FINANCIAL MANAGEMENT

UNIT-1

INTRODUCTION Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfil their business activities. In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity. MEANING OF FINANCE Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns. The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern. DEFINITION OF FINANCE

According to Khan and Jain, “Finance is the art and science of managing money”. 2 Financial Management According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’. Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of the management of funds’ and the management of fund as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.

DEFINITION OF BUSINESS FINANCE According to the Wheeler, “Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise”. According to the Guthumann and Dougall, “Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business”. In the words of Parhter and Wert, “Business finance deals primarily with raising, administering and disbursing funds by privately owned business units operating in nonfinancial fields of industry”. Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, investment analysis and fund procurement of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment. According to the Encyclopedia of Social Sciences, “Corporation finance deals with the financial problems of corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and their administration during early development, the

accounting problems connected with the distinction between capital and income, the administrative questions created by growth and expansion, and finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into financial difficulties”.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management, which is directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The following are the important scope of financial management. 1. Financial Management and Economics Economic concepts like micro and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to finance, and economical areas. 2. Financial Management and Accounting Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. But nowaday’s financial management and accounting discipline are separate and interrelated. 3. Financial Management or Mathematics Modern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management. 4. Financial Management and Production Management Production management is the operational part of the business concern, which helps to multiple the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities. 5. Financial Management and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements.

OBJECTIVES OF FINANCIAL MANAGEMENT

Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as: 1. Profit maximization 2. Wealth maximization. Wealth Profit Fig. 1.2 Objectives of Financial Management Profit Maximization Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features. 1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization. 2. Ultimate aim of the business concern is earning profit; hence, it considers all the possible ways to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. 4. Profit maximization objectives help to reduce the risk of the business. Favorable Arguments for Profit Maximization the following important points are in support of the profit maximization objectives of the business concern: (i) Main aim is earning profit. (ii) Profit is the parameter of the business operation. (iii) Profit reduces risk of the business concern. (iv) Profit is the main source of finance. (v) Profitability meets the social needs also. Unfavorable Arguments for Profit Maximization the following important points are against the objectives of profit maximization: (i) Profit maximization lead to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public shareholders, etc. Drawbacks of Profit Maximization Profit maximization objective consists of certain drawback also: (i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. (ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. (iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern. Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business.

Favourable Arguments for Profit Maximization The following important points are in support of the profit maximization objectives of the business concern: (i) Main aim is earning profit. (ii) Profit is the parameter of the business operation. (iii) Profit reduces risk of the business concern. (iv) Profit is the main source of finance. (v) Profitability meets the social needs also. Unfavourable Arguments for Profit Maximization The following important points are against the objectives of profit maximization: (i) Profit maximization leads to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the sake holders such as customers, suppliers, public shareholders, etc. Drawbacks of Profit Maximization Profit maximization objective consists of certain drawback also: (i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. (ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. (iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern. Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business. Introduction to Financial Management 7 Favourable Arguments for Wealth Maximization (i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. (ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. (iii) Wealth maximization considers both time and risk of the business concern. (iv) Wealth maximization provides efficient allocation of resources. (v) It ensures the economic interest of the society. Unfavourable Arguments for Wealth Maximization (i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. (ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization. (iii) Wealth maximization creates ownership-management controversy. (iv) Management alone enjoy certain benefits. (v) The ultimate aim of the wealth maximization objectives is to maximize the profit. (vi) Wealth maximization can be activated only with the help of the profitable position of the business concern. APPROACHES TO FINANCIAL MANAGEMENT Financial management approach measures the scope of the financial management in various fields, which include the essential part of the finance. Financial management is not a revolutionary concept but an evolutionary. The definition and scope of financial management has been changed from one period to another period and applied various innovations. Theoretical points of view, financial management approach may be broadly divided into two major parts. Approach Traditional Approach Modern Approach Fig. 1.3 Approaches to Finance Management 8 Financial Management Traditional Approach Traditional approach is the initial stage of financial management, which was followed, in the early part of during the year 1920 to 1950. This approach is based on the past experience and the traditionally accepted methods. Main part of the traditional approach is rising of funds for the business concern. Traditional approach consists of the

following important area. Arrangement of funds from lending body. Arrangement of funds through various financial instruments. Finding out the various sources of funds. FUNCTIONS OF FINANCE MANAGER Finance function is one of the major parts of business organization, which involves the permanent, and continuous process of the business concern. Finance is one of the interrelated functions which deal with personal function, marketing function, production function and research and development activities of the business concern. At present, every business concern concentrates more on the field of finance because, it is a very emerging part which reflects the entire operational and profit ability position of the concern. Deciding the proper financial function is the essential and ultimate goal of the business organization. Finance manager is one of the important role players in the field of finance function. He must have entire knowledge in the area of accounting, finance, economics and management. His position is highly critical and analytical to solve various problems related to finance. A person who deals finance related activities may be called finance manager. Finance manager performs the following major functions: 1. Forecasting Financial Requirements It is the primary function of the Finance Manager. He is responsible to estimate the financial requirement of the business concern. He should estimate, how much finances required to acquire fixed assets and forecast the amount needed to meet the working capital requirements in future. 2. Acquiring Necessary Capital After deciding the financial requirement, the finance manager should concentrate how the finance is mobilized and where it will be available. It is also highly critical in nature. 3. Investment Decision The finance manager must carefully select best investment alternatives and consider the reasonable and stable return from the investment. He must be well versed in the field of capital budgeting techniques to determine the effective utilization of investment. The finance manager must concentrate to principles of safety, liquidity and profitability while investing capital. Introduction to Financial Management 9 4. Cash Management Present days cash management plays a major role in the area of finance because proper cash management is not only essential for effective utilization of cash but it also helps to meet the short-term liquidity position of the concern. 5. Interrelation with Other Departments Finance manager deals with various functional departments such as marketing, production, personel, system, research, development, etc. Finance manager should have sound knowledge not only in finance related area but also well versed in other areas. He must maintain a good relationship with all the functional departments of the business organization. Department-I Department-II Department-III Department-IV Forecasting Funds Managing Funds Investing Funds Finance Manager Accquring Funds Fig 1.4 Functions of Financial Manager IMPORTANCE OF FINANCIAL MANAGEMENT Finance is the lifeblood of business organization. It needs to meet the requirement of the business concern. Each and every business concern must maintain adequate amount of finance for their smooth running of the business concern and also maintain the business carefully to achieve the goal of the business concern. The business goal can be achieved only with the help of effective management of finance. We can’t neglect the importance of finance at any time at and at any situation. Some of the importance of the financial management is as follows: Financial Planning Financial management helps to determine the financial requirement of the business concern and leads to take financial planning of the concern. Financial planning is an important part of the business concern, which helps to promotion of an enterprise. Acquisition of Funds Financial management involves the acquisition of required finance to the business concern. Acquiring needed funds play a major part of the financial management, which involve possible source of finance at minimum cost. 10 Financial Management Proper Use of Funds Proper use and

allocation of funds leads to improve the operational efficiency of the business concern. When the finance manager uses the funds properly, they can reduce the cost of capital and increase the value of the firm. Financial Decision Financial management helps to take sound financial decision in the business concern. Financial decision will affect the entire business operation of the concern. Because there is a direct relationship with various department functions such as marketing, production personnel, etc. Improve Profitability Profitability of the concern purely depends on the effectiveness and proper utilization of funds by the business concern. Financial management helps to improve the profitability position of the concern with the help of strong financial control devices such as budgetary control, ratio analysis and cost volume profit analysis. Increase the Value of the Firm Financial management is very important in the field of increasing the wealth of the investors and the business concern. Ultimate aim of any business concern will achieve the maximum profit and higher profitability leads to maximize the wealth of the investors as well as the nation. Promoting Savings Savings are possible only when the business concern earns higher profitability and maximizing wealth. Effective financial management helps to promoting and mobilizing individual and corporate savings. Nowadays financial management is also popularly known as business finance or corporate finances. The business concern or corporate sectors cannot function without the importance of the financial management.

Capital Budgeting

Major role of the financial management is the selection of the most gainful assortment of capital investment and it is vital area of decision-making for the financial manger because any action taken by the manger in this area affects the working and the success of the firm. Capital budgeting is the planning process used to regulate whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the procedure of allotting resources for major capital, or investment, expenditures (Sullivan, 2005). It is also stated by financial scholars that capital budgeting is the decision making process by which a firm appraises the purchase of major fixed assets including building, machinery and equipment.

Bulk of management literature explained the notion of the capital budgeting. Hamption, John specified that Capital budgeting is concerned with the firm's formal process for the acquisition and investment of capital. Several management experts have defined capital budgeting. Charles T. Homgreen elaborated that , "Capital Budgeting is long-term planning for making and financing proposed capital outlays." According to Richards and Greenlaw, "The capital budgeting generally refers to acquiring inputs and long-run returns." G. C. Philipattos stated that "Capital budgeting is concerned with the allocation of the firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project; with the immediate and subsequent stream of expenditures for it."

According to Joel Dean, "Capital Budgeting is a kind of thinking that is necessary to design and carry through the systematic programme for investing stockholders' money. The idea of capital budgeting has an immense importance in project selection as it supports in planning capital required for completing long-term projects. Selection of a project is a major investment decision for an organization

The capital budgeting process can be successful if company determines the total capital expenditure for a project that is expected to generate returns over a particular period of time. An organization uses various methods to determine the total expenditure for a project and rate of return yielded from it. Some of the popular techniques are net present value, internal rate of return, payback period, sensitivity analysis, and decision tree analysis.

Goals of Capital BudgetingPrime goals of capital budgeting investments is to upturn the value of the firm to the shareholders. It has also an objective to rank projects and raise funds. Basically, the purpose of budgeting is to provide a forecast of revenues and expenditures and construct a model of how business might perform financially. It means to construct a model of how a business might perform financially if certain strategies, events, and plans are carried out. It empowers the actual financial operation of the business to be measured against the forecast, and it establishes the cost

constraint for a project, program, or operation. Budgeting helps to aid the planning of actual operations by forcing managers to consider how the conditions might change, and what steps should be taken in such an event. It encourages managers to consider problems before they arise. It also helps co-ordinate the activities of the organization by compelling managers to examine relationships between their own operation and those of other departments.

Important objectives of capital budgeting:

1. To ensure the selection of the possible profitable capital projects.2. To guarantee the effective control of capital expenditure in order to achieve by

forecasting the long-term financial requirements.3. To make estimation of capital expenditure during the budget period and to see that the

benefits and costs may be measured in terms of cash flow.4. Determining the required quantum takes place as per authorization and sanctions.5. To expedite co-ordination of inter-departmental project funds among the competing

capital projects.6. To guarantee maximization of profit by allocating the available investible.

Other vital functions of a budget include:

1. To control resources.2. To communicate plans to various responsibility centre managers.3. To motivate managers to strive to achieve budget goals.4. To evaluate the performance of managers.5. To provide visibility into the company's performance.

Principles of Capital Budgeting Decisions:A decision regarding investment or a capital budgeting decision involves the following principles:

1. A careful approximation of the amount to be invested.2. Original search for profitable opportunities.3. A careful estimates of revenues to be earned and costs to be incurred in future in respect

of the project under consideration.4. A listing and consideration of non-monetary factors influencing the decisions.5. Evaluation of various proposals in order of priority having regard to the amount available

for investment.6. Proposals should be controlled in order to avoid costly delays and cost over-runs.7. Evaluation of actual results achieved against those budget.8. Care should be taken to think all the implication of long range capital investment and

working capital requirements.9. It should identify the fact that greater benefits are preferable to smaller ones and early

benefits are preferable to latter benefits.

The necessity of capital budgeting can be highlighted taking into consideration the nature of the capital expenditure such as heavy investment in capital projects, long-term implications for the

firm, irretrievable decisions and complicates of the decision making. Its importance can be judged on the following other grounds:

1. Indirect Forecast of Sales: The investment in fixed assets is associated with future sales of the firm during the life time of the assets purchased. It demonstrates the possibility of expanding the production facilities to cover extra sales shown in the sales budget. Any failure to make the sales prediction would result in over investment or under investment in fixed assets and any inaccurate forecast of asset needs may lead the firm to serious financial results.

2. Comparative Study of Alternative Projects: Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming outdated so as to make the best possible investment in the replacement of assets. For this purpose, the success of each projects is appraised.

3. Timing of Assets-Acquisition: It is emphasized by financial experts that appropriate capital budgeting leads to proper timing of assets-acquisition and improvement in quality of assets purchased. It is due to nature of demand and supply of capital goods. The demand of capital goods does not arise until sales impinge on productive capacity and such situation occur only intermittently. Alternatively, supply of capital goods with their availability is one of the functions of capital budgeting.

4. Cash Forecast: Capital investment requires substantial funds which can only be organised by making determined efforts to guarantee their availability at the right time. Thus it helps cash forecast.

5. Worth-Maximization of Shareholders: The impact of long-term capital investment decisions is far reaching. It safeguards the interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. Through selection of lucrative projects, the management accelerates the wealth maximization of equity share-holders.

6. Other Factors: The following other factors can also be considered for its importance:

a. It helps in formulating a sound depreciation and assets replacement strategy.b. It may be beneficial in considering methods of coast reduction. A reduction

campaign may necessitate the consideration of purchasing most up-to-date and modern equipment.

c. The practicability of replacing manual work by machinery may be seen from the capital forecast be comparing the manual cost and the capital cost.

d. The capital cost to enhance working conditions or safety can be obtained through capital expenditure estimating.

e. It enables the management to develop the long-term plans and assists in the formulation of general strategy.

f. It assesses the impact of capital investment on the revenue expenditure of the firm such as depreciation, insure and there fixed assets.

Basically, the firm may be challenged with three types of capital budgeting decisions: 

1. Accept-Reject Decision: This is a major decision in capital budgeting. If the project is accepted, the firm would invest in it. If the proposal is rejected, the firm does not invest in it. In general, all those proposals which produce a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. Through this criterion, all independent projects are accepted. Independent projects are the projects that do not compete with one another in such a way that the acceptance of one precludes the possibility of acceptance of another. Under the accept-reject decision, all independent projects that satiate the minimum investment standard, should be executed.

2. Mutually Exclusive Project Decision: Mutually Exclusive Project Decision usually compete with other projects in such a way that the approval of one will reject the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen. For example, firm is intending to buy a new folding machine. There are three competing brands, each with a different initial investment and operating costs. The three machines denote mutually exclusive alternatives, as only one of these can be selected. Furthermore, the mutually exclusive project decisions are not independent of the accept-reject decisions. The project should also be acceptable under the latter decision. Thus, mutually exclusive projects get significance when more than one tender is acceptable under the accept-reject decision.

3. Capital Rationing Decision: Capital Rationing Decision is applicable when in a situation where the firm has unlimited funds, all independent investment proposals yielding returns greater than some pre-determined level are accepted. Nevertheless, this situation does not succeed in most of the business forms in actual practice. They have a fixed capital budget. A large number of investment proposals compete for these limited funds. The firm must, therefore, share them. The firm assigns funds to projects in a manner that it maximises long-run returns. Therefore, capital rationing denotes to a situation in which a firm has more acceptable investments than it can finance. It is related with the selection of a group of Investment proposals out of many investment proposals acceptable under the accept-reject decision. Capital rationing utilizes ranking of acceptable Investment projects. These projects can be ranked on the basis of a pre-determined principle such as the rate of return. The projects are ranked in downward order of the rate of return.

Components of Capital Budgeting1. Initial Investment Outlay: It comprises of the cash necessary to obtain the new equipment or build the new plant less any net cash proceeds from the disposal of the replaced equipment. The initial outlay also includes any additional working capital related to the new equipment. Only changes that occur at the launch of the project are included as part of the initial investment outlay. Any additional working capital required or no longer needed in future period is accounted for as a cash outflow or cash inflow during that period.Net Cash benefits or savings from the operations: This component is calculated as under.(The incremental change in operating revenues minus the incremental change in the operating cost = Incremental net revenue) minus (taxes) plus or minus (changes in the working capital and other adjustments).Terminal Cash flow: It consist of the net cash generated from the sale of the assets, tax effects from the termination of the asset and the release of net working capital. The Net Present Value

technique: The Net Present Value technique is common among all techniques used. Under this method, a project with a positive NPV suggests that it is worth investing in.

Under payback method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it. It is mostly expressed in years.

Unlike net present value and internal rate of return method, payback method does not take into account the time value of money.

According to payback method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less.

Payback period formula – even cash flow:

When net annual cash inflow is even (i.e., same cash flow every period), the payback period of the project can be computed by applying the simple formula given below:

*The denominator of the formula becomes incremental cash flow if an old asset (e.g., machine or equipment) is replaced by a new one.

Example 1:

The Delta company is planning to purchase a machine known as machine X. Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value. The expected annual cash inflow of the machine is $10,000.

Required: Compute payback period of machine X and conclude whether or not the machine would be purchased if the maximum desired payback period of Delta company is 3 years.

Solution:

Since the annual cash inflow is even in this project, we can simply divide the initial investment by the annual cash inflow to compute the payback period. It is shown below:

Payback period = $25,000/$10,000

= 2.5 years

According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company.

Example 2:

Due to increased demand, the management of Rani Beverage Company is considering to purchase a new equipment to increase the production and revenues. The useful life of the equipment is 10 years and the company’s maximum desired payback period is 4 years.  The inflow and outflow of cash associated with the new equipment is given below:

Initial cost of equipment: $37,500

Annual cash inflows:

Sales: $75,000

Annual cash Outflows:

Cost of ingredients: $45,000

Salaries expenses: $13,500

Maintenance expenses: $1,500

Non cash expenses:

Depreciation expense: $5,000

Required: Should Rani Beverage Company purchase the new equipment? Use payback method for your answer.

Solution:

Step 1: In order to compute the payback period of the equipment, we need to workout the net annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated with the equipment.

Computation of net annual cash inflow:

$75,000 – ($45,000 + $13,500 + $1,500)= $15,000

Step 2: Now, the amount of investment required to purchase the equipment would be divided by the amount of net annual cash inflow (computed in step 1) to find the payback period of the equipment.

= $37,500/$15,000

=2.5 years

Depreciation is a non-cash expense and has therefore been ignored while calculating the payback period of the project.

According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years.

Comparison of two or more alternatives – choosing from several alternative projects:

Where funds are limited and several alternative projects are being considered, the project with the shortest payback period is preferred. It is explained with the help of the following example:

CAPITAL BUDGETING TECHNIQUES / METHODSThere are different methods adopted for capital budgeting. The traditional methods or non

discount methods include: Payback period and Accounting rate of return method. The

discounted cash flow method includes the NPV method, profitability index method and IRR.

Payback period method:

As the name suggests, this method refers to the period in which the proposal will generate cash

to recover the initial investment made. It purely emphasizes on the cash inflows, economic life

of the project and the investment made in the project, with no consideration to time value of

money. Through this method selection of a proposal is based on the earning capacity of the

project. With simple calculations, selection or rejection of the project can be done, with results

that will help gauge the risks involved. However, as the method is based on thumb rule, it does

not consider the importance of time value of money and so the relevant dimensions of

profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Example

  Project A   Project B

Cost 1,00,000   1,00,000

Expected future cash flow

Year 1 50,000   1,00,000

Year 2 50,000   5,000

Year 3 1,10,000   5,000

Year 4 None   None

TOTAL 2,10,000   1,10,000

Payback 2 years   1 year

Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is superior to B.

Need Guidance? Ask from Experts!

Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of

return is expressed as a percentage of the earnings of the investment in a particular project. It

works on the criteria that any project having ARR higher than the minimum rate established by

the management will be considered and those below the predetermined rate are rejected.

This method takes into account the entire economic life of a project providing a better means of

comparison. It also ensures compensation of expected profitability of projects through the

concept of net earnings. However, this method also ignores time value of money and doesn’t

consider the length of life of the projects. Also it is not consistent with the firm’s objective of

maximizing the market value of shares.

ARR= Average income/Average Investment

Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of an

asset. These are then discounted through a discounting factor. The discounted cash inflows and

outflows are then compared. This technique takes into account the interest factor and the return

after the payback period.

Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this

technique the cash inflow that is expected at different periods of time is discounted at a

particular rate. The present values of the cash inflow are compared to the original investment. If

the difference between them is positive (+) then it is accepted or otherwise rejected. This

method considers the time value of money and is consistent with the objective of maximizing

profits for the owners. However, understanding the concept of cost of capital is not an easy task.

The equation for the net present value, assuming that all cash outflows are made in the initial

year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the

investment proposal and n is the expected life of the proposal. It should be noted that the cost of

capital, K, is assumed to be known, otherwise the net present, value cannot be known.

NPV = PVB – PVC

where,

PVB = Present value of benefits

PVC = Present value of Costs

Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The

discounted cash inflow is equal to the discounted cash outflow. This method also considers time

value of money. It tries to arrive to a rate of interest at which funds invested in the project could

be repaid out of the cash inflows. However, computation of IRR is a tedious task.

It is called internal rate because it depends solely on the outlay and proceeds associated with

the project and not any rate determined outside the investment.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept

If IR < k = reject

Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to the

initial cash outflow of the investment. It may be gross or net, net being simply gross minus one.

The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

IMPORTANCE OF CAPITAL BUDGETING1) Long term investments involve risks: Capital expenditures are long term investments

which involve more financial risks. That is why proper planning through capital budgeting is

needed.

2) Huge investments and irreversible ones: As the investments are huge but the funds are

limited, proper planning through capital expenditure is a pre-requisite. Also, the capital

investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its

disposal shall incur losses.

3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in

the profitability of the company. It helps avoid over or under investments. Proper planning and

analysis of the projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING Capital budgeting is an essential tool in financial management

Capital budgeting provides a wide scope for financial managers to evaluate different

projects in terms of their viability to be taken up for investments

It helps in exposing the risk and uncertainty of different projects

It helps in keeping a check on over or under investments

The management is provided with an effective control on cost of capital expenditure

projects

Ultimately the fate of a business is decided on how optimally the available resources

are used