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SIKKIM MANIPAL UNIVERSITY DEPARTMENT OF DISTANCE EDUCATION ASSIGNMENT SEMESTER 2 FULL NAME ROLL NUMBER LEARNING CENTER SUBJECT NAME SUBJECT CODE BOOK ID MODULE NO : Galchar Pankaj N : 521113886 : 1771 : Financial Management : MB0045 : B1134 : SET 2

DATE OF SUBMISSION AT THE LEARNING CENTRE : 19-June-2012 FACULTY SIGNATURE :

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Master of Business Administration-MBA Semester 2nd MB0045 Financial Management -4 Credits Assignment Set- 2

Q.4) Ans;-

Examine the importance of capital budgeting.

Introduction Indian economy is growing at 9% per annum. New lines of business such as retailing investment, investment advisory services and private banking are emerging. All such businesses involve investment decisions. These investment decisions that corporates take are known as capital budgeting decisions. Such decisions help corporates reap the benefits arising out of the emerging business opportunities.
Capital budgeting decisions involve evaluation of specific investment proposals. Here the word capital refers to the operating assets used in production of goods or rendering of services. Budgeting involves formulating a plan of the expected cash flows during the future period. Capital budgeting is a blue-print of planned investments in operating assets. Therefore, capital budgeting is the process of evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the capital budget for implementation. Capital budgeting decisions involve investment of current funds in anticipation of cash flows occurring over a series of years in future. All these decisions are strategic because they change the profile of the organisations. Successful organisations have created wealth for their shareholders through capital budgeting decisions. Investment of current funds in long term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions. HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of Madurai. The motive behind all these mergers is to grow because in this era of globalisation the need of the hour is to grow as big as possible. In all these, one could observe the desire of the management to create value for shareholders as a motivating force. Another way of growing is through branch expansion, expanding the product mix and reducing cost through improved technology for deeper penetration into the market for the companys products.

Importance of Capital Budgeting : Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. longterm assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into:

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Decision to replace the equipments for maintenance of current level of

business or decisions aiming at cost reductions, known as replacement decisions

Decisions on expenditure for increasing the present operating level or

expansion through improved network of distribution

Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area Decisions to comply with the regulatory structure affecting the operations of

the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act
Decisions

on investment to build township for providing residential accommodation to employees working in a manufacturing plant

The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds in anticipation of cash flows in

future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.

o For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions.
Equally we have empirical evidence of companies which took decisions

on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders. The best example is the Reliance Group.
Any serious error in forecasting sales, the amount of capital expenditure

can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness.
Any downward bias in forecasting might lead the firm to a situation of

losing its market to its competitors.

Long time investments of the funds sometimes may change the risk profile

of the firm. Example A FMCA A FMCG company decides to enter into a new business of power generation. This decision will totally alter the risk profile of the business of the company. Investors perception of risk of the new business to be taken up by the company will change its required rate of return to invest in the company.

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In this connection it is to be noted that the power pricing is a politically sensitive area affecting the profitability of the organisation. Therefore, capital budgeting decisions change the risk dimensions of the company and hence the required rate of return that the investors want.

during the phase of execution must be synchronised with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a companys operation unproductive. Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment.

If a firm were to realise after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialised costly equipments. Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are: cost quality timing

Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability. Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE to sell its products in India at

a rate less than the rate at which Indian companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project.

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Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today.

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Q.5 Briefly exlain the process of capital rationing. Ans:Introduction Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be limited. Therefore, a firm has to prioritise the projects on the basis of availability of funds and economic compulsion of the firm. It is not possible for a company to take up all the projects at a time. There is the need to rank them on the basis of strategic compulsion and funds availability. Since companies will have to choose one from among many competing investment proposals, the need to develop criteria for capital rationing cannot be ignored. The companies may have many profitable and viable proposals but cannot execute them because of shortage of funds. Another constraint is that the firms may not be able to generate additional funds for the execution of all the projects. When a firm imposes constraints on the total size of the firms capital budget, it requires capital rationing. When capital is rationed, there is a need to develop a method of selecting the projects that could be executed with the companys resources yet giving the highest possible net present value. Steps involved in Capital Rationing In the above topic we have discussed about the different types of capital rationing. Now let us look at the different steps involved in capital rationing. The following are the steps involved in capital rationing (see figure 10 .4). Ranking of different investment proposals Selection of the most profitable investment proposal

Ranking of different investment proposals means the various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order. Net present value method recognises the time value of money. Net present value correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is a need to find out the present values of all the cash flows. NPV can be represented with the following formula. Profitability index is also known as benefit cash ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.

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Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the net present value of any project equal to zero. Internal rate of return is the rate of interest which equates the present value (PV) of cash inflows with the present value of cash outflows.
IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns. IRR can be determined by solving the following equation for

Profitability Index as the Basis of Capital Rationing Let us now discuss a Caselet regarding the concept of profitability index as the basis of capital rationing. The profitability index is calculated in the following Caselet based on the capital rationing factors per annum and the ranking is given according to the most preferable investment proposal.

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Q.6 explain the concepts of working capital. Ans:
Introduction Working capital is defined as the excess of current assets over current liabilities and provisions. It is that portion of asset of a business which is used frequently in current operations and in the operating cycle of the firm. Inadequacy or mismanagement of working capital is the leading cause of many business failures. A financial manger, therefore, spends a larger part of his time in managing working capital. There are two important elements to be considered under the working capital management: Decisions on the amount of current assets to be held by a firm for efficient operations of its business
Decisions on financing working capital requirement The need for proper management of working capital management is even more important in the modern era of information technology. In support of the above argument, let us consider the performance of Dell computers as reported in one of the recent Fortune articles. A perusal of the article will give you an insight into how Dell could use the technology for improving the performance of components of working capital. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and dealers Outsourcing on operations, if the firms competence does not permit the performance of the operation effectively Training the employees to accept change Introducing to internet business Releasing capital by reduction in investment in inventory for improving the profitability of operating capital

Concepts of Working Capital The four most important concepts of working capital are (see figure 11.1) Gross working capital, Net working capital, Temporary working capital and Permanent working capital.

Gross working capital Gross Working Capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance.

management Gross working capital helps in the fixation of various areas of financial responsibility

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Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets The need to plan and monitor the utilisation of funds of a firm demands working capital management, as applied to current assets

Net working capital Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance. Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firms working capital requirements A firms short term solvency is measured through the net working capital position it commands Permanent Working Capital Permanent working capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firms business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee. Permanent working capital is also known as fixed working capital. Temporary Working Capital Temporary working capital is also known as variable working capital or fluctuating working capital. The firms working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firms products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital.

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