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Unit VI
Capital and Capital Budgeting
Introduction
Every business enterprise irrespective of its size etc. needs adequate capital to
conduct its business operations. Capital is the life blood and nerve Centre of an
enterprise. Without capital no enterprise can run its business operations
smoothly.
The total capital required by an enterprise depends upon factors like cost
of fixed assets (land, buildings, machinery etc.), cost of current assets (cash,
bank balance etc.), cost of promotion (market surveys, legal advices etc.), cost
of establishing the business, cost of financing (brokerage, underwriting
commission etc.) and cost of intangible assets (good will, copy rights etc.).
Total capital can be classified into two type one is fixed capital and second
one is working capital.
Significance of capital:
Adequate capital is necessary to carry on business operations and achieve
business targets. Capital is required to establish, operate, expand, diversify and
modernize a business enterprise. Capital plays a very important role in the
modern production system. Large scale production and acquisition of modern
production system requires huge capital. Huge capital investments create
employment opportunities. Capital is required by every enterprise. Capital is
indispensable today. Capital is scarce resource; hence every business concern
has to utilize the same judiciously.
Types of capital
Fixed capital: Fixed capital is required to meet the long term needs of the
business. Every business needs fixed capital i.e., investments in fixed assets to
create production or business facilities.it is also called as block capital or long
term capital.
Working capital: Working capital refers to that part of the firms capital which is
required for conducting day to day operations. Working capital is also known as
short term capital or circulating capital. It is represented by excess of current
assets over current liabilities.
Lack of adequate working capital may endanger the survival of the concern.
Requirements of working capital differ from business to business.
Capital budgeting:
The term capital budgeting means planning for capital assets. Capital
budgeting involves decisions on investment of firms funds in long term
activities in expectation of an expected flow of future benefits over a series of
years.
If any business commitment of funds in long term assets/fixed assets such
as land and buildings other type of assets must be carefully made. Once the
decision to acquire a fixed asset is taken, it become very difficult to reverse the
decision. The expenditure on plant and machinery and other long term assets
affects business operation over a series of years.
Investments decisions are very difficult to make, primarily because of the
future which will be affected by acquisition of these assets is distant and difficult
to forecast. In any long term investment of funds has to be made immediately
but the returns are expected over a number of future years.
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Ned or characteristics or Importance of capital budgeting

Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the goal of the firm. The need and
importance of capital budgeting has been explained as follows:
1. Long-term Implication
Capital expenditure decision affects the company's future cost structure over a
long time span. The investment in fixed assets increases the fixed cost of the
firm which must be recovered from the benefit
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of the same project. If the investment turns out to be unsuccessful in future or
give less profit than expected, the company will have to bear the extra burden
of fixed cost. Such risk can be minimized through the systematic analysis of
projects which is the integral part of investment decision.
2. Irreversible Decision
Capital investment decision are not easily reversible without much financial loss
to the firm because there may be no market for second-hand plant and
equipment and their conversion to other uses may not be financially viable.
Hence, capital investment decisions are to be carried out and performed
carefully and effectively in order to save the company from such financial loss.
The investment decision which is undertaken carefully and effectively can save
the firm from huge financial loss aroused due to the selection of unfavorable
projects.
3. Long-term Commitments Of Funds
Capital budgeting decision involves the funds for the long-term. So, it is longterm investment decision. The long-term commitment of funds leads to the
financial risk. Hence, careful and effective planning is must to reduce the
financial risk as much as possible.
4. Long term effect on profitability:
Capital budgeting decisions affect the profitability of a firm. A firm may loose
business to competitors if a decision is not rightly taken.
5. Greater risks:
Benefits from capital investments are received in future. As the future is not
certain. The risk involved is also higher uncertainties such as wrong forecast of
earnings, change in consumer taste and preferences, strategy of the
competitors, technological changes etc.
6. National importance:
Investment decisions taken by individual concern is of national importance
because it determines employment opportunities, economic activities and
economic growth.
Why capital budgeting
The rationale underlying the capital budgeting is efficient strategic
investment decision should enable the firm to achieve its objective of
maximizing profit either by way of increased revenue or by cost reduction,
capital budgeting decisions can be classified into the following types
1. Projects that reduce costs
2. Projects that increase costs
Capital budgeting decisions:
The following are certain investment or capital budgeting decisions:
A. Modification and replacement of existing facilities
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B. General plant improvement

C. Quality improvement
D. Replacement of manual work by machinery
E. Mechanization process
F. Exploration
G. Research and development
H. Cost reduction
I. New products or expansion of existing products
J. Additional capacity
Kinds of capital budgeting decisions: Generally the business firms are
confronted with three types of capital budgeting decisions.
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(i) The accept-reject decisions; (ii) mutually exclusive decisions; and (iii) capital
rationing
decisions.
1. Accept-reject decisions: Business firm is confronted with alternative
investment proposals. If the proposal is accepted, the firm incur the investment
and not otherwise. Broadly, all those investment proposals which yield a rate of
return greater than cost of capital are accepted and the others are rejected.
Under this criterion, all the independent proposals are accepted.
2. Mutually exclusive decisions: It includes all those projects which compete
with each other in a way that acceptance of one precludes the acceptance of
other or others. Thus, some technique has to be used for selecting the best
among
all
and
eliminates
other
alternatives.
3. Capital rationing decisions: Capital budgeting decision is a simple process
in those firms where fund is not the constraint, but in majority of the cases,
firms have fixed capital budget. So large amount of projects compete for these
limited budgets. So the firm rations them in a manner so as to maximize the
long run returns. Thus, capital rationing refers to the situations where the firm
has more acceptable investment requiring greater amount of finance than is
available with the firm. It is concerned with the selection of a group of
investment out of many investment proposals ranked in the descending order of
the rate or return.
Capital budgeting process
Capital budgeting decisions are among the most crucial, complex and
critical business decisions as it involves decisions to the investment of current
funds for the benefit to be achieved in future and the future is always uncertain.
In order to make investment proposals of a firm profitable. Investment proposals
are to be properly evaluated in order to accept or reject them. The important
steps involved in the capital budgeting process are as follows
1. Identification of investment proposals:
First step in capital budgeting process is the conception of a profit making
idea. Generally capital budgeting decisions are originated from different
departments like production, marketing, R&D and other departments of the firm.
2. Screening the proposals:
Each investment proposal is subject to a preliminary screening process in
order to asses whether it is technically feasible, resources requires are available
and expected returns are adequate to compensate for the risk involved in the
execution and implementation of the proposed project. Comparison of the
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proposals with other projects according to criteria of the firm is also done at this
stage.
3. Evaluation of various proposals:
The next step is evaluating eh profitability of various proposals by
applying capital budgeting appraisal techniques like payback period, ARR,
NPV, IRR etc. Project where profitability is more should be given
preference.
4. Establishing priorities: after technical evaluation and financial
evaluation of various proposals, the unprofitable proposals are rejected.
The accepted proposals are put in priority, proposals are to be ranked on
the basis of profitability and riskiness, urgency etc.
5. Final Approval: Proposals evaluated are sent to the top management
along with a detailed report, both of capital expenditure and sources of
capital. Manager in charge of finance will have to present several
alternative capital expenditure budgets. After selecting proposals, funds
necessary/required are allotted. Projects are then sent to the budget
committee fodr in corpora ting them in the capital budget.
6. Implementation of proposals: At this stage resources allocation and
assigning responsibilities for complement
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Methods of capital budgeting:
Capital budgeting decisions are made under different criteria. How are these
criteria determined. These criteria differ in concepts. Some use thumb rules and
some use logic and scientific approach. So based on these criteria the methods
of capital budgeting can be classified into
I)
Traditional methods
a) Payback period
b) Accounting rate of return method
II)
Discounting cash flows methods
a) Internal rate of return method
b) Net present value method
c) Profitability index method
Payback method:
Under payback method the decision to accept or reject a proposal is
based on its payback method. 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.
Initial investment
Payback period =
Annual cash inflow
Advantages:
1) It is very simple measure of economic feasibility of investment proposals.
2) It is very easy to apply, calculate and interpret the results
3) It is easy to understand
4) It is emphasizes the liquidity and solvency of a concern
Limitations:
1) The main drawback of this method is not giving weight to time value of
money

2) It also fails to measure the profitability of projects. It ignores the cash

inflow beyond the payback period
3) It fails to consider the magnitude of cash in flows.
4) There is no rational basis for selecting the optimum payback period
Average or accounting rate of return (ARR):
This method is based on the accounting information rather than cash flow.
There are number of alternative methods of calculating the ARR
Average profit after tax
ARR =
* 100
Average investment
Average investment after tax
ARR =
* 100
Original investment
As an accept reject criterion, this method will accept all those projects
whose ARR is higher than rate of established by the management.
Advantages:
1) It is simple to use and understand
2) It places emphasis on the profitability of the project, rather than on
liquidity
3) It considers the entire stream of incomes over the entire life of the project
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4) In this method profit after taxes are considered.
Limitations:
1) It ignores time value of money
2) It gives equal weight to both near money and distant money
3) Cash inflows are not taken into account
4) It does not consider the length of the project
Modern or discounted cash flow techniques:
Discounted cash flow methods take into accounts both magnitude and
timing of expected cash flows in each period of projects life. This method is
based on the principle that the value of money decreases with time i.e. a sum of
money received today is worth than an equivalent amount received later. Under
this technique all the cash flows are to be discounted at the appropriate rate of
interest which is the cost of capital in order to find out the present value.
Net present value (NPV):
The net present value method is the classic economic method of
evaluating the investment proposals.in this method cash inflows and cash out
flows are discounted using the cost of capital as the discounting rate. If all cash
outflows are made in the initial year then their present value will be equal to the
mount invested. Then the net present value is to be found out by subtracting
the present value of cash outflows from the present value of cash inflows.
If the NPV is positive or equal to the zero, the project can be accepted, if it
is negative the proposals has to be rejected.
Advantages:
1) It recognizes the time value of the money
2) It uses the discounting rate which is the firms cost of capital
3) It consider all cash flows over the entire life of the project
4) It is simple to find out the acceptable projects
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5) By accepting the project with the highest positive NPV, the profit will be
maximized objective of maximizing the wealth of the shareholders is met
Limitations:
1) It is difficult to calculate
2) It is difficult to calculate the cost of capital especially the cost of equity
capital
3) Unless the cost of capital known this method cannot be used
4) It may mislead when dealing with alternative projects or limited funds
under the conditions of unequal lives
Internal rate of return method (IRR):
The internal rate of return is defined as the interest rate that equates the
present value of the expected future receipts to the cost of the investment
outlay.
Internal rate of return is generally calculated by trial method. First we
compute the present value of the cash flows from an investment using an
arbitrarily selected interest rate. Then we compare the present value so
obtained with the investment cost. If the present value is higher than the
investment cost we try at a higher rate of interest and go through the
procedure. An if the present value is low than the costs lower the interest rate
and repeat the process. The interest rate that brings about this equality is
referred as the internal rate of return. This rate of return compared to the cost of
capital and the project having higher difference will be accepted.

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Advantages:
1) It considers the time value of the money
2) This method is more meaningful and acceptable to the users
3) It is consistent with the objective of maximizing the wealth of
shareholders
4) IRR takes into account the cash flows over the entire life of the project
Limitations:
1) It is difficult to understand and use in practice as it involves complicated
computation problems
2) It is assumes that intermediate cash inflows are re invested at the internal
rate of the project but it may not be always correct
3) It may give negative rate or multiple rate under certain circumstances
4) Like other methods it is difficult to estimate the future earnings accurately
Profitability index or benefit cost ratio method:
This method is a refinement of the net present value approach and gives a
very good guide to profitability. It is that ratio of present value of cash inflows to
the present values of cash out flows.
Present value of cash inflow
Profitability index =
Present value of cash outflow

To accept the project, profitability index should be greater than one or at

least equal to one. And when the profitability index is less than one the proposal
is to be rejected.