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MIST

Capital Budgeting Handout: 2001

CAPITAL BUDGETING: An overview


All expenses of a firm are made to realize some future benefits.
When the time horizon for such expenditure is relatively short in
nature (in general less than 1 year) the expenditure is termed as
current expenditure. However, when an expeditor is made for a
purpose so that the benefit from which will be derived for a number
of years to come, it is called a capital expenditure. In order to make
a correct decision with regard to capital expenditure, capital
budgeting is done. Capital budgeting is the process of
identification of opportunities, estimation of cash flow to be
generated by the project, evaluating and selecting from among
the alternative courses of actions using the appropriate selection
criteria and implementing the investment project with proper
follow-up. Thus the capital budgeting is a process, which has the
following different steps:

Identification of the Opportunities: The first action required for


capital budgeting process will be to identify the appropriate
opportunities or requirements to make a capital investment. These
opportunities or requirements can emerge from any of the following
reasons:
i) Expansion of capacity : When a firm's existing production
capacity is fully utilized or about to be utilized, the firm should
go for expansion of its capacity so that it can retain its
customers.
ii) Growth potentials: A growth opportunities occur when a firm
seeks to (a) diversify its existing product line through
development of new product markets or (b) enhance the existing
market to newer dimension.
iii)

Replacement of machinery : When a firms existing

machinery become old or obsolete or the firm wants to balance


the capacities of different segments of the production facilities
replacement needs appear. Most often these are more or less
systematic investment decision.

iv)Exploratory investments: When a firm identifies mineral or


other

natural

resource

reserve

exploratory

investment

opportunity appears.
v) Research and development: The giant business firms can
afford to have research and development wings. These R&D
results in new product ideas or technologies or brings changes in
existing production system or product characteristics. Such
developments result in capital investment decision.
vi) Mandatory Investment: When a firm is obliged to make some
investment required by govt. For social benefit for employee
benefit, the firm is bound to make the investment. These include
environment protection laws and laws relating to employee
safety etc.
IDENTIFICATION OF ALTERNATIVES: In order to make
correct decision, the sound capital budgeting process requires
decisions from among the best alternative within the opportunity set
available. Therefore when an opportunity or requirements appear or
identified, the capital budgeting team must also find out all the
possible ways to explore or exploit it. Therefore, a systematic

appraisal must be made using appropriate selection or appraisal


technique.
CRITERIA

for

SELECTION

OF

APPROPRIATE

TECHNIQUE: In capital budgeting process, usage of most


appropriate selection criteria or technique is also important. There
are different techniques and one can find the right one depending
on ones knowledge base as well as upon the importance of the
project. It is always wise to select appropriate appraisal techniques
for capital investment decision. In order to be appropriate, the
following factors should be given consideration:
a) Realism: The criteria should be realistic given the
investment opportunities and volume of benefits and cost
involved.
b) Cost-effective: Whatever technique the appraisal team
seeks to use, it must be cost-effective for the purpose it is
being used.

c) Flexibility: The technique must be flexible enough to


accommodate all the changing situations prevailing in the
firm or in the market.
ESTIMATION of CASHFLOW: Cash-flow estimation is another
crucial step in capital budgeting process. The successful capital
budgeting depends significantly upon proper estimation of cash
flow. The details of cash-flow estimation are given in the latter part
of the handout.

IMPLEMENTATION AND FOLLOWUP: Once the right


project is selected, the investment should be made. After the
investment, the finance manager may find that, actual situation is
not as it was expected and hence appropriate action will be
required in those situations. Modified project can be launched or
the project can be abandoned. The experience will give the finance
manager a good feed back for future actions.

IMPORTANCE OF CAPITAL BUDGETING:

Capital budgeting is one of the most important functions of the


finance manager. Failure to perform capital budgeting activities
properly can affect not only the value maximization objective of
the firm but can endanger the very survival of the firm. Especially
when the capital investment project is relatively too big for the
firm, it can cause the firm loose its own existence. For the
following reasons, capital budgeting is considered as very much
crucial for every firm:
a) Volume: Most of the capital budgeting decisions involve
significant volume of funds. Some time such funds requirements
can be as big as the overall size of the firm. The bigger the size
of the project the more important it is for the firm.
b) Time: Capital budgeting involves commitment of funds for a
long time. Thus the funds remain tied up and causes inflexibility
in the managements decision making process.
c) Strategic Importance: AS the capital budgeting process opens
the firms future toward expansion or growth paths, so it has
significant strategic importance. If the firm fails to attain its

strategic advantage through capital budgeting process, the firm


can loose its position to its competitors.
5) Cost of Capital: In most of the capital budgeting decisions,
funds are accumulated through issuance of long term financing
securities. Consequently it is related to capital structure and cost
of capital issues. Failing in proper financing plan will affect cost
of capital and ultimately the value of the firm.

Considering all these issues, it can be concluded that, capital


budgeting is very much crucial for every firm.
Estimation of CASHFLOW: Cashflow estimation is another
important issue in capital budgeting process. In general the
following factors are considered in estimating cash flow:
1) Incremental Cash flow: The cash flow for capital budgeting
shall be the incremental cash flow only. That is - the cash flow
incidental to the particular project and not one, which would
have taken place even if the project were not accepted, should be

considered for this purpose. Thus the following factors can be


worth mentioning here:
(a) Differential cash-flow or the cash flow directly incidental to
the project will be considered:
(b) Sunk cost or the cash flow which has already been
committed and can not be recovered in any form even if the
current project is not under taken, is called sunk cost. Sunk cost
should not be considered in estimating cash flow.
(c) Opportunity cost or value of the facilities, which will be
used, for the project but was in existence before the project was
undertaken, should be considered at their fair market value. For
example, a factory building abandoned in any previous occasion
is going to be used for the current project. If any alternative use
for the same is identified, the income lost from that use must be
considered as the cost of the current project.
(d) Cannibalization is the affect of the new product upon the
cash flow of any existing product of the firm. The cash flow for
cannibalization should be considered as a cash lost in estimating
cash flow for the firm or of the project.

(e) Additional Working Capital required for the new project


should be included in the estimated cash outlay for the project.
At the end of project life such investment on working capital
should be considered as cash recovered from operation.
(f) Depreciation is a non-cash expense or a charge in the income
statement. The depreciation charge should be made to estimate
taxable income. After deducting the tax from EBT, the
depreciation should be added back to estimate net cash flow
from the project.
2) Inflation: Inflation is another important issue for which care
must be taken during the time of estimating cash flow. In fact, the
cash flow should be either in real terms or at constant price or
appropriately adjusted for inflation. In the case of cash flow at
constant price or inflation free price, the cost of capital should also
be a real cost of capital that is a cost of capital, which does not
consider inflation premium. On the other hand if we want to
estimate inflation adjusted cash flow, proper measures should be
taken to estimate expected inflation and apply it properly. The
inflation rate may not be the same for all the inputs. Consequently,

appropriate inflation rate for the different inputs is applied. There


should not be any inflation adjustment on depreciation as it is a
mere allocation from previously incurred cash outlay.

3) Risk:

Risk or uncertainty about the future is a natural

phenomenon. The longer the life of the project the greater will be
the degree of uncertainty about future cash flow. Therefore, the
future cash flow should be estimated by taking appropriate
measures to find the certainty equivalence of future cash flow.

CLASSIFICATION OF CAPITAL INVESTMENT


PROJECTS:
Capital investment projects can be classified into different types
namely as follows;
i

By Size: In this category big medium small projects subject


to the size of the firm.

ii

By type of benefit; A firm can derive benefit in different


form like cost reduction, market expansion etc.

iii By degree of dependence: The projects can have different


types of interrelationship. For example some projects may be
required in association with other project(s) and are known as
complementary projects ( ink and pen projects). There are
some projects, where acceptance of one necessitates rejection
of the others. These types of projects are called mutually
exclusive projects (e.g. a basket ball court and a swimming
pool in a single small piece of land). Some projects are
considered to be substitute when acceptance of one project
can serve the same purpose served by another project or
product (Diet Coke is a substitute of Classic Coke). When
acceptance of one project is no way related to the acceptance
or other decision factors of any other project, then the two
projects are said to be independent of each other.
iv By type of cash flow: In general it is assumed that the capital
projects will require some initial cash outlay and than there
will be cash inflow from the project. This known as typical or
traditional or conventional project cash flow. A cash flow is
considered as non-conventional when there is multiple net

cash outflow during the life of the project. In other words


when the cash flow pattern changes its signs more than one
time, it is a non-conventional cash flow.