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Also known as investment appraisal capital budgeting is the planning

process used to determine a farm͛s long term investment such as replacing an old

machinery or buying a new machinery, to make new plant or a new project are

worth mentioning.

firms decision to invest its current funds most efficiently in the long term assets in

anticipation of an expected flow of benefits over a series of years.͟

importance since they determine the value of the firm by influencing its growth,

profitability and risk.

Capital budgeting means planning for capital assets. Capital budgeting decisions

are vital to any organisation as they include the decision to:

1) hether or not funds should be invested in long term projects such as

setting of an industry, purchase of plant and machinery etc.

2) Analyze the proposal for expansion or creating additional capacities.

3) To decide the replacement of permanent assets such as building and

equipments.

4) To make financial analysis of various proposals regarding capital

investments sp as to choose the best out of many alternative proposals.

The importance of capital budgeting can be well understood from the fact that an

unsound investment decision may prove to be fatal to the very existence of the

concern. The need, significance or importance of capital budgeting arises mainly

due to the following:

b) Long-term commitment of funds

c) Irreversible nature

d) Long term effect on profitability

e) Difficulties of investment decisions

f) National importance

The key function of the financial management is the selection of the most

profitable assortment of capital investment. The need of the capital budgeting

can be emphasized 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 complicacies of the decision making.

1.

ʹ Capital budgeting decisions have long term

implications for the firm because they affect the future profitability of the

firm and cost structure. It influences the rate and the direction of firm͛s

growth. A wrong decision may lead the firm to a disastrous future and may

endanger the very survival of the firm.

ʹ The capital investment decisions involve a heavy

amount of funds. In most of the cases, the capital budgeting decisions are

irreversible and the amount invested cannot be taken back without causing

a substantial loss because it is very difficult to find a market for the second

hand capital goods, and their conversion into other uses may not be

financially feasible.

3.

ʹ By taking a capital

expenditure decision, a firm commits itself to a sizeable amount of fixed

costs in terms of labour, supervisor͛s salary, insurance, rent of the building

and so on. In short firm͛s future costs break-even points, sales and profits

will all be determined by the firm͛s selection of assets.

4. Bearing on Competitive Position of the Firm ʹ The capital investment in

fixed assets decisions also have a bearing on the competitive position of the

firm because the fixed assets, represent in a sense, true earning assets of

the firm. They enable the firm to generate finished goods that can

ultimately be sold for profit.

5. Cash Forecast ʹ Capital investment requires substantially large amount of

funds which can only be arranged by making determined efforts to ensure

their availability at the right time. Thus it facilitates cash forecasts to plan

the investment programme carefully, so that the firm can meet its long

term obligations without any difficulty.

6. orth maximization to share- holders ʹ The impact of long term capital

investment decision is far reaching. It protects the interests of the

shareholders and of the enterprise because it avoids over ʹ investment and

under ʹ investment in fixed assets.

7. Other factors ʹ The following other factors can also be considered for its

significance ʹ

replacement policy.

b) The feasibility of replacing manual work by machinery may be

seen from the capital forecast by comparing the manual cost

and the capital cost.

c) It facilitates the management in making of the long term plans

and assists in the formulation of general policy.

Estimation of the required rate of return (the opportunity cost of capital)

Application of decision rules for making the choice.

ʹ

techniques, or investment criteria. A sound appraisal technique should be used to

measure the economic worth of an investment project. The essential property of

a sound technique is that it should maximize the share holder͛s wealth.

profitability of the project.

r It should provide for an objective and unambiguous way of

separating good projects from bad projects.

r It should help ranking of projects according to their true

profitability.

r It should help to choose among mutually exclusive projects that

project which maximizes the shareholders͛ wealth.

r It should be a criterion which is applicable to any conceivable

investment project independent of others.

There are number of methods in use for evaluating a capital budgeting decision.

Different firms may use different methods for evaluating the project proposals.

hich method is appropriate for the particular purpose of the firm will depend

upon the circumstances. The most commonly used methods are the following ʹ

2. Accounting rate of Return

3. Time adjusted rate of Return calculated by

r Discounted cash flow method

! " # Payback period represents the length of time required

for the stream of cash proceeds produced by the investment to be equal to the

original cash outlay, i.e., the time required for the project to pay for itself. The

formula is simple:-

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ʹ Under this method, capital employed and related

income are determined by the following principles and practices commonly used

in accounting for assets and income. Rate of return may be calculated by taking

(a)income before taxes depreciation (b)income after taxes but including cash

flows from depreciation (c)income after taxes and after depreciation. The rate of

return will be very depending whether original investment or average investment

is used. Thus this method provides several rates of return.

There are two main variations; (i) original investment measure and (ii) average

investment measure. In the original investment method, the average annual

earnings over the life of the investment are compared with the amount of original

investment. The accounting method is simply a ratio of earnings to investment.

However, average investment assumes regular recovery of capital over the life of

the project. Accounting method does not allow for the time element in the return

of funds. It gives the same weight to the future rupees as it does to current

rupees. The time value of money is ignored which makes the rate of return

unrealistic.

In recent years , the time discounted rate of

return has come to be recognized as the most meaningful tool for the financial

decision making with respect to future commitments and the projects. Various

surveys have been made to ascertain the extent to which companies employ to

the different methods of calculating rate of return for decision making purposes.

Moreover, despite the growing awareness of the implications of the time

adjusted rate method, the payback still is a very popular method. The time ʹ

adjusted rate of return calculated either as the net present value or discounted

cash flow yield is being increasingly used not only to screen and rank proposed

capital expenditure but also employed in make ʹ or- by decision, in lease ʹ or ʹ

own judgments and in mergers and acquisitions. It has come to be one of the

most promising tools in financial decision making. The time adjusted methods can

be examined under two heads: - a) Present value method; and b) internal rate of

return method.

a) Present value method ʹ the present value method, also known as the

discounted benefit cost ratio method, takes account of all income whenever

received and to this extent complies with the bigger the better principle. Under

the present value method, minimum required rate of return is assumed and the

calculation is made to use a present value amount which is compared with the

original investment required. This discounting rate of return factor is also referred

to as the required earning rate .Thus the present value for a payment of Re 1 to

be received after n years at any rate of return can be found with the formula:

PV =

(1+K).n

!

) (NPV) The net present value is the difference between present

value of benefits and the present value of costs. If the net present value is

positive the conclusion is favorable to go ahead with the project, but it is negative

the project is rejected.

!

*ʹ If the present value method is used, the present value of one

project cannot be compared directly with the present value of earnings of

another unless the investments are of the same size. This is done by dividing the

present value of earnings by the amount of investments, to give a ratio that is

called the profitability index.

Benefit cost ratios ʹ Benefit cost ratios are often called profitability indexes. It

may be defined by the following equation ʹ

B/c ratio =

Net investment

b) Internal rate of return (IRR) In the present value method, the required earnings

rate is selected in advance. There is an alternative method which finds the

earnings rate at which the present value of the earnings equals the amount of

investment.

The internal rate of return for an investment is the discount rate that equates the

present value of them equates the present value of the expected cash outflows

with the present value of the expected inflows. It is represented by the rate, r ,

such that

here A is the cash flow period t, whether it be a net cash inflow or outflow, and

n is last period in which a cash flow is expected.

Capital budgeting is a process of making decision regarding investments in fixed

assets which are not meant for sale such as land, building, machinery or furniture.

So to take a logical and efficient decision in capital budgeting is of utmost

importance since they determine the value of the firm by influencing its growth,

profitability and risk. As discussed earlier capital budgeting is an utmost necessity

in a business.

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2.Financial management by- I. M Pandey

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