NATURE AND TECHNIQUES OF CAPITAL BUDGETING FOR NET COMMERCE/MANAGEMENT FINANCIAL MANAGEMENT

• NATURE AND TECHNIQUES OF CAPITAL BUDGETING FOR NET COMMERCE/MANAGEMENT 1
  FINANCIAL MANAGEMENT
• NATURE OF CAPITAL BUDGETING

1. AN EFFICIENT ALLOCATION OF CAPITAL IS VERY SIGNIFICANT FINANCE FUNCTION AND IT INVOLVES DECISIONS TO COMMIT THE FIRM’S FUNDS TO THE LONG TERM ASSETS
2. THE INVESTMENT DECISIONS OF THE FIRM ARE GENERALLY KNOWN AS THE CAPITAL BUDGETING DECISIONS
3. A CAPITAL BUDGETING DECISION MAY BE DEFINED AS THE FIRM’S DECISION TO INVEST ITS CURRENT FUNDS MOST EFFICIENTLY IN THE LONG TERM ASSETS IN ANTICIPATION OF THE EXPECTED FLOW OF BENEFITS OVER A LONG PERIOD OF TIME
4. THE FIRM’S INVESTMENT DECISIONS WOULD GENERALLY INCLUDE EXPANSION,MODERNIZATION,ACQUISITION AND REPLACEMENT OF THE LONG TERM ASSETS.

• SCOPE OF LONG TERM INVESTMENT DECISIONS

1. SALE OF DIVISION OR BUSINESS IS ALSO INVESTMENT DECISIONS
2. CHANGE IN METHOD OF SALE DISTRIBUTION OR AN ADVERTISEMENT CAMPAIGNS OR A RESEARCH AND DEVELOPMENT PROGRAMME HAVE LONG TERM IMPLICATION FOR THE FIRM’S EXPENDITURE AND BENEFITS ARE ALSO EVALUATED AS INVESTMENT DECISIONS
3. EXPENDITURE AND BENEFITS OF AN INVESTMENT  SHOULD BE MEASURED IN CASH
4. IT IS CASH FLOW WHICH IS MORE IMPORTANT THAN ACCOUNTING PROFIT
5. INVESTMENT DECISIONS AFFECT THE FIRM’S VALUE AND THE FIRM’S VALUE WILL ENHANCE  AND FIRM VALUE WILL ENHANCE WHEN THE INVESTMENTS MADE ARE PROFITABLE AND ADD VALUE TO THE SHAREHOLDER’S WEALTH
6. AN INVESTMENT WILL ADD  TO THE SHAREHOLDER’S WEALTH IF IT YIELD BENEFITS EXCESS OF OPPORTUNITY COST OF CAPITAL

• FEATURES OF INVESTMENT DECISIONS

1. THE EXCHANGE OF THE CURRENT FUNDS FOR THE FUTURE BENEFITS
2. THE FUNDS ARE INVESTED IN THE LONG TERM ASSETS
3. THE FUTURE BENEFITS WILL OCCUR TO THE FIRMS OVER A SERIES OF TIME

• ASSUMPTIONS

1. INVESTMENT’S PROJECT’S OPPORTUNITY COST OF CAPITAL IS KNOWN
2. EXPENDITURE AND BENEFITS OF THE INVESTMENT ARE KNOWN WITH CERTAINTY
3. IMPORTANCE OF INVESTMENT DECISIONS
4. THEY INFLUENCE THE FIRM’S GROWTH IN THE LONG RUN AS THEY  HAVE DECISIVE INFLUENCE ON THE RATE AND DIRECTION OF THE  GROWTH
5. RISK: SHAPE THE BASIC CHARACTER OF THE FIRM
6. THEY INVOLVE  COMMITMENT OF LARGE AMOUNT OF FUNDS
7. THEY ARE IRREVERSIBLE OR REVERSIBLE AT SUBSTANTIAL LOSS
8. THEY ARE THE AMONG THE MOST DIFFICULT DECISIONS TO MAKE

• TYPE OF INVESTMENT DECISIONS

1. EXPANSION AND DIVERSIFICATION
2. REPLACEMENT AND MODERNIZATION

·         ANOTHER WAY OF CLASSIFICATION:-

• MUTUALLY EXCLUSIVE INVESTMENTS:_ SERVE THE SAME PURPOSE AND COMPETE WITH EACH OTHER. IF ONE INVESTMENT IS UNDERTAKEN OTHERS WILL HAVE TO BE EXCLUDED
• INDEPENDENT INVESTMENTS:- SERVE DIFFERENT PURPOSE AND DO NOT COMPETE WITH EACH OTHER
• CONTINGENT INVESTMENTS:- DEPENDENT PROJECTS,THE CHOICE OF ONE INVESTMENT NECESSITATES UNDERTAKING ONE OR MORE OTHER INVESTMENTS. LIKE ORGANIZATION SETTING UP A BUSINESS UNITS IN RURAL AREA OR REMOTE AREA  AND HAS TO INVEST IN HOUSES,ROADS,SCHOOLS ETC
• CHARACTERISTICS OF SOUND INVESTMENT EVALUATION CRITERIA

1. SHOULD CONSIDER ALL CASH FLOWS TO DETERMINE THE TRUE PROFITABILITY OF THE PROJECT
2. 
   
3. PROVIDE FOR AN OBJECTIVE AND CLEAR WAY OF DIFFERENTIATING GOOD PROJECTS FROM THE BAD ONE
4. FACILITATE RANKING OF PROJECTS ACCORDING TO THEIR TRUE PROFITABILITY
5. BIGGER CASH FLOWS ARE PREFERABLE TO SMALLER ONE
6. EARLY CASH FLOWS ARE PREFERABLE TO LATER ONES
7. HELP TO CHOOSE MUTUALLY EXCLUSIVE PROJECTS WHICH MAXIMIZE THE SHAREHOLDER’ WEALTH
8. SHOULD BE CRITERION WHICH IS APPLICABLE TO ANY CONCEIVABLE INVESTMENT PROJECT,INDEPENDENT OF OTHERS

• TECHNIQUES OF EVALUATION
• TRADITIONAL OR NON DISCOUNTED CASH FLOW CRITERIA

1. PAYBACK
2. DISCOUNTED PAYBACK
3. ACCOUNTING RATE OF RETURN

·         DISCOUNTED CASH FLOW (DCF) CRITERIA

a)    NET PRESENT VALUE( NPV)

b)    (IRR) INTERNAL RATE OF RETURN

c)    PROFITABILITY INDEX(PI)

• PAYBACK

1. NUMBER OF YEARS REQUIRED TO RECOVER THE ORIGINAL CASH OUTLAY INVESTED IN PROJECT
2. IF THE PROJECT GENERATES CONSTANT ANNUAL CASH INFLOWS THEN THIS METHOD IS USED
3. PB= INITIAL INVESTMENT/ANNAUAL CASH INFLOW
4. ANNUAL CASH INFLOW MEANS NET PROFIT BEFORE DEPRECIATION AND AFTER TAXES

• A PROJECT COST 50,000 AND YIELD AN ANNUAL CASH FLOW OF RS 10,000 FOR 8 YEARS
• PB=50,000/10,000=5 YEARS
• EXAMPLE
•  A PROJECT COST RS 10,000,00 AND YIELD ANNUAL PROFIT OF 1,60,000  AFTER DEPRECIATION 12% PER ANNAM BUT BEFORE TAX OF 50%
• SOLUTION

1. DEPRECIATION=10,00,000X12/100=1,20,0000
2. PROFIT BEFORE TAX=1,60,000
3. TAX = 80,000
4. PROFIT AFTER TAX=1,60,000-80,000=80,000
5. PROFIT AFTER TAX BUT BEFORE DEPRECIATION=80,000+120,000=2,00,000
6. PAY BACK PERIOD = 10,00,000/2,00,000=5 YEARS

• UNEQUAL CASH INFLOWS
•  WHERE THE ANNUAL CASH INFLOWS ARE UNEQUAL THEN PAYBACK PERIOD CAN BE FOUND BY ADDING UP THE CASH INFLOWS UNTIL THE TOTAL IS EQUAL TO THE INITIAL  CASH OUTLAY OF THE PROJECT
• CONSIDER A PROJECT WHICH REQUIRE INITIAL INVESTMENT OF RS 20,OOO AND  PRODUCE CASH INFLOW OF 4,000,8000,6000, AND 4,000 IN THE FIRST,SECOND,THIRD AND FOURTH YEAR REPECTIVELY
•  
• ACCEPTANCE RULE

1. COMPARISON OF  PROJECT’S PAY BACK PERIOD WITH PREDETERMINED STANDARD PAYBACK PERIOD
2. ACCEPTED IF ITS PAYBACK PERIOD IS LESS THAN MAXIMUM OR STANDARD PAYBACK PERIOD
3. HIGHEST RANKING TO THE PROJECT WHICH HAS THE SHORTEST PAY BACK PERIOD
4. AND LOWEST TO HIGH PAYBACK PERIOD

• ADVANTAGE

1. SIMPLE TO UNDERSTAND AND EASY TO CALCULATE
2. COST EFFECTIVE
3. PROJECT WITH SHORTER PAY BACK PERIOD IS PREFERRED TO THE ONE HAVING A LONGER PAY BACK PERIOD,IT REDUCES THE LOSS THROUGH OUTDATEDNESS AND SUITABLE TO DEVELOPING NATIONS
4. STRESS IS ON THE EARLY REOCOVERY O THE INVESTMENT AND SO FUNDS RELEASED CAN BE PUT TO OTHER USES

• DISADVANTAGE

1. DOES NOT TAKE INTO ACCOUNT THE CASH INFLOWS EARNED AFTER PAY BACK PERIOD AND  TRUE PROFITABILITY CAN NOT BE ASSESSES
2. IGNORES THE TIME VALUE OF THE MONEY AND DOES NOT CONSIDER THE MAGNITUDE AND  TIMING OF CASH INFLOWS AND IT TREATS ALL CASH FLOWS OCCUR IN DIFFERENT PERIOD. IGNORE THE FACT CASH RECEIVED TODAY IS MORE IMPORTANT THAN THE SAME AMOUNT OF CASH RECEIVED AFTER SOME PERIOD
3.  DOES NOT CONSIDER THE COST OF CAPITAL INTO ACCOUNT
4. DIFFICULT TO DETERMINE THE MINIMUM ACCEPTABLE PAYBACK PERIOD
5. IT DOES NOT CONSIDER ALL THE CASH INFLOWS YIELDED BY THE PROJECT
6. NOT CONSISTENT WITH THE OBJECTIVE OF  MAXIMIZING THE WEALTH OF THE SHAREHOLDERS,

• SHOULD BE USED WITH DCF TECHNIQUES. SCREENING OF THE PROJECT.
• IMPROVEMENT IN TRADITIONAL APPROACH TO PAY BACK PERIOD
• PAY BACK RECIPROCAL : ANNUAL CASH FLOW M/INITIAL INVESTMENT
• THIS METHOD CAN BE USED WHEN TWO CONDITIONS ARE SATISFIED:

1. EQUAL CASH INFLOWS ARE GENERATED EVERY YEAR
2. PROJECT HAS LONG PERIOD WHICH MUST BE AT LEAST TWICE THE PAYBACK PERIOD

• USEFUL TECHNIQUE TO ESTIMATE THE TRUE RETURN BUT MAJOR LIMITATION IS  DOES NOT SATISFY THE CONDITION.

• MCQ
• WHICH OF THE FOLLOWING STATEMENT IS FALSE?

1. THE OPPORTUNITY COST OF AN INPUT IS CONSIDERED IN CAPITAL BUDGETING
2. CAPITAL BUDGETING DECISIONS ARE REVERSIBLE IN NATURE
3. CASH FLOW AND ACCOUNTING PROFITS ARE DIFFERENT
4. AN EXPANSION DECISION IS CAPITAL BUDGETING DECISIONS

• WHICH OF THE FOLLOWING STATEMENT IS NOT CORRECT?

1. THE COST OF CAPITAL IS REQUIRED RATE OF RETURN TO ASCERTAIN THE VALUE OF THE FIRM
2. DIFFERENT SOURCES OF FUNDS HAVE A SPECIFIC COST OF CAPITAL RELATED TO THAT SOURCE ONLY
3. COST OF CAPITAL DOES NOT COMPRISE ANY RISK PREMIUM
4. COST OF CAPITAL IS BASIC DATA FOR NPV TECHNIQUE

• WHICH OF THE FOLLOWING IS NOT TRUE WITH REFERENCE TO CAPITAL BUDGETING

1. CAPITAL BUDGETING IS RELATED TO ASSET REPLACEMENT DECISIONS
2. COST OF CAPITAL IS EQUAL TO MINIMUM REQUIRED RATE OF RETURN
3. TIMING OF CASH FLOW IS RELEVANT
4. EXISTING INVESTMENT IN A PROJECT IS NOT TREATED AS SUNK COST

• WHICH OF THE FOLLOWING IS NOT TRUE WITH REFERENCE TO CAPITAL BUDGETING

1. CAPITAL BUDGETING IS RELATED TO ASSET REPLACEMENT DECISIONS
2. COST OF CAPITAL IS EQUAL TO MINIMUM REQUIRED RATE OF RETURN
3. TIMING OF CASH FLOW IS RELEVANT
4. EXISTING INVESTMENT IN A PROJECT IS NOT TREATED AS SUNK COST

• WHICH OF THE FOLLOWING IS NOT FEATURE OF THE PAYBACK PERIOD

1. IT IS SIMPLY A METHOD OF COST RECOVERY AND NOT PROFITABILITY
2. IT DOES NOT CONSIDER THE TIME VALUE OF  MONEY
3. IT DOES NOT CONSIDER THE RISK ASSOCIATED WITH PROJECTS
4. IT IS VERY DIFFICULT TO CALCULATE

·         IN CAPITAL BUDGETING,THE TERM CAPITAL RATIONING IMPLIES

1. THAT NO RETAINED EARNING ARE AVAILABLE
2. THAT LIMITED FUNDS ARE AVAILABLE FOR INVESTMENT
3. THAT NO EXTERNAL FUNDS ARE RAISED
4. THAT NO FRESH INVESTMENT IS REQUIRED IN CURRENT YEAR

• CAPITAL BUDGETING IS ALSO KNOWN AS

1.     CAPITAL EXPENDITURE DECISIONS

2.     PLANNING CAPITAL EXPENDITURE

3.     INVESTMENT DECISION MAKING

4.     ALL OF THE ABOVE

• CAPITAL EXPENDITURE IS ONE WHICH IN INTENDED TO BENEFIT

1. CURRENT
2. PAST
3. FUTURE
4. NONE OF THESE

• CAPITAL BUDGETING IS LONG TERM PLANNING FOR MAKING AND FINANCING PROPOSED CAPITAL OUTLAY. DEFINITION IS GIVEN BY

1. MILTON H SPENCER
2. CHARLES T HORNGREEN
3. RM LYNCH
4. JOEL DEAN

• CAPITAL BUDGETING GENERALLY REFERS TO ACUIRING INPUTS WITH LONGER RUN RETURNS. THIS DEFINITION IS GIVEN BY

1. CHARLES T HORNGREEN
2. RM LYNCH
3. MAX D RICHARD AND PAUL S GREEN LAW

• THE PROCESS OF ALLOCATION OR DISTRIBUTION OF AVAILABLE CAPITAL FUNDS OVER VARIOUS CAPITAL PROJECTS ACCORDING TO THEIR RANK AND PROFITABILITY IS CALLED:

1. CAPITAL RATIONING
2. CAPITAL PLANNING
3. CAPITAL BUDGETING
4. NONE OF THESE

·         WHICH OF THE FOLLOWING METHOD DOES NOT CONSIDER THE PROFITABILITY OF THE WHOLE LIFE OF THE PROJECT

1. INTERNAL RATE OF RETURN
2. PAYBACK METHOD
3. PRESENT VALUE INDEX
4. NET PRESENT VALUE METHOD

• IMPORTANT DEFINITION
• CAPITAL BUDGETING IS  CONCERNED WITH DESIGNING AND CARRYING THROUGH A SYSTEMATIC INVESTMENT PROGRAMME
• CHARLES T H HORNGREEN
• WHICH OF THE FOLLOWING METHOD DOES NOT CONSIDER  THE  PROFITABILITY OF THE WHOLE LIFE OF THE PROJECT?

1. PAYBACK PERIOD
2. INTERNAL RATE OF RETURN
3. PRESENT VALUE OF INDEX METHOD
4. NET PRESENT VALUE METHOD

• WHICH OF THE FOLLOWING VARIABLE IS NOT KNOWN IN INTERNAL RATE OF RETURN METHOD OF CAPITAL BUDGETING?

1. AMOUNT OF CASH INFLOWS
2. LIFE OF THE PROJECT
3. AMOUNT OF CASH FLOWS
4. DISCOUNT RATE