in the form of new shares rather than cash