Capital and Capital

Budgeting
UNIT – VI
Capital and Capital Budgeting: Capital and
its significance, Types of capital, Estimation
of Fixed and Working capital requirements,
Methods and sources of raising finance.
Nature and scope of capital budging, features
of capital budgeting proposals, Methods of
capital Budgeting: Payback Method,
Accounting Rate of Return (ARR) and Net
Present Value Method (simple problems)
 Capital – definition
• Capital is defined as wealth, which is created over
a period of time through abstinence to spend.
• The different forms of capital are property, cash or
titles to wealth.
• It is the aggregate of funds used in the short - run
and long – run.
• Capital is the total amount of finances required by
the business to conduct its business operations
both in the short – run and long – run.
 Need for capital
• Promote business
• Conduct business operations smoothly
• Expand and diversify
• Meet contingencies
• Pay taxes , dividends and interests
• Replace the assets
• Welfare programmes
• To wind up
 Types of capital
• Fixed capital
• Working capital
 Fixed capital
• Fixed capital is that portion of the capital which is invested
in acquiring long – term assets such as land and buildings,
plant and machinery, furniture and fixtures, and so on.
• These assets are not meant for resale
Features:
• Permanent in nature
• Profit generation
• Low liquidity
• Amount of fixed capital
• Utilities for promotion and expansion
 Types of fixed assets
• Tangible fixed assets (land, machinery, motor
vehicles, furniture ..)
• Intangible fixed assets (goodwill, brand names,
trademarks, patents, copy rights..)
• Financial fixed assets (investments in shares,
foreign currency deposits, government bonds, shares held
by business in other companies and so on..)
 Working capital
• It the portion of the capital that makes a
company work.
• Also called as circulating capital
• It is used to meet regular or recurring needs
of the business.
• Working capital is the amounts needed to
cover the cost operating the business
 Features of working capital
• Short life span
• Smooth flow of operation
• Liquidity
• Amount of working capital
• Utilised for the payment of current
expenses
 Components of working capital
• Working capital = current assets – current liabilities
• Current assets
– Cash
– Stock of raw materials
– Stock of finished goods
– Debtors
– Prepaid expenses
– Bills receivable
• Current liabilities
– Creditors
– Accruals
– Bills payables
 Working capital cycle

Bills Raw Work in

Creditors
payables materials progress

Bills Finished
Cash
receivables goods

Debtors Sales
 Requirements of Working
•
Capital
Promotional and formation stage
• Position of business cycle
• Nature of business
• The length of manufacturing cycle
• Terms and conditions of purchase and sale
• Bottlenecks in the supply of raw materials
• Fluctuations in the demand
• Production policies
• Degree of competition
• Growth and expansion plans
• Profit margin
• Amount of taxes
• Depreciation policy
• Dividend policy
• Reserves policy
• Price level
• Operating efficiency
Methods and sources of finance
The common methods of finance are
• Long – term finance
• Medium – term finance
• Short – term finance
 LONG – TERM FINANCE
• Own capital
• Share capital
• Preference share capital
• Preference share

Types of preference shares

• Cumulative preference share
• Non – cumulative preference shares
• Participating preference shares
• Redeemable preference shares
• Non – redeemable preference shares
 LONG – TERM FINANCE
• Equity share capital
• Retained profits
• Long – term loans
• Debentures
– Convertible debentures
– Partly convertible debenture
– Secured debentures
– Partly secured debentures
– Unsecured debentures
– Redeemable debentures
– Non – redeemable debentures
• Government grants and loans
 MEDIUM – TERM FINANCE
• Bank loans
• Hire – purchase
• Leasing or renting
• Venture capital
 SHORT – TERM FINANCE
• Commercial paper (CP)
• Bank overdraft
• Trade credit
• Debt factoring or credit factoring
• Advance from customers
• Short – term deposits from the customers, sister
companies and outsiders
• Internal funds
Characteristics of common methods
of financing
• Points to be considered for deciding the
method and source of finance
– Duration of the loan
– Security of the loan
– Appropriateness of different sources of finance
to different assets
 Business finance and time period
Short – term Medium term Long – term

To purchase raw materials To replace machinery To buy fixed assets

To finance the salaries and To buy vehicles, To finance the

wages computers, office expansion of the new
machinery business
To finance credit sales To finance R&D To launch new
products
To meet the temporary To finance training and To finance takeovers,
shortages in the working development needs acquisitions, mergers,
capital growth and expansion
and so on
CAPITAL BUDGETING
 Nature of capital budgeting
“ The long term planning to make and finance
proposed capital outlays.” – Charles T Horngern
• Capital budgeting is the process of evaluating the
relative worth of long – term investment proposals
on the basis of their respective profitability.
• Operating budgets (such as sales budget, purchase
budget or overhead budget) show the firm’s
planned operations or resources allocation for a
given period in future, normally one year.
• Capital budgets are made for long – term period
say three years or beyond.
 Evaluating capital budgeting
The steps involved are
• Generating investment proposals
• Estimating cash flows for the proposals
• Evaluating cash flows
• Selection of projects based on an acceptance
criterion
• Monitoring and re – evaluating, on a continuous
basis, the investment projects, once they are
accepted.
Significance of capital budgeting
• Substantial capital outlays
• Long – term implications (5 to 15 years)
• Strategic in nature
• Irreversible
 Complications underlying capital
budgeting decisions
• Varying cash flows at different points of
time
• Time value factor
 Necessity of capital budgeting
• To reduce the costs and increase revenues
to maximise the profits
• For competitive , profitable, efficient and
vibrant business
• Capital budgeting decisions can be
classified into two types
– Projects that reduce costs
– Projects that increase revenues
 Capital budgeting decisions
Examples:
• Construction of new building or renovation of existing old buildings
• Purchase of technology
• Building a production facility
• Making a new product
• Labour agreements
• Decisions to expand into new products or markets such as R&D
• Starting a new business
• Replacing worn out or damaged equipment and obsolete equipment
The above examples can be classified as under
• Replacements
• Expansion
• Diversification
• R&D
• Others
 Complementary Vs Mutually
exclusive projects

• Complementary or contingent projects –

one of the projects can not be taken up
independently without the other (s)
• Mutually exclusive – when one can not be
taken up simultaneously with the other.
 Criteria for decision –making
• Accept or reject decisions
• Capital rationing
 Estimation of cash Inflows and
Outflows
Estimation of cash inflows
• Cash inflows refers to cash receipts
• It does not refer to future incomes.
• It may be calculated for a particular project or
asset or for the whole business for one year or
series of years.
• The cash inflows are determined on an after tax
basis, that is, from the gross inflows, deduct the
cash expenses and depreciation, and lastly taxes.
 Estimation of cash inflows (format)
Year Cash cash Cash flow before Depreciation Taxable Taxes Cash flow Cash
revenue expenses taxes (CFBT) income after taxes inflows
(CFAT)
A b c d =(b-c) e f =(d-e) g h = (f-g) i=
(h+e)
 Estimation of cash outflows
• Cash outflows refer to the amounts of cash going
out of the business.
• It may be calculated for a particular project or
asset or for the whole business for one year or
series of years.
• It constitutes the sum of all the outflows
(including the cost of the asset and installation)
and amounts introduced or withdrawn
periodically.
 METHODS OF CAPITAL BUDGETING

• Traditional methods
– Pay back period
– Accounting rate of return method
• Discounted cash flow method
– Internal rate of return (IRR) method
– Net present value (NPV) method
 Pay back method
• Under pay back method, the decisions to accept or reject a
proposal is based on its payback period.
• Payback period refers to the period within which the original
cost of the project is recovered. It is calculated by dividing
the cost of the project by the annual cash inflows.
Cost of the project
Pay back period 
Annual cash inf lows

• The shorter the length of the payback period, the better is the
project in terms of paying back the original investment.
• When the future is uncertain, the companies favour this
method
• Case 1: where the cash inflows are even
Example: the cost of a project Rs 50,000 the annual
cash inflows for the next 4 years are Rs 25,000.
what is the pay back period for the project?
• Case 2 : where the cash inflows are uneven
Example: the cost of the project is Rs 50,000 which
has an expected life of 5 years. The cash inflows
for next 5 years are Rs 24,000; Rs 26000; Rs
20,000; Rs 17,000 and Rs 16,000 respectively.
Determine the payback period.
• Case 3: where the cash inflows are same but
the timing is different
Example : Two projects, costing Rs 20,000
each, have the following cash inflows, both
have the same payback period. Which one
do you choose and why?
Year Project A Project B
I 8000 12000
II 12000 8000
III 10000 12000
IV 9000 7000
Total 39000 39000
Advantages
• Easy to calculate and understand
• Liquidity is emphasised
• Reliable technique in volatile business conditions
Disadvantages
• Post – payback earnings ignored
• Timing of cash flows ignored
• Liquidity over – emphasised (cost of proposal
and cost of capital are ignored)
 Accounting Rate of Return (ARR)
method
• Accounting rate of return refers to the ratio of annual profits after taxes to
the average investment.
• The average investment is equal to half of the original investment.
• Accounting rate of return is also called as average rate of return
• Where average investment is half of the capital outlay (i.e. capital outlay
divided by 2 ). Average capital employed is calculated to the usual
accounting convention that the original investment gets exhausted
steadily to zero over the life of the project.

Average annual profits after taxes

ARR 
Average investment
• The higher the ARR is ,the better is the profitability.
• Average profits can be considered before or after depreciation, interest or taxes.
At times, ARR is determined considering the original cost of the project as the
denominator.
• Example: A firm is considering two projects each with an initial investment of
Rs 20,000 and a life of 4 years. The following is the list of estimated cash
inflows after taxes.
Determine the average rate of return (a) average capital (b) original capital
employed.

Year Proposal I Proposal II Proposal III

1 12500 11750 13500
2 12500 12250 12500
3 12500 12500 12250
4 12500 13500 11750
Total 50000 50000 50000
Advantages
• It is easy to understand and calculate
• Can be compared with the cut off point of return and hence
the decision to accept or reject is made easier
• Considers all the cash inflows during the life of the project,
not like payback method
• It is a reliable measure because it considers net earnings that
is, earnings after depreciation, interests and taxes.
Disadvantages
• The concept of time value of money is ignored.
• Unless we have a cutoff point of return, accounting rate of
return cannot be meaningful and effective.
• The average concept is not reliable, particularly in times of
high or wild fluctuations in the returns.
• The average concept dilutes the profitability of the project. ( a
project with greater aggregate returns is given lower ranking)
• The method of computation of ARR is not standardised.
 Discounted cash flow methods
• Considers the time value of money
• They even consider the whole earnings of the proposal and
the cost of the project
• Also called modern methods of investment appraisal.
• Discounted cash flows are the future cash inflows reduced
to their present value based on a discounting factor.
• The process of reducing the future cash inflows to their
present value based on a discounting factor or cut – off
return is called discounting.
• Discounting is the obverse of compounding.
PV factor
Internal Rate of Return Method
Evaluation of IRR
Advantages:
• It is based on time value of money
• It is based on the earnings of all the years of the project
• It is a valuable tool to compare the projects with different cash inflows and different
life span
• It is independent of cost of capital
• Such project with higher IRR are recommended. Hence it directly contributes to the
wealth maximisation goal of the finance.
Disadvantages
• Difficult to understand and tedious to calculate IRR by even trial and error.
• It is based on certain assumptions, one of which is that the intermediate cash
inflows are reinvested at IRR. Where the company has more than one project with
different IRRs, this assumptions may not hold good.
• There could be cases of non – conventional projects with multiple IRRs, which are
difficult to understand.
• There are cases where higher IRR does not necessarily contribute to wealth
maximisation ( particularly in the case of mutually exclusive projects where NPV
method is better).
Net Present Value Method
Advantages
• Since the PV factor tables are available, determination of
NPV is relatively easier. It is to understand
• The goal of the financial management is wealth
maximisation and this method is enables the finance
manager to pursue this goal.
• It is based on the concept of time value and considers the
total earnings and expenses of the project
• NPV is a superior technique to IRR in case of mutually
exclusive proposals
• Each project can individually be evaluated.
Disadvantages:
• It is difficult to determine the appropriate discount rate
• The calculations are easier when compared to IRR, but is
beyond the comprehension of a common businessman.
• It does not indicate the cost of capital
• Where projects differ in their duration and their cash
flows, this method cannot be used. ( it is here, profitability
index is used.)
IRR and NPV compared
Profitability index
 Limitations of capital budgeting
• Uncertainty in the future
• Qualitative factors ignored
• Volatile business conditions
• Unrealistic assumptions