Planning Process Used To Determine Finance Essay
For assignment help please contact at help@hndassignmenthelp.co.uk or hndassignmenthelp@gmail.com
The capital budgeting decisions are related to the allocation of funds to different long term assets . Broadly speaking , the capital budgeting decision denotes a decision situation where the lump sum funds are invested in the initial stages of the project and the returns are expected over a long period . though there is no hard and fast rule to define the long term , yet period involving more than a year may be taken as a long period for investment decisions. The capital budgeting decision involve the entire process of decision making relating to acquisition of long term assets whose returns are expected to arise over a period beyond one year.
Some of the capital budgeting decisions may be to buy land , building or plants ; or to undertake a program on research and development of a product, to diversify into a new product line ; a promotional campaign , etc . some of these decisions may directly affect the profit of the firm e.g., launching a new product, whereas some other decision may affect the profit by reducing the costs e.g. replacing an existing machine by a more efficient one . but in both the cases , the decisin once taken set the profit line of the firm for several years .
The role of finance manager in the capital budgeting basically lies in the process of critical and in-depth analysis and evaluation of various alternative proposals and then to select one out of these . the objective of capital budgeting is to select those long term investment projects that are expected to make maximum contribution to the wealth of the shareholders.
Features and significance
Capital budgeting decisions are those decisions that involve current outlay in return for a series of benefits in coming years. the capital budgeting decisions are often said to be the most important part of corporate financial management . any decision that requires the use of resources is a capital budgeting decision ; thus the capital budgeting decisions cover everything from broad strategic decision at one extreme to say computerization of the office, at the other . the capital budgeting decisions affect the profitability of a firm for a long period , therefore the importance of these decisions is obvious . even a single wrong decision by a firm may endanger the existence of the firm as a profitable firm. There are several factors and considerations which make the capital budgeting decisions as the most important decisions of a finance manager . the relevance and significance of capital budgeting may be stated as follows :
Long -term effects
Perhaps the most important features of capital budgeting decision and which makes the capital budgeting so significant is that these decisions have a long term effects on the risk and return composition of the firm . these decision affect the future position of the firm to a oconsiderable extent as the capital budgeting decisions have long term implications and consequences. By taking a capital budgeting decision , a finance manager in fact makes a commitment into the future , both by committing to the future needs of the funds of the project and by committing to its future implications
Substantial commitments
The capital budgeting decisions generally involve large commitment of funds and as a result substantial portion of capital funds are blocked in the capital budgeting decisions in relative terms therefore , more attention is required for capital budgeting decision , otherwise the firm may suffer from the heavy capital losses in time to come .it is also possible that are turn from a projects may not be sufficient enough to justify the capital budgeting decision.
Irreversible decision
Most of the capital budgeting decisions are irreversible decisions. Once taken the firm may not be in the position to revert back unless it is ready to absorb heavy losses which may result due to abandoning a project in midway . Therefore the capital budgeting decisions should be taken only after considering and evaluating each and every minute detail of the project otherwise the financial consequences may be far reaching .
Affect the capacity and strength to compete
The capital budgeting decisions affect the capacity and strength of a firm to face the competition . a firm may loose competiveness if decision to modernize is delayed or not rightly taken. Similarly , a timely decision to take over a minor competitor may ultimately result even in the monopolistic position of the firm.
Thus , the capital budgeting decisions involve a largely irreversible commitment of resources i.e., subject to a significant degree of risk. These decisions may have far reaching effects on the profitability of the firm. These decisions therefore, required a carefully developed decision making process and strategy based on a reliable forecasting system.
Problems and difficulties in capital budgeting
The capital budgeting decisions are not only critical and analytical in nature , but also involve various difficulties which a finance manger may come across. The problem 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 return 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 along period.the cost and benefit of a decision may occur at a different point of time. As a result, the cost and benefits of a capital budgeting decision are generally not comparableunless adjusted for atime value of money. The cost of project is incurred immediately, however , it is recovered in number of a years. These total returns may be more than the cost incurred (in absolute terms ), still the net benefits 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 projects 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 this is very difficult to ascertain because the sales of other products may increase or decrease due to other factors also.
Types of capital budgeting decisions
Every capital budgeting decision is a specific decision in the given situation, for a given firm and with given parameters and therefore, an almost infinite number of types or forms of capital budgeting decisions may occur . Even if the same decision being considered by the same firm at two different points of time , the decision considerations may change as a result of change in any of the variables. However, the different types of capital budgeting decisions undertaken from time to time by different firms can be classified on a number of dimensions. In general, the projects can be categorized as follows:
From the point of view of firm's existence : the capital budgeting decisions may be taken by a newly incorporated firm or by an already existing firm.
New firm
A newly incorporated firm may be required to take a different decisions such as selection of a plant to be installed, capacity utilization at initial stages, to set up or not simultaneously the ancillary unit etc.
Existing firm
A firm which is already existing may also be required to take various decisions from time to time to meet the challenges of competition or changing environment. These decision may be :
Replacement and modernization decision
This is a common type of a capital budgeting decision. All types of a plant and machineries eventually requires replacement . if the existing plant is to be replaced because the economic life of plant is over , then the decisions may be known as a replacement decision. However , if an existing plant is to be replaced because it has become technologically outdated , the decision may be known as modernization decision. In case of a replacement decision , the objective is to restore the same or higher capacity, whereas in case of modernization decision, the objective is to increase the efficiency and or cost reduction. In general, the replacement decision and modernization decisions are known as cost reduction decisions.
Expansion
Sometimes the firm may be interested in increasing the installed production capacity so as to increase the market share. In such a case , the financial manager is required to evaluate the expansion program in terms of marginal costs and marginal benefits.
Diversification
Some times, the firm may be interested to diversify into new product lines, new markets, production of spare parts etc. in such a case, the financial manager is required to evaluate not only the marginal cost and benefits, but also the effect of diversification on the existing market share and profitability. Both the expansion and diversification decisions may also be known as revenue increasing decisions.
Contingent decisions
Sometimes, a capital budgeting decision is contingent to some other decision. For example, computerization of a bank branch may require not only air-conditioning but also transfer of some staff member to other branches. Similarly , installing a project at some remote location may require expenditure or development of infrastructure also. Any capital budgeting decision must be evaluated by the finance manager in Its totality. The contingent decision , if any , must be considered and evaluated simultaneously.
From the point of view of decision situation : the capital budgeting decisions may also be classified from the point of view of the decision situation as follows:
Mutually exclusive decision
Two or more alternative proposals are said to be mutually exclusive when acceptance of one alternative result in automatic rejection of all other proposals before it. For example, selecting one advertising agency to take care of the promotional campaign out rightly rejects all other competitive agencies. Similarly selection of one location out of different feasible locations is a mutually exclusive decision.
Accept-reject decisions
An accept-reject decision occurs when a proposal is independently accepted or rejected without regard to any other alternative proposal. This type of decision is made when
Proposal's cost and benefit neither affect nor are affected by the cost and benefits of other proposals,
Accepting or rejecting one proposal has not impact on the desirability of other proposals , and
The different proposals being considered are not competitive.
Capital budgeting : techniques of evaluation
The attractiveness of any investment proposal depends on the following elements
The amount expended i.e. the net investment,
The potential benefits i.e., the operating cash inflows, and
The time period over which these benefits will accrue i.e., economic life of the project
A proper investment analysis must relate these three elements to provide an indication of whether the investment is worthy of being taken up or not. How do these three basic elements i.e., the net investment the operating cash flows and the economic life can be related to determine the proposal's worthiness ? there are different techniques available for evaluation and selection of proposal. These techniques can be grouped into two categories as presented below
Capital Budgeting Techniques
Time-adjusted, Or Discounted Cash Flows
Traditional Or Non-discounting
Net Present Value
Profitability Index
Terminal Value
Discounted Pay Back
Internal Rate Of Return
Pay Back Period
Accounting Rate Of Return
Payback period
The payback period is defined as the number of years required for the proposal's cumulative cash inflows to be equal to its cash outflows. In other words, the payback period is the length of time required to recover the initial cost of the project. The payback period therefore, can be looked upon as a length of the time required for the proposal to 'break even' on its net investment.
Computation of the pay back period:
The payback period can be calculated in two different situations :
When annual inflows are equal
when the cash being generated by a proposal are equal per time period i.e., the cash flows are the form of an annuity, the pay back period can be computed by a dividing a cash outflow by the amount of annuity.
For example , a proposal requires a cash outflow of Rs 1,00,000 and is expected to generate cash flows of Rs 20,000 p.a. for six years. In this case, the pay back period is 5 years i.e. Rs 1,00,000/Rs 20,000. The initial cash outflow of Rs 1,00,000 will be fully recovered within a period of 5 years and the cash inflows occurring thereafter ( i.e., in the sixth year ) are ignored in the above case, if the annual cash inflow is Rs 30,000 then the payback period lies between 3 years and 4 years and is 3.33 years i.e., Rs 1,00,000/Rs 30,000
When the annual cash inflows are unequal
in case the cash inflows from the proposal are not in annuity form then the cumulative cash inflows are used to compute the payback period.
For example, a proposal requires a cash outflow of Rs 20,000 and is expected to generate cash inflows of Rs 8,000, Rs 6,000, Rs 4,000, Rs 2,000 and Rs 2,000 over next five years respectively. The payback period is 4 years because the sum of cash inflows of first four years is Rs 20,000 ( i.e., Rs 8,000, Rs 6,000, Rs 4,000 and Rs 2,000). A measurement problem may occur when the cumulative cash inflows do not exactly equal to proposal's cash outflow. In the same case , if the cash outflows is only Rs 18,500 then the payback period may calculated as follows:
Year
Annual CF
Cumulative CF
1
8,000
8,000
2
6,000
14,000
3
4,000
18,000
4
2,000
20,000
Now, the required cumulative cash inflows is Rs 18,500. At the end of 3rd year , the cumulative cash inflows is Rs 18,000. For the 4th year, the annual cash inflow is Rs 2,000. Therefore , the cash inflow of Rs 500 only during the 4th year will be sufficient to make the total cumulative cash inflows to be Rs 18,500. The precise period required to earn a cash inflow of Rs 500 during 4th year can be calculated ( on the assumption that the cash inflows occur evenly throughout the year) by linear interpolation i.e., the payback period is 3 years + (Rs 500/ Rs 2,000) = 3.25 years or 3 years and 3 months. However , it may be noted that cash inflows occur at the end of year only. Therefore , the payback period of 3.25 years may be increased to next full year i.e., 4 years.
The decision rule
The payback period calculated for a proposal is to be compared with some predetermined target period. If the payback period is more than the target period, then the proposal should be selected , otherwise it may be accepted. There is no systematic or accepted way of determination of target period and choosing a target period is subject to some arbitrariness on the part of decision maker. Further, if the different proposals are to be ranked in order of priority , then the proposal with the shortest payback period will be first in the priority list.
Critical evaluation
Out of all the available capital budgeting technique, the payback period is the easiest to understand and apply. The payback period measures the direct relationship between annual cash inflows from a proposal and the net investment required. This technique has been a popular method of evaluation of capital budgeting proposals merely because of its simplicity. Yet, it is having its own problem and disadvantages. The payback period a s a technique of evaluation of capital budgeting proposals can be critically examined in terms of its advantages and disadvantages as follows :
Advantages of payback method:
The payback period is simple and easy, in concept as well as in its applications. In particular, it can be adopted by a small firm having limited man-power which does not have any special skill to apply other sophisticated techniques.
It gives an indication of liquidity. In case a firm is having a liquidity problems , then the payback period is a good method to adopt as it emphasizes the earlier cash inflows.
In a broader sense, the payback period deals with the risk also. The period with a shorter payback period will be less risky as compared to project with a longer payback period, as the cash inflows which arise further in the future will be less certain and hence more risky. So, the payback period helps in weeding out the risky proposals by assigning lower priority.
Disadvantages of payback period:
The payback period entirely ignores many of the cash inflows which occur after the payback period. It ignores what happens after the initial investment is recouped.
It ignores the timing of the occurrence of the cash flows. It considers the cash flows. It considers the cash flows occurring at different point of time as equal in money worth and ignores the time value of money .
The payback period also ignores the salvage value and the total economic life of the project. A project which has substantial salvage value may be ignored in favor of a project with higher inflows in earlier years. It is insensitive to the economic life span.
The payback period is more a method of capacity recovery rather than a measure of profitability of a project. To recover the capital is not enough, of course, because from an economic view point one would hope to earn a profit on the funds while they are invested.
The payback period is designed to cover the conventional projects that involve large up-front investment followed by positive operating cash inflows. It breaks down, however, when the investment is spread over times or where there is no initial investment.
Suitability of payback method
Despite the shortcomings the payback period may be an appropriate method under certain circumstances. For example, in a politically unstable country, the firm may have a primary consideration of recovering the initial cost at the earliest opportunity and thus the payback period may be suitable if the firm has limited funds available and has no ability or willingness to raise additional funds. In such a case, the firm may wish to undertake those projects which ensure early liquidity / recovery to undertake some other projects.
3. ITC ltd has decided to purchase a machine to augment the company's installed capacity to meet the growing demand of its products. There are three machined under consideration of the management. The relevant details including estimated yearly expenditure and sales are given below: All sales are on cash. Corporate tax is 40%.
Particulars
Machine I
Machine II
Machine III
Initial investment required
300000
300000
300000
Estimated annual sales
500000
400000
450000
Cost of Production(estimated):
Direct Materials
40000
50000
48000
Direct Labour
50000
30000
36000
Factory Overheads
60000
50000
58000
Administration costs
20000
10000
15000
Selling and distribution costs
10000
10000
10000
The economic life of machine I is 2 years, while it is 3 years for the other two. The scrap values are Rs. 40,000 and Rs. 30,000 respectively. You are required to find put the most profitable investment based on "pay back method".
Solution.
Calculation of payback period of machines
Machine 1
Initial investment ( A )
Rs. 3,00,000
Sales ( B )
5,00,000
Costs
Direct material
40000
Direct labour
50000
Factory overheads
60000
Depreciation
1,30,000
Administration costs
20,000
Selling and distribution costs
10,000
Total cost ( C )
3,10,000
Profit before tax ( B-C )
1,90,000
Less : tax @ 40%
76,000
Profit after tax
1,14,000
Add : depreciation
1,30,000
Net cash flow ( D )
2,44,000
Pay back period ( years ) ( A/D )
1.23
Machine 2
Initial investment ( A )
Rs. 3,00,000
Sales ( B )
4,00,000
Costs :
Direct material
50,000
Direct labour
30,000
Factory overheads
50,000
Depreciation
91,667
Administration costs
10,000
Selling and distribution costs
10,000
Total cost ( C )
2,41,667
Profit before tax ( B-C )
1,58,333
Less : tax @ 40%
63,333
Profit after tax
95000
Add : depreciation
91,667
Net cash flow ( D )
1,86,667
Pay back period ( years ) ( A/D )
1.61
Machine 3
Initial investment ( A )
Rs. 3,00,000
Sales ( B )
4,50,000
Costs :
Direct material
48,000
Direct labour
36,000
Factory overheads
58,000
Depreciation
90,000
Administration costs
15,000
Selling and distribution costs
10,000
Total cost ( C )
2,57,000
Profit before tax ( B-C )
1,93,000
Less : tax @ 40%
77,200
Profit after tax
1,15,800
Add : depreciation
90,000
Net cash flow ( D )
2,05,800
Pay back period ( years ) ( A/D )
1.46
Machine 1 has lowest payback period , so it may be preferred over the other two machines .
No comments:
Post a Comment