EEFA Unit 06 CAPITAL BUDGETING - Vidyarthiplus

Engineering Economics and Financial Accounting , Unit - 06 Faculty -C.R. SANKARAN - Capital Budgeting - - Yr / Sem / Dept - III / 5 / IT

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Introduction Every organization, irrespective of its nature (profit-making or otherwise) or

size (big or small), in course of time of its functioning, usually acquires, upgrades,

replaces the assets such as land and buildings, plant and machinery and so on. For

each of these, there are two or more choices, alternatives, which need to be carefully

evaluated on the basis of their costs and revenues, before investment..

A mini - steel plant is considering building a new arc furnace; an insurance company

is planning to install a computer system for information processing; the Government

of India is thinking of an ambitious plan to link Ganges and Cauvery rivers; Gautam,

a graduate student, is planning to buy a moped. - all these situations involve a capital

expenditure decision. Essentially, each of them represents a scheme for investing

resources which can be analyzed and appraised reasonably independently. The basic

characteristic of a capital expenditure (also referred to as a capital investment or

capital project or just a capital project) is that it typically involves a current outlay

(or current and future outlays) of funds in the expectation of a stream of benefits

extending far into future.

Capital budgeting Thus to improve the quality of the decisions, understanding the principles of

investment in capital budgeting is essential.

Capital budgeting is defined as " the long term planning to make and finance

proposed capital outlays".

The capital budgeting decisions involve long term planning for selection and

financing theinvestment proposal. Capital budgeting is the process of evaluating the

relative worth of long term investment proposals on the basis of respective

profitability.

Capital budgets are different from operating budgets from time to time from

point of view. operating budgets (such as sales budget, purchase budget or

overheads budget) show the firm's planned operations or resource allocations for a

given period in future, normally one year. on the other hand, capital budgets are

made for long term period , say three years or beyond.

Long term investment proposals involve large cash outlays. this require

careful analysis of cash outflows and inflows associated with each of these

proposals.

Capital Expenditures Importance and Difficulties

Importance Capital expenditure decisions often represent the most important decisions taken by

a firm. Their importance stems from three interrelated reasons:

1) Long-Term Effects - The consequences of capital expenditure decisions

extend far into the future. The scope of current manufacturing activities of a firm is

governed largely by capital expenditures in the past. Likewise current capital

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expenditure decisions provides the framework for future activities. Capital

investment decisions have an enormous bearing on the basic character of a firm.

2) A reversibility - The market for used capital equipment in general is

ill-organised. Further, for some types of capital equipments, custom-made to meet

specific requirement .the market may virtually be non-existent. Once such an

equipment is acquired, reversal of decision may mean scrapping the capital

equipment. Thus, a wrong capital investment decision, often cannot be reversed

without incurring a substantial loss.

3) Substantial Outlays Capital expenditures usually involve substantial

outlays. An integrated steel plants for example involves an outlay of several

thousand millions. Capital costs tend to increase with advanced technology.

Difficulties While capital expenditure decisions are extremely important, they also pose

difficulties which stem from three principal sources:

Measurement Problems - Identifying and measuring the costs and benefits of a

capital expenditure proposal tends to be difficult. This is more so when a capital

expenditure has a bearing on some other activities of the firm (like cutting into the

sales of any existing product) or has some intangible consequences (like improving

the morale of workers).

Uncertainty - A capital expenditure decision involves costs and benefits that

extend far into the future. It is impossible to predict exactly what will happen in

future. Hence, there is usually a great deal of uncertainty characterizing the costs and

benefits of a capital expenditure decision.

Temporal Spread - The costs and benefits associated with a capital expenditure

decision are spread out over a long period of time, usually 10-20 years for industrial

projects and 20-50 year for inf'ra-structtual projects. Such a temporal spread creates

some problems in estimating discount rates and establishing equivalences.

Phases of Capital Budgeting - Capital budgeting is a complex process, divided

into five broad phases: - planning; analysis; selection; implementation; review

-

The solid arrows reflect

the main sequence:; planning

precedes analysis; analysis

precedes selection; and so on.

The dashed arrows indicate that

the phases of capital budgeting

are not related in a simple,

sequential manner. Instead, there

are several feedback loops

reflecting the iterative nature of

the process.





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A. Planning The planning phase of a firm's capital budgeting process is concerned with the

articulation of its broad investment strategy and the generation and preliminary

screening of project proposals, The investment strategy of the firm delineates the

broad areas or types of investments the firm plans to undertake. This provides the

framework which shapes, guides, and circumscribes the identification of individual

project opportunities.

Once a project proposal is identified, it needs to be examined. To begin with, a

preliminary project analysis is done. A prelude to the full blown feasibility study,

this exercise is meant to assess

(i) Whether the project is prima facie worthwhile to justify a feasibility study

(ii) What aspects of the project are critical to its viability and hence warrant an

in-depth investigation.

B. Analysis If the preliminary screening suggests that the project is prima facie worthwhile, a

detailed analysis of the marketing, technical, financial economics and ecological

aspects is under taken. the questions and issues raised in such a detailed analysis are

described in the following section.

The focus of the phase of capital budgeting is on gathering, preparing, and

summarizing relevant information about various project proposals which are being

considered for inclusion in the capital budget. Based on the information developed

in this analysis, the stream of costs and benefits associated with the project can be

defined.

C. Selection Selection follows, and often overlaps, analysis. It addresses the question-is the

project worthwhile? A wide range of appraisal criteria have been suggested to judge

the worthwhileness of a project. They are divided into two broad categories, viz.,

non-discounting criteria and discounting criteria.

The principal non-discounting criteria are the payback period and the accounting

rate of return.

The key discounting criteria are the net present value, the internal rate of ream, and

the benefit cost ratio.

The selection rules associated with these criteria are as follows:

Criterion Accept Reject

Payback period (PBP) PBP < target period PBP > target period

Accounting rate of return (.ARR) ARR > target rate ARR < target rate

Net present value (NPV) NPV > 0 NPV < 0

Internal rate of return (IRR) IRR > cost of capital IRR < cost of capital

Benefit cost ratio (BCR) BCR > 1 BCR < 1





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Capital

rationing

Where the given projects are equally viable, and all of these are

necessary for the survival of the firm, but not have enough resources

to finance all these projects, based on the priorities, the company

has to allocate funds for each of the project

To apply the various appraisal criteria suitable cut-off values (hurdle rate, target rate,

and cost of capital) have to be specified. These are essentially a function of the mix

of financing and the level of project risk. While the former can be defined with

relative ease, the latter truly tests the ability of the project evaluator. Indeed, despite

a wide range of tools .and techniques for risk analysis (sensitivity analysis, scenario

analysis, Monte Carlo simulation, decision tree analysis, portfolio theory, capital

asset pricing model, and so on), risk analysis remains the most irritable part of the

project evaluation exercise.

D. lmplemenlailon The implementation phase for an industrial project, which involves

setting up of manufacturing facilities, consists of several stages:

(i) project and engineering designs,

(ii) negotiations and contracting,

(iii) construction,

(iv) training,

(v) plant commissioning.

What is done in these stages is briefly described below: Stage Concerned with

Engineering and project designs Site probing and prospecting,

preparation of blueprints, and plant

designs plant engineering selection of

specific machineries and equipment.

Negotiations and contracting Negotiating and drawing up of legal

contracts with respect to project

financing, acquisition of technology,

construction of building and civil works

provision of utilities, supply of

machinery and equipment, marketing

arrangements, etc.

Construction Site preparation, construction of

buildings and civil works, erection and

installation of machinery and equipment.

Training Training of engineers technicians and

workers. (This can proceed





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simultaneously along with the

construction work.)

Plant commissioning Start up of the plant. ( This is a brief but

commissioning technically crucial stage

in the project development cycle)

Translating an investment proposal into a concrete project is a complex,

time-consuming, and risk-fraught task. Delays in implementation, which are

common, can lead to substantial cost overruns.

For expeditious implementation at a reasonable cost, the following are helpful.

1. Adequate Formulation of projects : - A major reason for the delay is an

inadequate formulation of projects. Put differently, if necessary homework in terms

of preliminary studies and comprehensive and detailed formulation of the project is

not done, many surprises and shocks are likely to spring on the way. Hence, the need

for adequate formulation of the project cannot be over-emphasized.

2. Use of the Principle of Responsibility Accounting - Assigning specific

responsibilities to project managers for completing the project within the defined

time-frame and cost limits is helpful in expeditious execution and cost control.

3. Use of Network Techniques - For project planning and control two basic

techniques are available- PERT (Program Evaluation Review Technique) and CPM

(Critical Path Method). These techniques have, of late, merged and are being

referred to by a common terminology, that is network techniques. With the help of

these techniques, monitoring becomes easier.

E. Review

Once the project is commissioned the review phase has to be set in motion.

Performance review should be done periodically to compare actual performance

with projected pedormonce.

A feedback device, it is useful in several ways:

(i) It throws light on how realistic were the assumptions underlying the project;

(ii) It provides a documented logo of experience that is highly valuable in future

decision making;

(iii) It suggests corrective action to be taken in the light of actual performance;

(iv) It helps in uncovering judgmental biases;

(v) It induces a desired caution among project sponsors.

Levels of Decision Making In addition to looking at the various phases of capital budgeting, researchers have

also examined different levels of decision maldng. Gordon Miller, Mintzberg ,

forexample, defined three levels of decision making:: - operating, administrative,

and strategic.





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The key characteristics of decisins at these levels are described below:

Characteristics Operating

decisions

Administrative

decisions

Strategic

decisions

Where is the decision taken Lower level

management

Middle level

management

Top level

management

How structured fs the decision Routine Semi-structured Unstructured

What is the level of resource

commitment

Minor

resource

commitment

Moderate

resource

commitment

Major

resource

commitment

What is the tithe horizon Short-term Medium-term Long-term

The three levels (operating, administrative, and strategic) of decision making can be

readily applied to capital budgeting decisions.

Examples are given below:

1. Operating capital budgeting decision - Minor office equipmen

2. Administrative capital budgeting decision - Balancing equipment

3. Strategic capital budgeting decision - Diversification project

Steps to be considered for evaluating capital budgets - a) Generating investment proposals

b) estimating cash flows for the proposals

c) Evaluating cash flows

d) Selection of project based on an acceptance criterion

e) Monitoring and re-evaluating, on a continuous basis, the investment projects,

once they are accepted

Complications underlying Capital Budgeting Decisions: - Varying cash flos at different points of time - the future cash flows (both inflows

and outflows) are to be estimated ,which is uncertain, and hence a specialized task

Time value factor - cash inflows occurring at different points of time have to be

compared with the corresponding cash outflows using the concept of time value of

money.

Estimation of cash flows Cash Inflow refers to cash receipts and does not refer to future income. It may be

calculated for a particular project or asset or for the whole business for one year or

several years.

Format for computing cash inflows

Yr Cash

revenue

Cash

expenses

Cash

flow

before

taxes

(CFBT)

Depre-

ciation

Taxable

income

Taxes Cash flow

after taxes

(CFAT)

Cash

Inflows

A B C D=(B-C) E F=(D-E) G H=(F-G) I=H+E





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Cash Outflow - refers to the amount of cash going out of business. it may be

calculated for a particular project or asset or for the whole businessfor one year or

series of years. it constitutes the sum of al the outflows (including the cost of the

asset and installation) and amounts introduced or withdrawn periodically.

Methods of capital budgeting





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Limitations of capital budgeting -

A. Uncertainty in the future - all data used in the evaluation of proposals are

purely estimated. the data is error-prone more with the human judgement; bias or

discretion in the identification of cash flows

B. Qualitative factors ignored - factors considered are in term money, can be

quantified, but factors such as improved morale of employees as a result of





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implementation of proposals are not focussed. Other factor in the business

environment such as social economic conditions and so on, are not reflected here.

C. Volatile business conditions - the factors influencing business decisions include

� Technologicall advancement,

� government policies(such as fiscal policy, monetary policy),

� Sales forecast,

� Attitude of management (conservative or progressive),

� Estimated cash flow,

� Discount factors and rate of return.

Any change in one or more of these factors is going to affect the capital budgeting.

D. Unrealistic assumptions - they are:

� there is no risk and uncertainity in the business environment, which is untrue

and future of the business is full of uncertainity and different management

techniques are applied to minimise the risk

� the cash flows are received in lumpsum at the end of the given period

� the key variables such as sales revenue, costs, price or investments and so on

are taken based on past data, particularly in times of rising prices, these seldom holds

god for future.

� the cost of capital and discount rate are one and the same.




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EEFA Unit 06 CAPITAL BUDGETING - Vidyarthiplus