Capital Budgeting

The term capital budgeting means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. 

It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives. The finance manager has various tools and techniques by means of which he assists the  management in taking a proper capital budgeting decision. 

Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. 

Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate. Also as business is a part of society, it is its moral responsibility to undertake only those projects that are socially desirable. Capital budgeting decision is an important, crucial and critical business decision due to :

1) substantial expenditure :

capital budgeting decision involves the investment of substantial amount of funds and is thus it is necessary for a firm to make such decision  after a thoughtful consideration, so as to result in profitable use of scarce resources. Hasty and incorrect decisions would not only result in huge losses but would also account for failure of the firm.

2) long time period :

capital budgeting decision has its effect over a long period of time, they affect the future benefits and also the firm and influence the rate and direction of growth of the firm.

3) irreversibility :

most of such decisions are irreversible, once taken, the firm may not been in a position to reverse its impact. This may be due to the reason, that it is difficult to find a buyer for second-hand capital items.

4) complex decision :

capital investment decision involves an assessment of future events, which in fact are difficult to predict, further, it is difficult to estimate in quantitative terms all benefits or costs relating to a particular investment decision. 

Read Also :

• Time value Of Money
• Financial Ratios
• Cost Of Capital

various types of capital investment decisions

there are various ways to classify capital budgeting decisions, generally they are

classified as :

1) on the basis of the firm's existence :

              capital budgeting decisions are taken by both newly incorporated and existing firms. New firms may  require to take decision in respect of selection of plant to be installed, while existing firms may require to take decision to meet the requirements of new environment or to face challenges of competition. These decisions may be classified into:

i) replacement and modernisation decisions : replacement and modernization decisions aims to improve operating efficiency and reduce costs. Usually, plants require replacement due to they been economically dead i.e. no more economic life left or on they becoming technologically outdated. The former decision is of replacement and latter one of modernization , however, both these decisions are cost reduction decisions.

ii) Expansion decision : existing successful firms may experience growth in demand of the product and may experience shortage or delay in delivery due to inadequate production facilities and thus, would consider proposals to add capacity to existing product lines.

iii) Diversification decisions : these decisions require evaluation proposals to diversify into new product lines, new markets, etc. to reduce risk of failure by dealing in different products or operating in several markets. expansion and diversification decisions are revenue expansion decisions.

2) on the basis of decision situation :

i) mutually exclusive decisions : decisions are said to be mutually exclusive when two or more alternative proposals are such that acceptance of one would exclude the acceptance of the other.

ii) Accept-Reject decisions : the accept-eject decisions occurs when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which have a higher return than certain desired rate of return are accepted and rest rejected.

iii) Contingent decisions :

contingent decisions are dependable proposals, investment in one requires investment in another.

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Financial Statement Analysis

The basis of financial analysis, planning and decision making is financial information. A firm prepares final accounts viz. Balance Sheet and Profit and Loss Account providing information for decision making. Financial information is needed to predict, compare and evaluate the firm's earning ability. 

Profit and Loss account shows the concern's operating activities and the Balance Sheet depicts the balance value of the acquired assets and of liabilities at a particular point of time. However, these statements do not disclose all of the necessary and relevant information. 

For the purpose of obtaining the material and relevant information necessary for ascertaining of financial strengths and weaknesses of an enterprise, it is essential to analyse the data depicted in the financial statement. 

The financial manager have certain analytical tools that help in financial analysis and planning. In addition to studying the past flow, the financial manager can evaluate future flows by means of funds statement based on forecasts. 

            
Financial Statement Analysis is the process of identifying the financial strength and weakness of a firm from the available accounting data and financial statements. It is done by properly establishing relationship between the items of balance sheet and profit and loss account as,

1)  The task of financial analysts is to determine the information relevant to the decision under consideration from total information contained in the financial statement.

2) To arrange information in a way to highlight significant relationships.

3) Interpretation and drawing of inferences and conclusion. Thus, financial analysis is the process of selection, relation and evaluation of the accounting data/information.

Purposes of Financial Statement Analysis : Financial Statement Analysis is the meaningful interpretation of 'Financial Statements' for 'Parties Demanding Financial Information', such as :

1) The Government may be interested in knowing the comparative energy consumption of some private and public sector cement companies.

2) A nationalised bank may may be keen to know the possible debt coverage out of profit at the time of lending.

3) Prospective investors may be desirous to know the actual and forecasted yield data.

4) Customers want to know the business viability prior to entering into a long-term contract.

              There are other purposes also, in general, the purpose of financial statement analysis aids decision making by users of accounts.

Read Also :

• Time value Of Money
• Financial Ratios
• Cost Of Capital

Steps for financial statement analysis :

·         Identification of the user's purpose

·         Identification of data source, which part of the annual report or other information is required to be analysed to suit the purpose

·         Selecting the techniques to be used for such analysis

 

As such analysis is purposive, it may be restricted to any particular portion of the available financial statement, taking care to ensure objectivity and unbiasedness. It covers study of relationships with a set of financial statements at a point of time  and with trends, in them, over time. It covers a study of some comparable firms at a particular time or of a particular firm over a  period of time or may cover both.

Types of Financial statement analysis : The main objective  of financial analysis is to determine the financial health of a business enterprise, which may be of the following types :

1) External analysis : It is performed by outside parties, such as trade creditors, investors, suppliers of long term debt, etc.

2) Internal analysis : It is performed by corporate finance and accounting department and is more detailed than external analysis.

3) Horizontal analysis : This analysis compares financial statements viz. profit and loss account and balance sheet of previous year with that of current year.

4) Vertical analysis : Vertical analysis converts each element of the information into a percentage of the total amount of statement so as to establish relationship with other components of the same statement.

5) Trend analysis : Trend analysis compares ratios of different components of financial statements related to different period with that of the base year.

6) Ratio Analysis : It establishes the numerical or quantitative relationship between 2 items/variables of financial statement so that the strengths and weaknesses of a firm as also its historical performance and current financial position may be determined.

7) Funds flow statement : This statement provides a comprehensive idea about the movement of finance in a business unit during a particular period of time. 

8) Break-even analysis : This type of analysis refers to the interpretation of financial data that represent operating activities.

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Introduction to Financial Management

Introduction of financial management : Basics and Definitions 
The primary task of an Accountant is to deal with funds, 'Management of Funds' is an important aspect of financial management in a business undertaking or any other institution like hospital, art society, and so on.

The term 'Financial Management' has been defined differently by different authors.
According to Solomon "Financial Management is concerned with the efficient use of an important economic resource, namely capital funds."

Phillippatus has given a more elaborate definition of the term, as , "Financial Management, is concerned with the managerial decisions that results in the acquisition and financing of short and long term credits for the firm."

Thus, it deals with the situations that require selection of specific problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effect on managerial objectives.

The most acceptable definition of financial management is that given by S.C.Kuchhal as, "Financial management deals with procurement of funds and their effective utilisation in the business."




Thus, there are 2 basic aspects of financial management :

1) procurement of funds :
As funds can be obtained from different sources thus, their procurement is always considered as a complex problem by business concerns. These funds procured from different sources have different characteristics in terms of risk, cost and control that a manager must consider while procuring funds. The funds should be procured at minimum cost, at a balanced risk and control factors.

Funds raised by issue of equity shares are the best from risk point of view for the company, as it has no repayment liability except on winding up of the company, but from cost point of view, it is most expensive, as dividend expectations of shareholders are higher than prevailing interest rates and dividends are appropriation of profits and not allowed as expense under the income tax act. The issue of new equity shares may dilute the control of the existing shareholders.

Debentures are comparatively cheaper since the interest is paid out of profits before tax. But, they entail a high degree of risk since they have to be repaid as per the terms of agreement; also, the interest payment has to be made whether or not the company makes profits.

Funds can also be procured from banks and financial institutions, they provide funds subject to certain restrictive covenants. These covenants restrict freedom of the borrower to raise loans from other sources. The reform process is also moving in direction of a closer monitoring of 'end use' of resources mobilised through capital markets. Such restrictions are essential for the safety of funds provided by institutions and investors. There are other financial instruments used for raising finance e.g. commercial paper, deep discount bonds, etc. The finance manager has to balance the availability of funds and the restrictive provisions tied with such funds resulting in lack of flexibility.

In the globalised competitive scenario, it is not enough to depend on available ways of finance but resource mobilisation is to be undertaken through innovative ways or financial products that may meet the needs of investors. Multiple option convertible bonds can be sighted as an example, funds can be raised indigenously as also from abroad. Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major sources of finance from abroad along with American Depository Receipts (ADR's) and Global Depository Receipts (GDR's).

The mechanism of procuring funds is to be modified in the light of requirements of foreign investors. Procurement of funds inter alia includes:

• Identification of sources of finance
• Determination of finance mix
• Raising of funds
• Division of profits between dividends and retention of profits i.e. internal fund generation.

2) Effective use of such funds :
The finance manager is also responsible for effective utilisation of funds. He must point out situations where funds are kept idle or are used improperly. All funds are procured at a certain cost and after entailing a certain amount of risk. If the funds are not utilised in the manner so that they generate an income higher than cost of procurement, there is no meaning in running the business.

It is an important consideration in dividend decisions also, thus, it is crucial to employ funds properly and profitably. The funds are to be employed in the manner so that the company can produce at its optimum level without endangering its financial solvency. Thus, financial implications of each decision to invest in fixed assets are to be properly analysed.

For this, the finance manager must possess sound knowledge of techniques of capital budgeting and must keep in view the need of adequate working capital and ensure that while firms enjoy an optimum level of working capital they do not keep too much funds blocked in inventories, book debts, cash, etc.

Fixed assets are to financed from medium or long term funds, and not short term funds, as fixed assets cannot be sold in short term i.e. within a year, also a large amount of funds would be blocked in stock in hand as the company cannot immediately sell its finished goods.

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