(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be reserved or withdrawn without sustaining a loss.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.
|
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.
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Question - What is product mix? Explain product mix decisions. Answer Meaning of Product Mix Product mix or product assortment ref...
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