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UNIT I INVESTMENT DECISIONS: CAPITAL BUDGETING

Structure

1.1 Introduction to Capital Budgeting

1.2 Importance of Capital Budgeting
1.3 Difficulties in Capital Budgeting
1.4 Capital Budgeting Process
1.5 Determining Cash Flows for investment analysis
1.6 Summary
1.7 Key words
1.8 Further Reading
1.9 Exercises
1.10 Self Assessment Questions

Objectives

After studying this unit you should be able to:

 Assess the meaning and importance of Capital budgeting for a firm.

 Illustrate the difficulties associated with Capital Budgeting
 Follow the process of Capital Budgeting
 Determine cash flows for investment analysis

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 1.1 INTRODUCTION

An efficient allocation of capital is the most important finance function. It involves decisions to
commit the firm’s funds to the long – term assets. Such decisions are of considerable importance
to the firm since they tend to determine its value size by influencing its growth, profitability and
risk. The investment decisions of a firm are generally known as the Capital budgeting or capital
expenditure decisions. It may be defined as the 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. The long-term assets are those which affect the firms operations beyond one-year period.

The following are some of the examples of capital expenditure:

 Cost of acquisition of permanent assets as land and building, plant and machinery,
goodwill, etc.
 Cost of addition, expansion, improvement or alteration in the fixed assets.
 Cost of replacement of permanent assets.
 Research and development project cost etc.

It may be concluded that the important features which distinguish capital budgeting
decision from the ordinary day to day business decisions are:

 Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in future;
 The future benefits are expected to be realized over a series of years;
 The funds are invested in non-flexible and long term activities;

 They have a long term and significant effect on the profitability of the concern;
 They involve, generally, huge funds;
 They are irreversible decisions;
 They are ‘strategic’ investment decisions, involving large sums of money, major
departure from the past practices of the firm as compared to ‘tactical’ investment
 decisions which involve a relatively small amount of funds that do not result in a major
departure from the past practices of the firm.

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1.2 IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting decisions are of paramount importance in financial decision making. Such
decisions affect the profitability of a firm. They also have a bearing on the competitive position
of the enterprise mainly because of the fact that they relate to fixed assets. The fixed assets
represent the true earning assets of the firm. They enable the firm to generate finished goods that
can ultimately be sold for profit. Current assets are important to operations, but without fixed
assets to generate finished products that can be converted into current assets, the firm would not
be able to operate. Further, they are ‘strategic’ investment decisions as against ‘tactical’ – which
involve a relatively small amount of funds. Therefore, such capital investment decisions may
result in a major departure from what the company has been doing in the past. Acceptance of a
strategic investment will involve a significant change in the company’s expected profits and in
the risks to which these profits will be subject. Thus, capital budgeting decisions determine the
future destiny of the company. An opportune investment decision can yield spectacular returns.
On the other hand, an ill-advised and incorrect decision can endanger the very survival of the
large firms.

A capital expenditure decision has its effect over a long time span and inevitably affects the
company’s future cost structure. Capital investment decisions, once made, 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.
Capital investment involves costs and the majority of the firms have scarce capital resources.
This underlines the need for the thoughtful, wise and correct investment decisions, as an
incorrect decision would not only result in losses but also prevent the firm from earning profits
from other investments which could not be undertaken for want of funds.

The need, significance or importance of capital budgeting arises mainly due to the following:

 Large investments: Capital budgeting decisions, generally, involve large investment of

funds, but the funds available with the firm are always limited and the demand for funds
far exceeds the resources. Hence, it is very important for a firm to plan and control its
capital expenditure.

 Long – term commitment of funds: Capital expenditure involves not only large amount
of funds but also funds for long-term or more or less on permanent basis. The long-term
commitment of funds increases the financial risk involved in the investment decision.
Greater the risk involved, greater is the need for careful planning of capital expenditure
i.e. capital budgeting.

 Irreversible nature: The capital expenditure decisions are of irreversible nature. Once
the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose
of these assets without incurring heavy losses.

 Long – term effect on profitability: Capital budgeting decisions have a long-term and
significant effect on the profitability of a concern. Not only the present earnings of the
firm are affected by the investments in capital assets but also the future growth and
profitability of the firm depends upon the investment decision taken today. Capital
budgeting is of utmost importance to avoid over investment or under investment in fixed
assets.
  Difficulties of investment decisions: The long term investment decisions are difficult to
be taken because (i) decision extends to a series of years beyond the current accounting
period, (ii) uncertainties of future and (iii) higher degree of risk.

 National Importance: Investment decision though taken by individual concern is of

national importance because it determines employment, economic activities and
economic growth.

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1.3 DIFFICULTIES IN CAPITAL BUDGETING

The capital budgeting decisions are not only critical and analytical in nature, but also involve
various difficulties which a finance manager may come across. The problems in capital
budgeting decisions may be as follows:

 Future Uncertainty: All capital budgeting decisions involve long term which is
uncertain. Even if every care is taken and the project is evaluated to every minute detail,
still 100% correct and certain forecast is not possible. The finance manager dealing with
the capital budgeting decisions, therefore, should try to be as analytical as possible. The

uncertainty of the capital budgeting decisions may be with reference to cost of the
project, future expected returns from the project, future competition, expected demand in
future, legal provisions, political situation etc.

 Time Element: The implications of a capital budgeting decision are scattered over a long
period. The cost and benefit of a decision may occur at different point of time. As a
result, the cost and benefits of a capital budgeting decision are generally not comparable
unless adjusted for time value of money. The cost of a project is incurred immediately;
however, it is recovered in number of years. These total returns may be more than the
cost incurred (in absolute terms), still the net benefit cannot be ascertained unless the
 future benefits are adjusted to make them comparable with the cost. Moreover, the longer
the time period involved, the greater would be the uncertainty.

 Measurement Problem: Sometimes a finance manager may also face difficulties in

measuring the cost and benefits of a project in quantitative terms. For example, the new
product proposed to be launched by a firm may result in increase or decrease in sales of
other products already being sold by the same firm. But how much? This is very difficult
to ascertain because the sales of other product may increase or decrease due to other
factors also.

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1.4 CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions relating to the investment of

current funds for the benefits to be achieved in future and the future is always uncertain.

However, the following, procedure may be adopted in the process of capital budgeting:

1.4.1 Identification of investment proposals: The capital budgeting process begins

with the identification of investment proposals. The proposal or the idea about
potential investment opportunities may originate from the top management or
may come from the rank and file worker of any department or from any officer of
the organization. The departmental head analyses the various proposals in the
light of the corporate strategies and submits the suitable proposals to the Capital
 Expenditure Planning Committee in case of large organizations or to the officers
concerned with the process of long-term investment decisions.

1.4.2 Screening the proposals: The Expenditure Planning Committee screens the
various proposals received from different departments. The committee views
these proposals from various angles to ensure that these are in accordance with
the corporate strategies.

1.4.3 Evaluation of various proposals: The next step in the capital budgeting process
is to evaluate the profitability of various proposals. The various proposals to be
evaluated may be classified as:

 Independent proposals – proposals which do not compete with one another and the
same may be either accepted or rejected on the basis of a minimum return on investment
required.

 Contingent or dependent proposals – proposals whose acceptance depends upon the

acceptance of one or more other proposals e.g., further investment in building or
machineries may have to be undertaken as a result of expansion programme.

 Mutually exclusive proposals – proposals are those which compete with each other and
one of those may have to be selected at the cost of the other.

1.4.4 Fixing priorities: After evaluating various proposals, the unprofitable or

uneconomic proposals may be rejected straightway. But it may be possible for the
firm to invest immediately in all the acceptable proposals due to limitation of
funds. Hence, it is very essential to rank the various proposals and to establish
priorities after considering urgency, risk and profitability involved therein.

1.4.5 Final approval and preparation of capital expenditure budget: Proposals

meeting the evaluation and other criteria are finally approved to be included in the
 capital expenditure budget. The capital expenditure budget lays down the amount
of estimated expenditure to be incurred on fixed assets during the budget period.

1.4.6 Implementing proposal: Preparation of a capital expenditure budgeting and

incorporation of a particular proposal in the budget does not itself authorize to go
ahead with the implementation of the project. A request for authority to spend the
amount should further be made to the capital expenditure committee which may
like to review the profitability of the project in the changed circumstances.

1.4.7 Performance review: The last stage in the process of capital budgeting is the
evaluation of the performance of the project. The evaluation is made through post
completion audit by way of comparison of actual expenditure on the project with
the budgeted one, and also by comparing the actual return from the investment
with the anticipated return. The unfavourable variances, if any should be looked

into and the causes of the same be identified so that corrective action may be
taken in future.

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1.5 DETERMINING CASH FLOWS FOR INVESTMENT ANALYSIS

The cash flows estimation is the most crucial step in investment analysis. A sophisticated
technique applied to incorrect cash flows would produce wrong results. The management of a
company should devote considerable time, effort and money in obtaining correct estimates of
cash flows. The financial manager prepares the cash flow estimates on the basis of the
information supplied by experts in Accounting, Production, Marketing, Economics and so on. It
is his responsibility to check such information for relevance and accuracy.
1.5.1 Conventional and Non-conventional cash flows

When an initial cash outlay (outflow) is followed by a series of cash inflows of uniform or
unequal amounts, it is called conventional cash flows. Most of the capital investment decisions
follow this pattern. For example, a firm may invest Rs 3,00,000 initially in a project at time 0 and
may expect to receive an annual cash inflow of Rs 45000 at the end of each year for a period of 7

years. The other example of conventional cash flows could be where a firm may invest say Rs
4,00,000 initially and as a result may expect to receive cash flows of Rs 2,00,000 at the end of
first year, Rs 1,00,000 at the end of second year, Rs 1,50,000 at the end of third year, Rs,
1,00,000 at the end of fourth year and Rs 90,000 at the end of fifth year.

Non-conventional cash flows on the other hand refer to the cash flow pattern where not one but a
series of cash outflows are followed by a series of cash inflows of equal or unequal amounts. For
example, a project may require an investment of Rs 1,50,000 in the beginning of the first year
and another Rs 30,000 at the beginning of second year followed by cash inflows of Rs 30,000,
Rs 40,000, Rs 70,000 Rs 80,000 and Rs 40,000 at the end of each of the first five years
respectively. Another simple example of non-conventional cash flows may be where a firm may
purchase a machine for Rs 2,00,000 initially at time 0 and may expect to receive annual cash
flows of Rs 30,000 each year for five years and then another cash outflow of Rs 40,000 may be
required for overhauling of the machine in the sixth year to generate further cash inflows of Rs
25,000 each year for next four years.

1.5.2 Incremental Cash Flows

All investment decisions involve comparison of alternative proposals. In case of a single
proposal, the comparison will be between investing in the project and not investing in the
project, however in case of two or more proposals, the comparison will be between investing in
one project or the other. Single project proposals are evaluated on the basis of ‘absolute cash
flows’ whereas, competing project proposals are evaluated on the basis of ‘relative or
incremental cash flows’. The term ‘incremental cash flows’ refers to the differential cash flows
between the two proposals.

The following table illustrates the concept of incremental cash flows

Incremental cash flows for proposal 1 and proposal 2

Year (t) CASH FLOWS
1 2 3 4 5
(Rs)
Proposal 1 50,000 20,000 15,000 15,000 10,000 5,000
Proposal 2 30,000 11,000 9,000 9,000 5,000 2,000
Incremental 20,000 9,000 6,000 6,000 5,000 3,000
Cash Flows

1.5.4 TYPES / COMPONENTS OF CASH FLOWS

A typical investment will have three components of cash flows:

 Initial investment
 Operating Cash Flow or Annual Net Cash Flows
 Terminal cash flows
Initial Investment:

The initial investment is an outlay that takes place in the initial period, t=0, when an asset is
purchased. It comprises, primarily, cost of the new asset to purchase land, building, machinery
etc, including expenses of insurance, freight, loading and unloading, installation cost and
expenses on modification and repairs etc. before the asset is put to use. In addition to the cost of

the asset, new investment in capital assets may also require increased investment in working
capital i.e. the excess of current assets over current liabilities. Thus the net working capital
increases are also added to the cost of the asset. Further, if the new investment makes use of
some existing facilities, the opportunity cost of the same should also be added to arrive at the
amount of initial investment. For example, if a firm proposes to invest in a machine to be
installed at some surplus land of the firm, the firm should find out the opportunity cost of selling
the land and add the same while calculating the initial investment. In the same manner, in case of
replacement decisions, the existing asset may be sold if the new asset is purchased. The sale
proceeds of the discarded asset should, therefore, be deducted while determining the amount of
initial investment.

The computation of cash outflows, comprising the initial investment has been shown in the
following table:

Computation of initial investment

Purchase price of the asset (including duties and taxes if any) Rs.
Add: Insurance, freight, Loading, Unloading and Installation costs
Add: Net increase in working capital requirements
Add: Opportunity costs (if any)
Less: Cash inflows in the form of sale Proceeds (of the old asset in case of
replacement decisions
Less: Investment allowance ( if any)

Operating cash flows/ Annual Net Cash flows

Every investment in capital assets is expected to generate future benefits in the form of net

annual cash flows from operations. These annual cash flows should be estimated on an after-tax
basis. In simple words annual net cash flows refer to the annual net earnings (profits) before
depreciation and taxes. Depreciation being a non-cash charge, is subtracted from earnings before
tax and added to earnings after tax. The net annual cash flows can be determined as follows:

Determination of Annual Net Cash Flows

Years
1 2 3 4 ……..n
Amount in Rs
Cash Revenue (Sales)
Less: Cash expenses (Operating costs)
Earnings Before Depreciation and taxes (EBIT)
Less: Depreciation
Earnings Before Tax
Less: Tax
Earnings After Tax
Add: Depreciation
Cash Inflow After Tax (CFAT)

Terminal Cash Flows

At the end of the economic life of a capital asset i.e. the last year when the asset is terminated,
there is usually, some value in the asset left. The asset may be sold at that point of time as scrap
or it may fetch some salvage value. This inflow to a firm is the last (terminal) year is called
terminal cash flow. Similarly, in the case of the replacement decision where an old existing asset
is replaced with a new asset, the reduction in the cost of the new asset i.e. the sales value of the
old asset, is the terminal cash flow of the asset replaced.

DETERMINATION OF CASH FLOWS

Illustration 1:

A project cost Rs10,00,000 and yields annually a profit of Rs 1,00,000 after depreciation @ 12%
per annum but before tax of 50%. Calculate Net cash flows of the project.

Solution:

Rs
Profit Before Tax 1.00.000
Less: Tax @ 50% 50,000
Profit After Tax 50,000
Add back depreciation @ 12% on Rs 10,00,000 1,20,000
Net Annual Cash inflows 1,70,000

Illustration 2:

PNR Ltd. is considering the introduction of a new product. The firm estimates that it can sell
annually 5000 units of this product at Rs 20 per unit. The cash variable expenses to manufacture
and sell the product are estimated at Rs 12 per unit. It will also involve cash fixed cost of Rs
5,000 per annum. The plant to manufacture the product is available for Rs 1,00,000. Further, Rs
20,000 will be needed for installation of the machine. The salvage value of the plant after its life
of 10 years is estimated to be Rs 5,000. A working capital investment for Rs 30,000 would be
required in the year of installing plant. The firm uses the straight line method (SLM) of
depreciation on original cost of the asset ignoring salvage value of fixed assets. Assuming the

same depreciation as allowable under income – tax and 50% tax rate for this firm you are
required to calculate:

(i) Initial investment

(ii) Annual Net Cash Flows
(iii) Terminal cash flows

Solution

(i) Calculation of Initial Investment

Rs
Cost of the plant 1,00,000
Add: Installation cost 20,000
Increase in net working Capital 30,000
Initial Investment 1,50,000
(ii) Calculation of Net Annual Cash Flows
Rs
Sales Revenue (5,000 x 20) 1,00,000
Less: Cash Operating costs
Variable Cost (5,000 x 12) 60,000
Cash Fixed cost 5,000 65,000

Earnings Before Depreciation and tax 35,000

Less: Depreciation (1,50,000 x 1/10) 15,000
Earnings Before Tax 20,000
Less: Tax at 50% 10,000
Earnings After Tax 10,000
Add: Depreciation 15,000
Net Annual Cash Flow (CFAT) 25,000

(iii) Calculation of Terminal Cash Flows

Rs
Salvage Value of the Plant 5,000
Recovery of working capital 30,000
Terminal Cash Inflows (at the end of the 10th year) 35,000

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1.6 SUMMARY

The basic characteristic of a capital budgeting (also referred to as capital investment or capital
expenditure) is that it 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 is a complex
process which may be divided into the following phases: (i) identification of investment
proposals (ii) screening the proposals (iii) evaluation of various proposals (iv) fixing priorities
(v) final approval and preparation of capital expenditure budget (vi) implementing proposals (vii)
performance review. Cash Flows should be estimated on incremental basis. Incremental Cash
flows are found out by comparing alternative investment proposals. The comparison can be
simply between cash flows with and without the investment proposal under consideration real
alternatives do not exist. Three components of cash flows can be identified (i) Initial investment
will comprise the original cost (including freight and installation charges) of the project, plus any
increase in working capital. In case of replacement decision, the salvage value of the old asset
should also be adjusted to compute the initial investment. (ii) Annual net cash flows is the
difference between cash inflows and cash outflows including taxes. (iii) terminal cash flows. Tax
computations are based on accounting profits. Care should be taken for properly adjusting
depreciation while computing net cash flows. Depreciation is a non cash item, but it affects cash
flows through tax shield.

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1.7 KEYWORDS

1. Incremental cash flows: The differential cash flows between the two proposals.

2. Depreciation: It is an allocation of asset. It involves an accounting entry and does not require
any cash outflow.

3. Salvage value: It is the market price of an investment at the time of sale of an asset.

4. Opportunity cost: It is the expected benefit which the company would have derived from those
resources if they were not committed to the proposed project.

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1.8 FURTHER READING

1. Shashi K Gupta and R K Sharma, 2002, Financial Management, Theory and Practice, Kalyani
Publishers, Kolkata.

2. Prasanna Chandra, 2004, Financial Management, Theory and Practice, 6th edition, Tata Mc
Graw-Hill Publishing company Limited, New Delhi
3. I.M Pandey, 2004, Financial Management, Eighth edition, Vikas Publishing House Pvt Ltd,
New Delhi

1.9 EXERCISES

1. A Project costs Rs. 2,00,000 and yields annually a profit of Rs. 30,000 after charging
depreciation @ 10% per annum but before tax rate at 50%. Calculate net annual cash
inflows for the project.
2. A company has two mutually exclusive proposals under consideration and provides you
the following information.

Particulars Proposal I Proposal

II
Initial Investment 1,00,000 80,000
Net Cash savings in operating costs before depreciation
and taxes
Year
30,000 28,000
1
40,000 36,000
2
25,000 20,000
3
20,000 18,000
4
15,000 10,000
5

You are required to determine the incremental cash flows assuming straight line method
of depreciation, no salvage value and tax rate at 50%.

3. A company is considering the introduction of a new product. The firm estimates that it
can sell annually 5000 units of this product at Rs 28 per unit. The case variable expenses
 to manufacture and sell the product are estimated at Rs 22 per unit. It will also involve
cash fixed cost of Rs 4500 per annum. The plant to manufacture the product is available
for Rs 75,000. Further. Rs 18,000 will have to be spent on installation of the plant. The
salvage value of the plant after its life of 10 years is estimated at Rs 2,500. A working
capital investment of Rs 22,000 is also required in the year of installing the plant.
The firm uses the straight line method of depreciation of original cost of the asset
ignoring salvage value. Tax rate for firm is 35%. You are required to calculate:

(i) Initial investment

(ii) Annual net cash flows and
(iii) Terminal cash flows

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1.10 SELF ASSESMENT QUESTIONS

Multiple Choice Questions

1. Capital Budgeting is also known as ______________ and _______________

(a) Capital Expenditure and Investment Decisions
(b) Working Capital and Investment Decisions
(c) Investment Decisions and Dividend Decisions

2. Capital Budgeting decisions are generally of _____________ nature.

(a) Short term

(b) Irreversible
(c) Reversible

3. Incremental Cash flows refer to ________________

(a) Net Cash flows (b) Differential Cash Flows (c) Terminal Cash Flows
Short Questions

1. Define Capital Budgeting.

2. Write a note on Capital Budgeting process.

3. What are the difficulties of Capital Budgeting.

Essay Questions

1. What is Capital Budgeting? Examine its need and importance.

2. Is Capital Budgeting merely a question of selecting investment projects? Defend your

answer.

3. How should depreciation be treated in capital budgeting? Do the depreciation methods

affect the cash flows differently? How?

4. Explain in detail (i) conventional and non-conventional cash flows and (ii) incremental
cash flows.