Economics Notes on Capital Budgeting

Economics Notes on Capital Budgeting:- 1. Concept of Capital Budgeting 2. Need for Capital Budgeting 3. Pre-Requisites 4. Process 5. Issues Involved.

Concept of Capital Budgeting:

Capital budgeting or capital expenditure management is concerned with planning and control of capital expenditure. Budgeting of capital expenditure is an important factor in the management of a business. The term capital budgeting refers to long term planning for proposed capital outlays and their financing. It includes both raising of long term funds as well as their utilisation.

It may thus be defined as “the firms formal process for the acquisition and investment of capital”. It is the decision-making process by which the firms evaluate the purchase of major fixed assets. It involves the firm’s decision to invest its current funds for addition, disposition, modification, and replacement of long term fixed assets. Decisions in this area should be based on carefully determined rate of return appraisals.

Capital investment must be the result of capital budgeting and capital budgeting is a reconciliation between the marginal revenue and marginal cost. Marginal revenue represents the percentage rate of return on investment while marginal cost is the cost of capital to the business.

Capital budgeting as a prelude for capital investment requires the management to have some highly objective and rational means of determining the size and content of the capital budget and to screen all proposals in order to select those which seem to be the most beneficial.

The following definitions give a clear meaning of the term capital budgeting:

(i) As put by Charles T. Horngren, “Capital budgeting is a long term planning for making and financing proposed capital outlays”.

(ii) Gilman L.J. has put thus, “Capital budgeting refers to the total process of generating, evalu­ating, selecting and following up on capital expenditure alternatives”.

(iii) Max D. Richards and Paul S. Greenlaw have defined as follows, “Capital budgeting generally refers to acquiring inputs with long run returns”.

(iv) R.M. Lynch has said, “Capital budgeting consists in planning for development of available capital for the purpose of maximising the long term profitability of the firm”.

(v) Hampton John. J. has defined it as “firm’s formal process for the acquisition and investment of capital”.

(vi) Milton H. Spencer has opined it as, “Capital budgeting involves the planning of expenditure for assets, the return from which will be realised in future time periods”.

The above definitions give the meaning of capital budgeting as essentially a list of what manage­ment believes to be worthwhile projects for the acquisition of new capital assets together with the estimated cost of each project.

Need for Capital Budgeting:

The need for capital budgeting arises for various reasons which are listed below:

(i) Capital budgeting is indispensable for establishing and running industrial organisation. In modern times, a lump amount is needed to set up a plant which will have to be raised from the financial market. If the outcome from the investments is not sufficient then the firm incurs losses. While for spending large amount for a project, the management will have to make a proper study of its future profitability.

(ii) Capital budgeting is essential in order to secure adequate return from investment. For this purpose, higher operating expenses are to be reduced and idleness of the machinery should be avoided. The level and planning period of investment should be done carefully through capital budgeting.

(iii) There arises long term nature of fund commitment when capital expenditure is incurred on a project. Different investment proposals have varying degrees of risks and uncertainties. When a huge investment is made, it cannot be transferred, and the investment sinks. All these uncertainties can be avoided if a realistic capital budgeting is made.

(iv) Capital budgeting decisions are quite vital for the reputation of the management. Apart from this, the decision regarding choice of capital projects, addition to the stock of capital, replacement of worn out capital, volume and timing of investment are very essential for capital budgeting. Thus capital budgeting is one of the areas of managerial decision making.

All these arguments show the importance of capital budgeting. Capital budgeting is very neces­sary whenever long term investment is required to be made, since the firm’s very survival depends on managerial ability to conceive, analyse, and set the most profitable projects for investment, given the objectives of the firm.

Prerequisites of Capital Budgeting:

Before we proceed to discuss the major aspects of capital budgeting, the information regarding the pre-requisites of capital budgeting are necessary for the preparation of a capital budget.

Capital Expenditure:

Investment on the machinery is called capital expenditure. The capacity of the machinery de­pends upon the probable sales of different sizes. If the firm is small there is centralisation, the capital budget is prepared straight away. If it is a large company and there is decentralisation, the capital budget is prepared department wise and then a consolidated budget for the entire company is prepared.

Joel Dean has suggested that capital expenditure should be defined in terms of economic behaviour, rather than in terms of accounting convention. For the purpose of capital budgeting, therefore, only long term capital expenditures which are un-adjustable in the short run are taken into account. Such items of capital expenditure as inventories and receivables which keep varying and are adjustable during short run are ignored.

Capital expenditure budget is a type of functional budget. It is the firm’s formal plan for the expenditure of money for purchase of fixed assets. It provides a guidance as to the amount of capital that may be required for procurement of capital assets during the budget period.

The budget is prepared after taking into account the available production capacities, probable reallocation of existing resources and possible improvements in production techniques. If required, separate budgets can be prepared for each item of capital asset.

Broadly speaking the items which are included in capital budgeting are:

(i) Expenditure of new capital equipment or creation of long term assets by a new firm;

(ii) Expenditure on expansion or diversification of assets, and addition to the existing capital stock;

(iii) Expenditure on replacement of depreciated capital;

(iv) Expenditure on advertisement which bears fruit over time; and

(v) Expenditure on research, development and innovation.

The objectives of a capital expenditure budget are as follows:

(i) It determines the capital projects on which work can be started during the budget period after taking into account their urgency and the expected rate of return on each project.

(ii) It estimates the expenditure that would have to be incurred on capital projects approved by the management together with the source or sources from which the required funds would be obtained.

(iii) It restricts the capital expenditure on projects within authorised limits.

There are different kinds of capital expenditure budgets. There are different ways in which they are used by the companies. The differences are only to the extent of details, timing and methods in evaluation.

There are two types of capital expenditure budgets:

(i) Short-range capital budgets.

(ii) Long-range capital budget.

The short-range capital budgets relate to the estimated amount to be spent in the coming year. Budget is prepared to spend a fixed amount. This method does not deal with individual projects. The management takes a decision based upon profit potential of the proposed projects. This kind of budget is a necessity for the management device of planning and control.

The long-range capital budgets involve analytical calculations of the estimates of projected amounts. One version of this approach is to use a per cent of sales growth for expansion investment and a per cent of continuing sales volume for replacements or reinvestments.

It includes the areas of future investment interest. It is mostly confined to a product or product line and may deal with the marketing facilities or production processes of improvement.

Where there are several divisions in a company, a division itself is an area of investment. It also involves complete long range projection of capital requirements for specific projects. This approach has been found practically impossible because plan­ning for a long period is subject to limitations and will result in uncertainty. It is the usual practice for companies to prepare capital budgets for five years.

Types of Capital Expenditures:

All expenditures which are incurred for acquiring fixed assets for the continuous use in the business to earn profit are known as capital expenditures or investment proposals or investment projects.

The following types of capital expenditures are incurred in a large business concern:

(i) Capital expenditures for the progress and the improvement of the business. These expenditures are incurred on new plants and buildings.

(ii) Capital expenditures for normal operations of the business. Such expenditures are incurred on replacing old machines by new ones, on new plant layout and on establishing new office and the like.

(iii) Capital expenditures on publicity, advertisement, exploration of new market, etc.

(iv) Capital expenditures on various types of research. Different types of research are conducted covering the various aspects of the business operations and all such research entails some sort of expenditure.

(v) Capital expenditures on projects indirectly related to production and also those required under some legal obligations are included in this category.

Process of Capital Budgeting:

It may involve a number of steps depending upon the size of the concern, nature of projects, their numbers, complexities and diversities, etc.

The important steps involved in a capital budgeting process are the following:

(i) Project Generation:

Capital expenditure proposals may be of two types:

(a) Proposals for expanding the revenues, and

(b) Proposals for reducing the cost.

Under the first category, proposals to add new products and to expand the capacity in existing lines may be included. Under the second category, replacement proposals are included. Such proposals are designed to bring savings in cost.

(ii) Project Evaluation:

It involves:

(a) Estimating the cost and benefits in terms of cash flows, and

(b) Selecting an appropriate criterion for judging the desirability of the projects.

(iii) Project Selection:

This step is related to the screening and selecting the projects.

(iv) Project Execution:

When capital expenditure proposals are finally selected, funds are allo­cated for them. It is the duty of the top management to ensure that funds are spent in accordance with the allocation made in the capital budgets.

(v) Follow up:

Lastly, a system of following-up the result of completed projects should be established.

Issues Involved in Capital Budgeting:

1. Planning Period:

The determination of span of planning period is another major issue involved in capital budgeting, for the projects differ in their gestation period.

A good idea about the plan period is necessary for:

(i) Effective planning, its execution and control;

(ii) Possible dovetailing of old plans with new ones for future or integrated development of the company;

(iii) Assessment of economies of scale and determination of plant size; and

(iv) Financial planning and timely acquisition of necessary finances.

2. Decision Rules:

A particular capital project may be capable of standing the test against several criteria but the various criteria may not be in conformity with each other. It is, therefore, necessary that decision rules for accepting or rejecting a project must be decided well in advance. Decision rules are normally decided as the basis of the objectives of the firm.

3. Collection of Relevant Data:

Capital budgeting requires collection of adequate, necessary and relevant data regarding:

(i) Cost of the projects,

(ii) Expected rate of return,

(iii) Availability of alternative projects,

(iv) Period of fruition, maturity and overall longevity of alternative projects,

(v) Market rate of interest, and

(vi) Degree of uncertainty.

4. Planning and Management of Capital Investment:

Once capital budget has been prepared, it becomes a commitment of resources which is an outcome of conscious and deliberate planning. While planning a budget, the resources of a company have to be committed, keeping in view the benefits. The planning of a budget, forecast of production and sales have to be done simultaneously.

The planning process includes:

(i) The setting of objective, which relates to product objective;

(ii) The planning of research and development, i.e., product research and planning for development; and

(iii) The estimate of capital requirements, it is also known as the engineering estimate.

At this phase, it is important to consider the different components of the master budget or capital budget. The budget contains three sub-budgets, namely the operating budget (sales budget, cost budget and distribution budget), the non-operating budget and the financial budget (capital expenditure budget, profit and loss budget and cost budget).

In capital budgeting, there is long coverage of activities ranging from planning the availability, allocation and control of expenditures of long run as well as short run investment funds. The long-range capital budget usually covers three to five or more years of period. It is a long range planning tool covering future expenditures in general.

The main process of preparing long-range capital budget starts from the management. Economist who forecasts outlook for the industry, projects a position for the firm covering a probable market share. On the basis of this, forecast managers estimate their prospec­tive capital expenditure.

All their requirements for capital expenditure are combined for the firm’s capital budget. Short-term capital budget as an effective tool for allocation and rationing of capital budget is in effect a tool for allocation and rationing of capital resources. In the short term, plan details can be worked out and carried over from the past can be easily incorporated. This is why many companies prefer to follow a short term rather than long term plan.

There are two aspects of capital management:

They are:

(i) Short term capital management.

(ii) Long term capital management.

(i) Short term capital management:

In the short term capital management, a business manager is concerned with managing working capital and fixed capital for operational efficiency, whereas in the long run he is much more concerned with managing the capital structure of the enterprise for growth.

Managing Working Capital:

Working capital refers to the investment by a company in short term assets such as cash, mar­ketable securities, accounts receivable and inventories. Management of working capital, therefore, includes management of all current assets and current liabilities.

Excess of current assets over current liabilities provides the net working capital. Working capital is purely a tool for financial analysis in the hands of the management accountant who can assess the liquid position of the enterprise for the present as well as for the near future as compared to the near past. It is also called a circulating capital or operating capital.

A company’s profitability in one way is determined by the management of its working capital. Requirements of working capital are assessed keeping in view the general nature of business, length of operation, quantum of turnover of inventories, account receivables, cost of product, terms of sales and purchases, seasonal variations, expansional programmes for the future and contingencies involved in the business.

There are two concepts as regard working capital gross working capital and net working capital. Gross working capital refers to the amount of funds required for production of goods and services to satisfy the demand. Temporary capital changes from its part and are invested in current assets which are employed in a business. Net working capital refers to the difference between the current assets and current liabilities.

Working capital may be further classified using time as the basis. They are permanent working capital and temporary or variable working capital. Permanent working capital is the amount of funds required for production of goods and services to satisfy the demand. Temporary working capital changes its form from cash to inventory and from inventory to receivables and then to cash. Businesses which are of seasonal nature require more of temporary working capital.

The main sources of working capital are of two types and they are:

(i) Internal sources, and

(ii) External sources.

Internal sources of working capital requirements can be met from four sources and they are:

(i) Financing from account receivables either through outright sale of such receivables or bor­rowings on them by offering as securities.

(ii) Financing from inventories.

(iii) Depreciation is also a source of working capital.

(iv) Tax liabilities.

External sources of working capital may include short term borrowings from banks and financial institutions or individual lenders. Ratio analysis helps in assessing the working capital requirements, its adequacy, shortage or excess.

Management of Fixed Assets:

Fixed assets assume desirable shape and form part of the working apparatus of the enterprise.

Fixed assets broadly include three categories and they are:

(i) Tangible assets or physical assets.

(ii) Intangible assets.

(iii) Fixed security investments.

Sources for acquisition of fixed assets may be internal and/or external. Internal sources are equity holders, money in the shape of equity, retained earnings, depreciation fund or reserves.

External sources include long term borrowings from banks and financial institutions, issue of debentures or term deposits from public. For managing the fixed capital, an economist has to seek help of financial analyst who prepares fund flow statement showing sources and uses for the funds for the short period analysis. Ratio analysis is also used for managing fixed capital.

(ii) Long Term Capital Management:

It is concerned with managing the capital structure of the firm which is comprised of long term debt, preferred stock and net worth. Net worth is the equity stock holders, fund and includes equity stock, capital surplus, earned surplus and reserves. In short, capital structure of a firm is comprised of owner’s money and non-owner’s money.

For determining the capital structure of a firm, a business manager may require the following information:

(i) The total amount of total assets to be employed;

(ii) The time limit by which various financial requirements may materialise, and

(iii) The position of sources of funds to acquire assets.

Optimum capital structure refers to that state when a firm obtains the best mix of equity and debt sources of funds to minimise overall cost of capital and maximises market value of the firm for a given level of capital.

Objective of Working Capital Management:

The main objective of working capital is to provide adequate support for the smooth functioning of the normal business operations of a company.

The objective of working capital management covers not only the management of current assets in tune with the attitude of management toward risk and arriving at a satisfactory level of current assets that balances the liquidity and profitability criteria but also the management of financing the chosen level of current assets, once again taking into considera­tion the attitude of the management toward risk.

Working capital management encompasses the man­agement of current assets and means of financing them. The objective of working capital management is one of balancing the ‘liquidity’ and ‘profitability’ criteria.

Criteria for Evaluating Working Capital:

The following criteria may be adopted for evaluating the working capital management.

1. Liquidity:

The current assets of a company are considered to be more liquid than fixed assets. Among the current assets some items are considered to be highly liquid than others. In a descending order of liquidity, the current asset items can be stated as cash and bank balances, marketable securities, sundry debtors, raw material inventory, finished good inventory and work in process inventory.

These inven­tories are considered to be less liquid. The final test of liquidity is the ability of a company to meet its current obligations. Even though accounts receivable are considered to be liquid, the degree of liquidity depends upon the paying habits of customers and the mobilisation efforts made by the company.

Flow of Cash:

Established companies may have faced at some-time the problem of cash short­age. It is much common in seasonal industries. It has happened because of mismatching of cash inflows and cash outflows. As a result, companies keep some minimum cash balance. The large the proportion of current assets held in the form of cash and bank balances, the more liquidity position of the company improves.

2. Turnover of Inventory:

Too high a level of inventory and too low a level of inventor)’ are not conducive to the financial health of a company. Any type of inventory will represent the amount of cash locked up and the amount of carrying costs which can be as high as 25 per cent of the value of inventory associated with inventory.

Too high a level of inventory can create problems of liquidity, while too low a level of inventory can affect profitability due to stoppage of work for want of raw materials. Turnover of inventory can be useful for comparisons across time.

3. Credit Extended to Customers:

In the present day competitive market, the output of a com­pany is usually sold on credit basis. It may result in higher volume of sales, larger amount of cash locked up in the form of receivables and higher incidence of bad debt losses.

By adopting high credit standards, the company’s sales volume may get adversely affected. Therefore, it is essential to make sure whether reasonable credit is provided to customers as part of the evaluation of working capital management.

4. Credit Received from Suppliers:

Generally, a company extends credit to its customers just as it would also obtain credit from its suppliers. Working capital management should provide adequate flexibility to the purchase department so that they can shop around and get better terms for procurement of supplies. Further, regular payment habit on the part of the company can instill confidence in the minds of the suppliers.