Chapter one

Introduction

No decision places a company in more jeopardy than those decisions involving capital

improvements. Often these investments can cost billions of dollars, and without a suitable return

the very existence of the company can be compromised. In the course of their business, firms

have to make capital investment decisions. This involves critical evaluation of long-term

investments and their impact on the value of the company. The corporations make large

investments in buildings and land, and in plant and equipment. There is a constant need for

modernization of equipment due to changes in technology. As the firm grows, they need larger

facilities. A firm may embark on new projects, which may entail large investment of time and

capital. The firm considers all these decisions in light of the long-term benefit of the corporation.

From the financial point of view, only those projects will be acceptable that add to the value of

the firm, and increase the wealth of the owners of the firm.

A company has to evaluate many projects. Some of these projects may be mutually exclusive in

the sense that you have to pick only one and exclude others. A company may want to install gas

heat, or oil heat, in a factory, but not both. The company may have to evaluate several alternative

projects and rank them according to their profitability. Finally, they may have to pick only one or

two projects that they can finance with the available capital. Thus, capital budgeting becomes an

important issue.

1.1 Scope of the Paper:

The paper has been prepared with considering the following scopes:

The main focus of the paper is to understand the concept of capital budgeting.

The paper identifies the factors influencing the need of capital budgeting.

The paper evaluates factors affecting changes in capital budgeting decision.

It identifies different capital budgeting techniques, their advantages and disadvantages.

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1.2 Objective of the Paper:

The paper has been undertaken with the following objectives:

To identify scopes of improvement in the capital budgeting process.

To evaluate the strengths and weaknesses of each capital budgeting method and conduct

a comparison

To identify those capital budgeting practices that are used in the private sector

To learn about the risks involved in capital budgeting decision.

1.3 Limitation of the Paper:

The paper is subjected to the following limitations:

The paper has been prepared under the time constraints.

All the rationales are based on secondary data.

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Chapter Two

Capital Budgeting

Capital budgeting is the process of planning significant outlays on projects that have long-term

implications such as the purchase of new equipment or the introduction of a new product

Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether

resources should be allocated to a project or not. It is the process by which the financial manager

decides whether to invest in specific capital projects or assets. Capital budgeting addresses the

issue of strategic long-term investment decisions. In some situations, the process may entail in

acquiring assets that are completely new to the firm. In other situations, it may mean replacing an

existing obsolete asset to maintain efficiency. Process of capital budgeting ensure optimal

allocation of resources and helps management work towards the goal of shareholder wealth

maximization

Capital investment involves a cash outflow in the immediate future in anticipation of returns at a

future date. A capital investment decision involves a largely irreversible commitment of

resources that is generally subject to significant degree of risk. Such decisions have for reading

efforts on an enterprise’s profitability and flexibility over the long-term. Acceptance of non-

viable proposals acts as a drag on the resources of an enterprise and may eventually lead to

bankruptcy. For making rational decisions regarding the capital investment proposals, the

decision maker needs some techniques to convert the cash outflows and cash inflows of a project

into meaningful yardsticks which can measure the economic worthiness of projects.

During the capital budgeting process answers to the following questions are sought:

What projects are good investment opportunities to the firm?

From this group which assets are the most desirable to acquire?

How much should the firm invest in each of these assets?

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Chapter Three

The Evolution of Capital Budgeting Practices

Budgeting for capital expenditure has evolved over the decades and its importance has increased

over time. Overall, six discernible stages of changes in capital budgeting practices and systems

can be identified.

The first stage is the Great Depression years during which efforts were mainly focused on

designing ways to ensure economic recovery. At the time, public borrowing for financing capital

outlays, except for emergencies, was not favored. In a cautious approach, Sweden introduced a

capital budget that was to be funded by public borrowing and used to finance the creation of

durable and self-financing assets that would contribute to an expansion of net worth equivalent to

the amount of borrowing. This so-called investment budget found extended application in other

Nordic countries in following years.

The second stage took place during the late 1930s when the colonial government in India

introduced a capital budget to reduce the budget deficit by shifting some items of expenditures

from the current budget. It was believed that the introduction of this dual budget system would

provide a convenient way to reduce deficits while justifying a rationale for borrowing.

The third stage refers to the growing importance attached to capital budgets as a “vehicle” for

development plans. Partly influenced by the Soviet-style planning, many low-income countries

formulated comprehensive five-year plans and considered capital budgets the main impetus for

economic development. Where capital budgets did not exist, a variant known as the development

budget was introduced.

The fourth stage reflects the importance of economic policy choices on the allocation of

resources in government. Quantitative appraisal techniques were applied on a wider scale during

the 1960s leading to more rigorous application of investment appraisal and financial planning. In

the 1960s and 1970s, it was widely believed that government budget allocation, including

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investment expenditures, could be largely reduced to a “scientific” process by systems such as

PPBS (planning, programming and budgeting system) or even ZBB (zero-based budgeting).

A fifth stage saw a revival of the debate about the need for a capital budget in government,

particularly in the United States. Along with the growing application of quantitative techniques

during the 1960s came the view that the introduction of a capital budget could be advantageous.

But this view did not gain much support. A president’s commission in 1999 investigating budget

concepts in the United States concluded that a capital budget could lead to greater outlays on

bricks and mortar, and as a result, current outlays could suffer. Having rejected the use of

separate capital budgets, the commission advocated the introduction of accrual accounting in

government accounts. The introduction of accrual accounting which did not make any progress

in the United States until the early 1990s would have meant the division of expenditures into

current and investment outlays. Meanwhile, however, a development cast more serious doubts on

the need for capital budgets. Sweden (and other Nordic countries), which had made pioneering

efforts in the 1930s, undertook a review of its budget system in the early 1970s. They found that

excessive focus on capital budgets would need to be tempered by a recognition that the overall

credibility and creditworthiness of a government depend more on its macroeconomic policy

stance and less on a government’s net worth. This shift in emphasis contributed to a decline in

the popularity of the use of the capital budget until the late 1980s, when it came to be revived in

a different form.

During the sixth stage, partly because of the experiences of Australia and New Zealand, there

was a renewed push by the professional bodies and, from the late 1990s, the international

financial institutions for the introduction of accrual budgeting and accounting. These ideas found

a foothold in the United States, where advocates held the view that the absence of a distinction

between investment outlays and ordinary or current outlays led to unintended neglect of

infrastructure or accumulated assets. Ensuring proper asset maintenance (as important as asset

creation) required a division of outlays into current and capital outlays, as a part of day-to-day

budget management.

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Chapter Four

CURRENT CAPITAL BUDGETING PRACTICES

Dual budgeting originated in European countries, but in those countries it lasted only for a short

period. It was introduced in the late 1930s in order to help governments ensure that the resources

they borrowed were used only for capital expenditures. After the Second World War, as

governments relaxed their use of borrowed funds, budgets were integrated. The change in

approach reflected several factors: massive postwar reconstruction work and increased recurrent

expenditures, along with the acceptance of the Keynesian model of linking government spending

and the size of the budget deficit and borrowing requirements to both fiscal and monetary

determinants and the business cycle. Moreover, it soon became clear that the need to reap a

return—whether financial, social, or economic—applied to the entire spectrum of government

spending. Hence, it came to be accepted that regardless of their financing sources, government’s

recurrent spending and capital investment are complements in any logical combination that may

be required, and that the two types of expenditures together produce results, provided the context

is one of overall macro-fiscal balance.

The U.K. government, in an effort to keep its budget deficit in a fiscally sound range, has in

recent years reintroduced the golden rule of limiting capital expenditures to the size of

borrowing, but this should be regarded as a self-imposed fiscal discipline measure only, and has

not created any type of dual budgeting.

In the United States, periodic recommendations were made for the introduction of a separate

capital budget. But this never materialized, primarily because it might tilt the resource allocation

in favor of “bricks and mortar.” However, the budget documents presented a special analysis of

investment expenditures, which was for information only and had no accounting or other

implementation impact for the budget structure

Most OECD countries have also achieved a high degree of integration of their current and capital

budgets. This has usually occurred through a process of development in their public

administration and budgetary systems that has taken place over many decades. It is the result of a

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growing realization by these governments that: (i) the distinction between recurrent and capital

spending is often quite arbitrary or uncertain; and (ii) better resource allocation and management

decisions can often be made within a single, unified (and medium term) framework for revenues

and expenditures.

While there are now few developed countries which maintain totally separate budgets, the extent

and form of budgetary integration—particularly the management of capital spending—still

differs significantly in some instances. For this reason, effective integration of current and capital

budgets is perhaps best measured qualitatively by the extent to which the current and investment

spending decisions of the government are “well-balanced,” in the sense of being logically

consistent with, and mutually supportive of, a given policy framework or set of policy objectives.

In practice, this means that the services for which government departments and spending

agencies are responsible are delivered as effectively and efficiently as possible, given the budget

resources available. The budget systems of countries with a high degree of integration between

current and capital expenditures exhibit several key features:

a single (combined) annual budget law and appropriation process;

clear, and unified, responsibilities for budgetary preparation and implementation within

the relevant public sector institutions;

the existence of effective and widely employed investment appraisal techniques;

a unified budget presentation, with supporting classification and accounting systems; and

budget planning and management techniques within individual spending agencies that

encourage and enable good use of financial resources.

Most developed countries’ budgetary systems incorporate some of these features. However, the

full benefits of a unified budget can only be achieved where each of these conditions is present.

And although each of these features is important, it is often in the last area the budget planning

and management within spending agencies where the most challenging reform measures, and

greatest gains, are to be found.

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Above-mentioned characteristics of a sound budgetary system are often strengthened by the use

of a medium-term approach to public investment. Public investments are primarily meaningful in

a medium- to long-term perspective. If the sole focus is only on preparing and executing the

annual budget, the main reasons for pursuing investment projects will be related to short-term

macro-economic effects, for instance on employment, and short-term political considerations. In

such a setting, the potential long-term effects of the investments may be accorded little

importance. As a result, the capital budget will tend to be underfunded. In addition, project

selection will tend to prioritize high-visibility, fast-track projects, not the projects that give the

highest net benefits. Allocation of resources to different sectors and investment projects should

ideally be based on efficiency. What are the benefits compared to the costs of the projects? In the

short term, the main focus will tend to be on static efficiency: what are the expected results of

allocating resources to certain sectors based on their current capacity to deliver specific public

goods and services? In a longer-term perspective, dynamic efficiency becomes more important:

resource allocation should also be governed by the possibilities for improving the capacity of the

sectors over time, and investment projects will play a critical role in this regard.

It is also important to pursue cost-effective delivery of individual public goods and services. In

the short term, efforts to improve cost-effectiveness will tend to focus on cost minimization,

without any fundamental changes in production processes and methods. In an longer-term

perspective, it will be possible to pursue more ambitious modernization and re- engineering of

the way in which government agencies operate, while still producing the same type of public

service. Such restructuring will often require investments.

Many of the efforts to extend the time horizon for investment planning also include the

introduction of medium-term budget frameworks (MTBFs). There are many differences between

countries in the exact nature of these MTBFs, and in their focus and level of detail.

However, in general, effective MTBFs tend to share certain characteristics:

The ministry of finance develops a medium-term macroeconomic forecast, which forms

the basis for multi-year spending ceilings by organizations or programs.

The line ministries develop policy-based, three-year budget estimates for their activities.

These estimates should reflect ministries’ strategies and policies.

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The ministries’ budget estimates distinguish clearly between the costs of existing policies

and programs, and the costs of new proposals, including investments.

The budget preparation process gives a formal status to the out-year estimates. On a

rolling basis, the first out-year estimates of expenditures should become the basis of

preparation of the following year’s budget.

Currently, the majority of OECD countries prepare comprehensive MTBFs. Few low-income

countries have been able to introduce full-fledged MTBFs so far. Experience shows that this type

of reform is conceptually and practically very demanding. In particular, it has turned out to be

difficult for line ministries to develop credible, multi-year budget estimates.

A viable alternative is to begin by preparing multi-year budget estimates only for public

investments and for major expenditures driven by demographics and entitlements. These

estimates should be based on common methodologies, and the estimates should be agreed upon

by the line ministries and the ministry of finance. While this approach does not provide the

stringency of a full MTBF, it does give a much better basis for effective budget deliberations

than the traditional, annual approach. Another factor that has been mostly successful only in

developed countries is the development of a well-designed process

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Chapter Four

Importance of Capital Budgeting

Capital expenditures can be very large and have a significant impact on the firm’s financial

performance. Besides, the investments take time to mature and capital assets are long-term,

therefore, if a mistake were done in the capital budgeting process, it will affect the firm for a

long period of time. Basically, the importance of capital budgeting are as follow:

1. Substantial expenditure:

Capital budgeting decisions involves the investment of substantial amount of funds. It is

therefore necessary for a firm to make such decisions after a thoughtful consideration so as to

result in the profitable use of its scarce resources. The hasty and incorrect decisions would not

only result into huge losses but may also account for the failure of the firm.

2. Long time period:

The capital budgeting decision has its effect over a long period of time. These decisions not only

affect the future benefits and costs of the firm but also influence the rate and direction of growth

of the firm.

3. Irreversibility:

Most of the investment decisions are irreversible. Once they are taken, the firm may not be in a

position to reverse them back. This is because, as it is difficult to find a buyer for the second-

hand capital items.

 

4. Complex decision:

The capital investment decisions involve an assessment of future events, which in fact is difficult

to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the costs

relating to a particular investment decision

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5. Avoid forecast error:

The future success of a business largely depends on the investment decisions that corporate

managers make today. Investment decisions may result in a major departure from what the

company

6. Get better grades:

Through making capital investments, firm acquires the long-lived fixed assets that generate the

firm’s future cash flows and determine its level of profitability. Thus, this decision greatly

influences a firm’s ability to achieve its financial objectives.

For example, if the firm invests too much it will cause higher depreciation and expenses. On the

other hand, if the firm does not invest enough, the firm will face a problem of inadequate

capacity and thus, lose its market share to its competitors.

7. Helps firm to plan its financing:

Proper capital budgeting analysis is critical to a firm’s successful performance because capital

investment decisions can improve cash flows and lead to higher stock prices. Yet, poor decisions

can lead to financial distress and even to bankruptcy. Although a tactical investment decision

generally involves a relatively small amount of funds, strategic investment decisions may require

larger amount of funds.

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Chapter Five

B usiness decisions required for capital budgeting analysis

Business decisions that require capital budgeting analysis are decisions that involve in outlay

now in order to obtain some return in the future.

This return may be in the form of increased revenue or reduced costs. Typical capital budgeting

decisions include:

1. Cost reduction decisions. Should new equipment be purchased to reduce costs?

 

2. Expansion decisions. Should a new plan, warehouse, or other facility be acquired to

increase capacity and sales?

 

3. Equipment selection decision. Which of several available machines should be the most

cost effective to purchase?

 

4. Lease or buy decisions. Should new equipment be leased or purchased?

 

5. Equipment replacement decisions. Should old equipment be replaced now or later?

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Chapter Five

Capital Budgeting Process

Financial planners recommend developing a capital budgeting process for small and large

businesses to ensure long-term success. In today's economy, it takes money to make money and

it takes making wise choices to stay on top. Whether large or small, no business can operate

efficiently without implementing a long-term plan to invest monetarily in equipment and

facilities to expedite the corporate mission and increase profitability. Improper planning results

in failed enterprises and a loss of resources; but proprietorships and corporations which make

prudent decisions about what, where, when, and how much money to allocate to new facilities or

improve on existing ones will have a fighting chance at staying in the black.

Steps in Capital Budgeting Process:

Finance Manager is not initiating the project he just evaluating the proposals and arranges funds

for approved projects.

1. Strategic planning

2. Identification of investment opportunities

3. Preliminary screening of projects

4. Financial appraisal of projects

5. Qualitative factors in project evaluation

6. The accept/reject decision

7. Project implementation and monitoring

8. Post-implementation audit

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Figure 1 : Capital Budgeting Process

The capital budgeting process

Capital budgeting is a multi-faceted activity. There are several sequential stages in the process.

For typical investment proposals of a large corporation, the distinctive stages in the capital

budgeting process are depicted, in the form of a highly simplified flow chart, in Figure 1

1. Strategic planning

A strategic plan is the grand design of the firm and clearly identifies the business the firm is in

and where it intends to position itself in the future. Strategic planning translates the firm’s

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corporate goal into specific policies and directions, sets priorities, specifies the structural

strategic and tactical areas of business development, and guides the planning process in the

pursuit of solid objectives. A firm’s vision and mission is encapsulated in its strategic planning

framework. There are feedback loops at different stages, and the feedback to ‘strategic planning’

at the project evaluation and decision stages – indicated by upward arrows in Figure 1 is

critically important. This feedback may suggest changes to the future direction of the firm which

may cause changes to the firm’s strategic plan.

2. Identification of investment opportunities

The identification of investment opportunities and generation of investment project proposals is

an important step in the capital budgeting process. Project proposals cannot be generated in

isolation. They have to fit in with a firm’s corporate goals, its vision, mission and long-term

strategic plan. Of course, if an excellent investment opportunity presents itself the corporate

vision and strategy may be changed to accommodate it. Thus, there is a two-way traffic between

strategic planning and investment opportunities. Some investments are mandatory – for instance,

those investments required to satisfy particular regulatory, health and safety requirements – and

they are essential for the firm to remain in business. Other investments are discretionary and are

generated by growth opportunities, competition, cost reduction opportunities and so on. These

investments normally represent the strategic plan of the business firm and, in turn, these

investments can set new directions for the firm’s strategic plan. These discretionary investments

form the basis of the business of the corporation and, therefore, the capital budgeting process is

viewed in this book mainly with these discretionary investments in mind. A profitable

investment proposal is not just born; someone has to suggest it. The firm should ensure that it has

searched and identified potentially lucrative investment opportunities and proposals, because the

remainder of the capital budgeting process can only assure that the best of the proposed

investments are evaluated, selected and implemented. There should be a mechanism such that

investment suggestions coming from inside the firm, such as from its employees, or from outside

the firm, such as from advisors to the firm, are ‘listened to’ by management. Some firms have

research and development (R&D) divisions constantly searching for and researching into new

products, services and processes and identifying attractive investment opportunities. Sometimes,

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excellent investment suggestions come through informal processes such as employee chats in a

staff room or corridor.

3. Preliminary screening of projects

Generally, in any organization, there will be many potential investment proposals generated.

Obviously, they cannot all go through the rigorous project analysis process. Therefore, the

identified investment opportunities have to be subjected to a preliminary screening process by

management to isolate the marginal and unsound proposals, because it is not worth spending

resources to thoroughly evaluate such proposals. The preliminary screening may involve some

preliminary quantitative analysis and judgments based on intuitive feelings and experience.

4. Financial appraisal of projects

Projects which pass through the preliminary screening phase become candidates for rigorous

financial appraisal to ascertain if they would add value to the firm. This stage is also called

quantitative analysis, economic and financial appraisal, project evaluation, or simply project

analysis. This project analysis may predict the expected future cash flows of the project, analyse

the risk associated with those cash flows, develop alternative cash flow forecasts, examine the

sensitivity of the results to possible changes in the predicted cash flows, subject the cash flows to

simulation and prepare alternative estimates of the project’s net present value. Thus, the project

analysis can involve the application of forecasting techniques, project evaluation techniques, risk

analysis and mathematical programming techniques such as linear programming. While the basic

concepts, principles and techniques of project evaluation are the same for different projects, their

application to particular types of projects requires special knowledge and expertise. For example,

asset expansion projects, asset replacement projects, forestry investments, property investments

and international investments have their own special features and peculiarities.

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5. Qualitative factors in project evaluation

When a project passes through the quantitative analysis test, it has to be further evaluated taking

into consideration qualitative factors. Qualitative factors are those which will have an impact on

the project, but which are virtually impossible to evaluate accurately in monetary terms. They are

factors such as:

the societal impact of an increase or decrease in employee numbers

the environmental impact of the project

possible positive or negative governmental political attitudes towards the project

the strategic consequences of consumption of scarce raw materials

positive or negative relationships with labor unions about the project

possible legal difficulties with respect to the use of patents, copyrights and trade or brand

names

impact on the firm’s image if the project is socially questionable.

Some of the items in the above list affect the value of the firm, and some not. The firm can

address these issues during project analysis, by means of discussion and consultation with the

various parties, but these processes will be lengthy, and their outcomes often unpredictable. It

will require considerable management experience and judgmental skill to incorporate the

outcomes of these processes into the project analysis. Management may be able to obtain a feel

for the impact of some of these issues, by estimating notional monetary costs or benefits to the

project, and incorporating those values into the appropriate cash flows. Only some of the items

will affect the project benefits; most are externalities. In some cases, however, those qualitative

factors which affect the project benefits may have such a negative bearing on the project that an

otherwise viable project will have to be abandoned.

6. The accept/reject decision

NPV results from the quantitative analysis combined with qualitative factors form the basis of

the decision support information. The analyst relays this information to management with

appropriate recommendations. Management considers this information and other relevant prior

knowledge using their routine information sources, experience, expertise, ‘gut feeling’ and, of

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course, judgement to make a major decision – to accept or reject the proposed investment

project.

7. Project implementation and monitoring

Once investment projects have passed through the decision stage they then must be implemented

by management. During this implementation phase various divisions of the firm are likely to be

involved. An integral part of project implementation is the constant monitoring of project

progress with a view to identifying potential bottlenecks thus allowing early intervention.

Deviations from the estimated cash flows need to be monitored on a regular basis with a view to

taking corrective actions when needed.

8. Post-implementation audit

Post-implementation audit does not relate to the current decision support process of the project; it

deals with a post-mortem of the performance of already implemented projects. An evaluation of

the performance of past decisions, however, can contribute greatly to the improvement of current

investment decision-making by analysing the past ‘rights’ and ‘wrongs’.

The post implementation audit can provide useful feedback to project appraisal or strategy

formulation. For example, expost assessment of the strengths (or accuracies) and weaknesses (or

inaccuracies) of cash flow forecasting of past projects can indicate the level of confidence (or

otherwise) that can be attached to cash flow forecasting of current investment projects. If

projects undertaken in the past within the framework of the firm’s current strategic plan do not

prove to be as lucrative as predicted, such information can prompt management to consider a

thorough review of the firm’s current strategic plan.

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Chapter Six

CAPITAL BUDGETING TECHNIQUES

Firms operating in a dynamic environment must continuously make changes in different areas of

its operations in order to meet the needs of a challenging environment for growth and survival.

Continuous change assists in improving the operational process, thereby putting the organization

at an advantage over their competitors. Most changes involve capital expenditure decisions,

which can invariably involve large sums of money. The expenditure might involve expansion in

the current line of business, diversification or takeovers. Prior to the decision of appraising an

investment opportunity, the organization must identify a strategic need for investment in the

project. The need will determine aspects like, which of the many investment opportunities before

the entity will best help to meet their strategic objectives, how much to commit to the project in

terms of funds, human resource and the time towards the investment. Most of the strategic

decisions which necessitate large investments require managers to undertake detailed project

analysis before a final decision is made on whether or not to invest money in such a project.

A number of capital budgeting techniques are available to financial managers of either small

businesses or large businesses. The generally accepted techniques are

Payback Period

Discounted payback period

Accounting Rate of Return

Net Present Value

Internal Rate of Return

Profitability Index

The most popular primary and secondary capital budgeting techniques used by large businesses

are payback period and internal rate of return. A recent study showed that most firms using a

discounted cash flow model utilize the weighted average cost of capital of their firm for the

discount rate.

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6.1 Payback Period

Payback period is the time duration required to recoup the investment committed to a project.

Business enterprises following payback period use "stipulated payback period", which acts as a

standard for screening the project.

The basic element of this method is to calculate the recovery time, by year wise accumulation of

cash inflows (inclusive of depreciation) until the cash inflows equal the amount of the original

investment. The time taken to recover such original investment is the “payback period” for the

project.

The payback period is the most frequently used capital budgeting technique for large businesses,

although in large businesses it is very rarely used alone, but generally with some other technique

as well. Unfortunately, this is not true for small businesses, where frequently the payback period

is the only technique used.

Small business owners rely on payback period for their capital budgeting decisions because the

principles underlying it are easily understood. The payback period shows the small business

owner how long it will take him to payback his/her investment in the project. This concept is

more meaningful to a small business owner than the other methods, particularly because of the

interest in the liquidity of the firm, rather than the return on investment. Because cash flows in

the distant future are inherently risky, a shorter payback period implies that a project is less risky.

6.1.1Computation Process

The formula or equation for the calculation of payback period is as follows:

Payback period = Investment required / Net annual cash inflow

6.1.2 Decision Rules

A. Capital Rationing Situation

• Select the projects which have payback periods lower than or equivalent to the stipulated

payback period.

• Arrange these selected projects in increasing order of their respective payback periods.

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• Select that project from the top of the list till the capital Budget is exhausted.

B. Mutually Exclusive Projects

In the case of two mutually exclusive projects, the one with a lower payback period is accepted,

when the respective payback periods are less than or equivalent to the stipulated payback period.

6.1.3 Advantages of Payback Period

It is easy to understand and apply. The concept of recovery is familiar to every decision-

maker.

Business enterprises facing uncertainty - both of product and technology - will benefit by

the use of payback period method since the stress in this technique is on early recovery of

investment. So enterprises facing technological obsolescence and product obsolescence -

as in electronics/computer industry - prefer payback period method.

Liquidity requirement requires earlier cash flows. Hence, enterprises having high

liquidity requirement prefer this tool since it involves minimal waiting time for recovery

of cash outflows as the emphasis is on early recoupment of investment.

No assumptions about future interest rates.

In case of uncertainty in future, this method is most appropriate.

A company is compelled to invest in projects with shortest payback period, if capital is a

constraint.

Ranking projects as per their payback period may be useful to firms undergoing liquidity

constraints.

6.1.4 Disadvantages of Payback Period

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The time value of money is ignored. For example, in the case of project

A Tk.500 received at the end of 2nd and 3rd years are given same weight age. Broadly a

rupee received in the first year and during any other year within the payback period is

given same weight. But it is common knowledge that a Taka received today has higher

value than a rupee to be received in future.

But this drawback can be set right by using the discounted payback period method. The

discounted payback period method looks at recovery of initial investment after

considering the time value of inflows.

Cash generation beyond payback period is ignored.

Percentage Return on the capital invested is not measured.

Projects with long payback periods are characteristically those involved in long-term

planning, which are ignored in this approach.

The payback rules do not properly consider the riskiness of cash flows.

Investment decision is essentially concerned with a comparison of rate of return

promised by a project with the cost of acquiring funds required by that project. Payback

period is essentially a time concept; it does not consider the rate of return.

Academics have not succeeded much in understanding the preference for the use of payback

period by managers. However in a study by Narayanan (1985), who investigates for an economic

rationale for the use of PB ascertains that under separate ownership and control, the management

has an incentive to make decisions that yield cash flows earlier in time when there is

informational asymmetry. It can be ascertained that many companies still use the PB as a

measure of the capital attractiveness however its use as a single criterion seems to have

decreased over time and it may be probably best regarded as an initial screening tool. It is

inappropriate as a basis for sophisticated investment decisions.

6.2 Discounted Payback Period

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The discounted payback period can be defined as the period required for the initial cash

investment in a project to equal the discounted value of the expected cash inflows . The

discounted payback method is similar to the payback period in that it looks at the length of time

it takes a project to "payback." The difference lies in the discounting of the cash flows with the

discounted payback period, while the cash flows are not discounted in the traditional payback

period. The discounted payback period is a better gauge of break-even than the payback period

because it is a period beyond which a project generates economic profit rather than accounting

profit. The discounted payback period is also a more conservative approach to capital budgeting

than the traditional payback period. The weighted average cost of capital of the firm should be

used as the discount rate in calculating the cash flows of the project. Another limitation of the

discounted payback period is that it is much harder to calculate than the traditional payback

period. It does, however, make a suitable substitute for the traditional payback period for a small

business owner because it is almost as easy to understand as the traditional payback period.

6.2.1 Computation Process

Same as the payback period, only discounted cash flow is used instead of normal cash flow.

6.2.2 Decision Rule

An investment is good or acceptable if its discounted payback period is less than some pre-determined

# of years.

6.2.3 Advantages of Discounted Payback Period

Considers the time value of money

Considers the riskiness of the project's cash flows (through the cost of capital)

6.2.4 Disadvantages of Discounted Payback Period

Requires an estimate of the cost of capital in order to calculate the payback

Ignores cash flows beyond the discounted payback period

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6.3 Accounting Rate of Return

Accounting rate of return is the rate arrived at by expressing the average annual net profit (after

tax) as given in the income statement as a percentage of the total investment or average

investment. The accounting rate of return is based on accounting profits. Accounting profits are

different from the cash flows from a project and hence, in many instances, accounting rate of

return might not be used as a project evaluation decision. Accounting rate of return does find a

place in business decision making when the returns expected are accounting profits and not

merely the cash flows.

The accounting rate of return (ARR), computed from the financial statements, is a periodic and

an ex post indicator. Vatter (1966) ascertains that ARR is a figure based only on the data related

to a given year, and is not referenced to other parts of the project except the year to which it

applies. It is commonly defined as the ratio of accounting profit earned in a particular period to

the book value of the capital employed in the period. According to the different numerators and

denominators applied to calculate ARR, there are several kinds of definitions used in analysis.

For the numerator of ARR, it is usually financial annual accounting profit or income, while the

denominator is often determined by book value of assets or book value of equity. Employing the

‘clean surplus’ concept, Peasnell (1982) defines ARR as the ratio of the accounting profit to the

book value of assets at the beginning of the period.

6.3.1 Computation of Accounting Rate of Return

The accounting rate of return using total investment.

Or

Sometimes average rate of return is calculated by using the following

Formula: (Net profit after tax /Average Investment)*100

Where average investment = (Initial Investment + Salvage Value)/2

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6.3.2 Decision Rules

A. Capital Rationing Situation

• Select the projects whose rates of return are higher than the cut-off rate

• Arrange them in the declining order of their rate of return and

• Select projects starting from the top of the list till the capital available is exhausted.

B. No Capital Rationing Situation

Select all projects whose rate of return are higher than the cut-off rate.

C. Mutually Exclusive Projects

Select the one that offers highest rate of return.

6.3.3 Advantages of Accounting Rate of Return

It Is Easy To Calculate.

The Percentage Return Is More Familiar To The Executives.

This method considers all the years in the life of the project.

It is based upon profits and not concerned with cash flows.

Quick decision can be taken when a number of capital investment proposals are being

considered.

The advantage in ARR is the easy availability of information for the computation of

results. The accounting data can be readily obtained from annual reports.

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6.3.4 Disadvantages of Accounting Rate of Return –

The definition of cash inflows is erroneous; it takes into account profit after tax only. It,

therefore, fails to present the true return.

Definition of investment is ambiguous and fluctuating. The decision could be biased

towards a specific project, could use average investment to double the rate of return and

thereby multiply the chances of its acceptances.

Time value of money is not considered here.

It is biased against short-term projects.

The ARR is not an indicator of acceptance or rejection, unless the rates are compared

with the arbitrary management target.

It fails to measure the rate of return on a project even if there are uniform cash flows.

When analyzing investment / projects the managers are interested in the cash flows earning over

the life of the project and since ARR is based on numbers that include non-cash items, it doesn’t

give a true picture of project quality. The ARR method does not take into account the time value

of money. Unlike the other modern techniques which account for the timing of the cash flows,

ARR values £1 today as similar to £1 at the end of the year. Although the ARR is simple to

calculate the other methods of capital investment valuation are not very difficult to calculate

given the availability of computing power. The data may also be unreliable due to problems of

creative accounting

We can conclude on the basis of previous literature and criticism that since ARR does not take

into account the time value of money, and is wholly unadjusted for non-cash items, any

investment decision based on it is necessarily seriously flawed. Its only advantage is that it is

very easy to calculate.

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6.4 Net Present Value

The net present value method provides a framework to consider alternative capital investments,

utilizing a discount rate for the time value of money. The present value of the cash inflows are

compared against the present value of the cash harder to calculate than net present outflows. As

long as the present value of the cash inflows is greater than the present value of the cash

outflows, the project is acceptable. With limited capital, those investments with the highest net

present value are accepted, until the available capital is exhausted. The discount rate that is

generally used is the weighted average cost of capital for the firm (12).

The net present value method is very useful, and considers the time value of money. Although it

is more difficult to calculate than payback period, the recent advances in hand-held calculators

have made the determination of net present value much easier. The main obstacle to its greater

acceptance by the small business community is a lack of understanding of the process by small

business owners. Many of the owners are unaware the process exists, how it can be used, and the

principles underlying it.

Another problem with the net present value method is that it assumes that positive net present

value projects do exist and can be identified. Shapiro outlined a general set of situations in which

positive net present value projects generally occur. He pointed out the service is the key to

extraordinary profit ability for many firms, and for small businesses this alternative is probably

the best.

NPV is a standard method in finance for capital budgeting purposes. Managers use NPV as a

cutoff / criterion for project selection, by undertaking a project if the present value of all future

cash inflows minus the present value of all cash outflows (which equals the net present value) is

greater than zero. The key inputs of the calculation of NPV are the interest rate or “discount rate”

which is used to compute present values of future cash flows. If the discount rate exceeds the

shareholder’s required rate of return, and the project has a positive NPV at this rate, then

shareholders will expect an additional profit that has a present value equal to the NPV. Thus if

the goal of the corporation is to maximize shareholder wealth, managers would undertake all

projects that have a positive NPV, or choose the higher NPV project if faced with two or more

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mutually exclusive positive NPV projects. NPV analysis is sensitive to the reliability of future

cash inflows that an investment or project will yield.

Net present value of an investment/project is the difference between present value of cash

inflows and cash outflows. The present values of cash flows are obtained at a discount rate

equivalent to the cost of capital.

6.4.1 Computation of Net Present Value (NPV)

• Let 'b' be the cash outflow in period’t’ where t = 0, 1, 2………, n

• 'B' be the present value of cash outflows

• 'c' be the cash inflow in period’t’=0, 1, 2 ...n

• 'C' be the present value of cash inflows

• 'K' be the cost of capital

Then,

Present value of cash inflows, C = ∑ ct / (1+k) t

Present value of cash outflows, B = ∑ bt / (1+k) t

Net Present Value, NPV = (C-B) or

NPV= ∑ (ct-bt) / (1+k) t

When the cash outflow is required for only one year i.e., in the present year, then the Net

present value is calculated as follows

NPV = ∑ ct / (1+k) t – I

"I" is the initial investment (cash outflow) required by the project

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6.4.2 Decision Rules

A. "Capital Rationing" situation

Select projects whose NPV is positive or equivalent to zero.

Arrange in the descending order of NPVs.

Select Projects starting from the list till the capital budget allows.

B. "No capital Rationing" Situation

Select every project whose NPV >= 0

C. Mutually Exclusive Projects

Select the one with a higher NPV.

6.4.3 Advantages of NPV

It recognises the Time Value of Money.

It considers total benefits during the entire life of the Project.

This is applicable in case of mutually exclusive Projects.

Since it is based on the assumptions of cash flows, it helps in determining

Shareholders Wealth.

The NPV is based on the forecasted cash flows from the investment. Hence the

accounting practice like depreciation and non-cash expenditures, managements

taste and profits from existing business don’t affect the decision.

Since the present values are a measure of future returns, they can be easily added

up. Hence incase of two projects even with different time horizon, the present

value of the combines investment is the sum of the parts. The additive property

assists in recognizing suboptimal opportunities which are packaged with good

projects

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6.4.4 Disadvantages of NPV

This is not an absolute measure.

Desired rate of return may vary from time to time due to changes in cost of capital.

This Method is not effective when there is disparity in economic life of the projects.

More emphasis on net present values. Initial investment is not given due importance

If a project NPV exhibits inconsistent behavior of annual net benefits or net cash flow

from a project due to change in sign more than once over the planning horizon, the

method becomes unsuitable for certain types of investment decisions. (Boehme, 2000)

This makes NPV technique less useful in valuing highly technical and risky projects.

NPV systematically undervalues all investment projects. This is due to the strong implicit

assumptions made that no decisions would be taken in the future after the investment

decision. The technique ignores the managerial flexibility has been made. Managers are

known to undertake negative NPV projects in many cases because they are armed with

the options of expansion, delay, abandonment and contracting (shrink) the project which

has value.

NPV technique treats some options as mutually exclusive from others. Consider a

deferral option where a project can be deferred forgone or two years. NPV would value

the two cases separately to seek the option with higher value. It forces to conceive of

false mutually exclusive alternatives when confronted with decisions that could be made

in the future.

The NPV method has been successfully accepted and widely used by all mid-size and large size

companies as a primary capital budgeting technique. Survey by Graham and Harvey (2001)

reveals that 75% of the CFO’s taken from a large random sample always or almost always use

NPV as the preferred capital budgeting technique. They mainly attribute this to the CEO

characteristics, the size of the firm and leverage. Another factor can be the availability of huge

computing power and sophistication.

6.5 Internal Rate of Return

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The internal rate of return is similar to the net present value, in that it considers the time value of

money. An internal rate of return is the true or effective interest yield generated by an investment

over its life, and can be defined as the discount rate that equates the present values of the cash

outflows to equal the present values of the cash inflows. The internal rate of return is used by

businesses more often than net present value. The internal rate of return is also more easily

understood by users who do not have formal training in accounting or finance.

Internal rate of return has some drawbacks, one of which is that it is harder to calculate than net

present value, particularly if it has uneven cash flows. This problem has been partially alleviated

by the increase in the capabilities of handheld calculators, but still can be tough for the small

business owners to grasp. Another problem with internal rate of return is that, when projects are

ranked by this criterion, it assumes the firm has the opportunity to reinvest the cash generated at

the internal rate of return. The net present value method assumes the cash flows generated by a

project can be reinvested at the firm's cost of capital. Brigham also noted that the net present

value method is preferable over the internal rate of return in the ranking of investment

alternatives.

The internal rate of Return (IRR) is the discount rate that equals the present value of a future

steam of cash flows to the initial investment. In simple terms, discount rate is the rate at which

the Net present value of a project equals zero. It can be thought of as the annualized rate of return

(in percent) of an investment using compound interest rate calculations.

6.5.1 Decision Rules

A. "Capital Rationing" Situation Select those projects whose IRR (r) = k, where k is the cost

of capital. Arrange all the projects in the descending order of their Internal Rate of Return. Select

projects from the top till the capital budget allows.

B. "No Capital Rationing" Situation Accept every project whose IRR (r) = k, where k is the

cost of capital. C. Mutually Exclusive Projects

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6.5.2 Advantages of IRR

The Time Value of Money is considered.

All cash flows in the project are considered

The IRR technique computes the present value of investment opportunities cash flows

and hence takes into account the time value of money. This value states that a pound

today is more valuable than a pound tomorrow. This is a primary condition in the choice

of investment of investment appraisal techniques.

The IRR is based on the expected net cash flows from the project. These cash flows are

computed as total cash inflow less total cash outflow. Hence the accounting practice like

depreciation and profits from existing business don’t affect the decision making process.

Returns expressed in terms of percentage are easier to understand and communicate for

managers and shareholders compared to NPV, due to unfamiliarity with the details of the

appraisal techniques

6.5.3 Disadvantages of IRR

Possibility of multiple IRR, interpretation may be difficult.

If two projects with different inflow/outflow patterns are compared, IRR will lead to

peculiar situations.

If mutually exclusive projects with different investments, a project with higher

investment but lower IRR contributes more in terms of absolute NPV and increases the

shareholders’ wealth

The IRR assumes that the time value of money is the project specific IRR, as it doesn’t

discount the cash flows at the opportunity cost of capital. The method assumes that the

intermediate cash flows can earn the same rate of returns as the original project, and this

creates unrealistic returns to the management and shareholders. (Kelleher and

McCormack, Aug 2004) It can be very unreasonable to expect the returns to remain

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stable over the life of the projected hence can give a misleading view of a proposed

investment.

The IRR method is unsuccessful in measuring returns in terms of absolute amounts of

wealth changes. It only gives a percentage measure of returns and this may cause

difficulties in ranking projects where there are conditions of mutual exclusivity.

The IRR technique fails to supports the additive principle when evaluating multiple

projects as the returns are expressed in percentage terms. The additive principle is

particularly necessary when evaluating project of different time horizons.

Although academics have been always certified NPV as the most appropriate theoretical method

for project evaluation, IRR has always been the favored technique in practice by the managers

around the globe. Surveys conducted (Arnold and Hatzpoulos, July 2000;

Graham and Harvey, 2001) confirm that IRR has been the most accepted primary technique of

capital budgeting by CFO’s is most developed and developing nations.

Chapter Seven

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CAPITAL RATIONING

In capital budgeting Capital rationing is a situation where a constraint or budget ceiling is placed

on the total size of capital expenditures during a particular period. Often firms draw up their

capital budget under the assumption that the availability of financial resources is limited. Under

this situation, a decision maker is compelled to reject some of the viable projects having positive

net present value because of shortage of funds. It is known as a situation involving capital

rationing. Financial Management & international finance 125

7.1 Factors Leading to Capital Rationing

Two different types of capital rationing situation can be identified, distinguished by the source of

the capital expenditure constraint.

I. External Factors - Capital rationing may arise due to external factors like imperfections of

capital market or deficiencies in market information which might have for the availability of

capital. Generally, either the capital market itself or the Government will not supply unlimited

amounts of investment capital to a company, even though the company has identified investment

opportunities which would be able to produce the required return. Because of these imperfections

the firm may not get necessary amount of capital funds to carry out all the profitable projects.

II. Internal Factors - Capital rationing is also caused by internal factors which are as follows:

Reluctance to take resort to financing by external equities in order to avoid assumption of

further risk

Reluctance to broaden the equity share base for fear of losing control.

Reluctance to accept some viable projects because of its inability to manage the firm in

the scale of operation resulting from inclusion of all the viable projects.

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7.2 Situations of Capital Rationing

Situation I - Projects are divisible and constraint is a single period one:

The following are the steps to be adopted for solving the problem under this situation:

a. Calculate the profitability index of each project

b. Rank the projects on the basis of the profitability index calculated in (a) above.

c. Choose the optimal combination of the projects.

Situation II - Projects are indivisible and constraint is a single period one

The following steps to be followed for solving the problem under this situation:

a. Construct a table showing the feasible combinations of the project (whose aggregate of initial

outlay does not exceed the fund available for investment.

b. Choose the combination whose aggregate NPV is maximum and consider it as the optimal

project mix.

Chapter Eight

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Risk Analysis in Capital Budgeting

Capital budgeting appraisal techniques were applied on the assumption that the project will

generate a given set of cash flows. It is quite obvious that one of the limitations of DCF

techniques is the difficulty in estimating cash flows with certain degree of certainty. Certain

projects when taken up by the firm will change the business risk complexion of the firm.

This business risk complexion of the firm influences the required rate of return of the investors.

Suppliers of capital to the firm tend to be risk averse and the acceptance of a project that changes

the risk profile of the firm may change their perception of required rates of return for investing in

firm’s project.

Generally the projects that generate high returns are risky. This will naturally alter the business

risk of the firm. Because of this high risk perception associated with the new project a firm is

forced to assess the impact of the risk on the firm’s cash flows and the discount factor to be

employed in the process of evaluation.

8.1 Risk:

Risk may be defined as the variation of actual cash flows from the expected cash flows. The term

risk in capital budgeting decisions may be defined as the variability that is likely to occur in

future between the estimated and the actual returns. Risk exists on account of the inability of the

firm to make perfect forecasts of cash flows.

Risk arises in project evaluation because the firm cannot predict the occurrence of possible future

events with certainty and hence, cannot make any correct forecast about the cash flows. The

uncertain economic conditions are the sources of uncertainty in the cash flows. For example, a

company wants to produce and market a new product to their prospective customers. The

demand is affected by the general economic conditions. Demand may be very high if the country

experiences higher economic growth. On the other hand economic events like weakening of US

dollar, subprime crises may trigger economic slowdown. This may create a pessimistic demand

drastically bringing down the estimate of cash flows. Risk is associated with the variability of

future returns of a project. The greater the variability of the expected returns, the riskier the

project is. Every business decision involves risk. Risk arises out of the uncertain conditions

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under which a firm has to operate its activities. Because of the inability of firms to forecast

accurately cash flows of future operations the firms face the risks of operations. The capital

budgeting proposals are not based on perfect forecast of costs and revenues because the

assumptions about the future behavior of costs and revenue may change. Decisions have to be

made in advance assuming certain future economic conditions.

There are many factors that affect forecasts of investment, cost and revenue.

The business is affected by changes in political situations, monetary policies, taxation,

interest rates, policies of the central bank of the country on lending by banks etc.

Industry specific factors influence the demand for the products of the industry to which

the firm belongs.

Company specific factors like change in management, wage negotiations with the

workers, strikes or lockouts affect company’s cost and revenue positions.

Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management.

The best business decisions may not yield the desired results because the uncertain conditions

likely to emerge in future can materially alter the fortunes of the company.

Every change gives birth to new challenges. New challenges are the source of new opportunities.

A proactive firm will convert every problem into successful enterprise opportunities. A firm

which avoids new opportunities for the inherent risk associated with it, will stagnate and

degenerate. Successful firms have empirical history of successful management of risks.

Therefore, analysing the risks of the project to reduce the element of uncertainty in execution has

become an essential aspect of today’s corporate project management.

8.2 Different types of risk:

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Risks in a project are many. It is possible to identify three separate and distinct types of risk in

any project.

1) Stand – alone risk: it is measured by the variability of expected returns of the project.

2) Portfolio risk: A firm can be viewed as portfolio of projects having as certain degree of risk.

When new project added to the existing portfolio of project the risk profile the firm will alter.

The degree of the change in the risk depends on the covariance of return from the new project

and the return from the existing portfolio of the projects. If the return from the new project is

negatively correlated with the return from portfolio, the risk of the firm will be further diversified

away.

3) Market or beta risk: It is measured by the effect of the project on the beta of the firm. The

market risk for a project is difficult to estimate.

Stand alone risk is the risk of a project when the project is considered in isolation. Corporate risk

is the projects risks to the risk of the firm. Market risk is systematic risk. The market risk is the

most important risk because of the direct influence it has on stock prices.

8.3 Sources of risk:

The sources of risks are

1. Project – specific risk

2. Competitive or Competition risk

3. Industry – specific risk

4. International risk

5. Market risk

1. Project – specific risk: The sources of this risk could be traced to something quite specific to

the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead

to a situation of actual cash flows realised being less than that projected.

2. Competitive risk or Competition risk: unanticipated actions of a firm’s competitors will

materially affect the cash flows expected from a project. Because of this the actual cash flows

from a project will be less than that of the forecast.

3. Industry – specific: industry – specific risks are those that affect all the firms in the industry.

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It could be again grouped into technological risk, commodity risk and legal risk. All these risks

will affect the earnings and cash flows of the project. The changes in technology affect all the

firms not capable of adapting themselves to emerging new technology.

The best example is the case of firms manufacturing motor cycles with two strokes engines.

When technological innovations replaced the two stroke engines by the four stroke engines those

firms which could not adapt to new technology had to shut down their operations.

Commodity risk is the risk arising from the effect of price – changes on goods produced and

marketed.

Legal risk arises from changes in laws and regulations applicable to the industry to which the

firm belongs. The best example is the imposition of service tax on apartments by the

Government of India when the total number of apartments built by a firm engaged in that

industry exceeds a prescribed limit. Similarly changes in Import – Export policy of the

Government of India have led to the closure of some firms or sickness of some firms.

4. International Risk: these types of risks are faced by firms whose business consists mainly of

exports or those who procure their main raw material from international markets. For example,

rupee – dollar crisis affected the software and BPOs because it drastically reduced their

profitability. Weakening reduced their competitiveness in the global markets. The surging Crude

oil prices coupled with the governments delay in taking decision on pricing of petro products

eroded the profitability of oil marketing Companies in public sector like Hindustan Petroleum

Corporation Limited. Another example is the impact of US subprime crisis on certain segments

of Indian economy.

The changes in international political scenario also affect the operations of certain firms.

5. Market Risk: Factors like inflation, changes in interest rates, and changing general economic

conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course

of business. Techniques used for incorporation of risk factor in capital budgeting decisions There

are many techniques of incorporation of risk perceived in the evaluation of capital budgeting

proposals. They differ in their approach and methodology so far as incorporation of risk in the

evaluation process is concerned.

Chapter Nine

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Capital Budgeting Challenges

Leveraging your cost data into strategic planning requires sound processes and sharp tools.

Many of the requirements, workflows, and data management methods for capital planning,

procurement, and construction make it hard to streamline visibility of your past efforts.  Teams

do the best they can with Excel models, but disconnected forms and processes are cumbersome;

too often people are comparing apples to oranges when critical questions arise.

Store costs must be in line with the financial plan and sales projections; an isolated real estate

and construction department has the potential to undermine an entire company.

To summarize the challenges:

1. Different sources pulling from varying “all-in” numbers to create a single budget. 

2. Accounting, Procurement and most Budgeting systems are not estimating solutions;   

3. System limitations dictate the current depth and level of line items in the budget.

4. Limited ability to quickly analyze budgets in more than two simple dimensions.

These limitations make it hard to:

1. Control project costs and develop performance metrics.

2. Quickly and effectively leverage existing data to make clear decisions.

3. Identify sources of variance between the proforma, funding budgets, and actuals.

4. Identify certain budget owners’ costs within cost categories and cost targets.

5. Determine the impact of a departments’ category spend on the total cost.

Opening a store is a complex process.  It’s essential that a company’s real estate and construction

department support Operations and Finance by aligning its costs with the overall business plan.

The integrated processes and tools offered by site folio will provide the visibility and consistency

required.

Chapter Ten

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CONCLUSIONS

Many small businesses continue to use payback period for their capital budgeting decisions.

Unfortunately, this is not a good criterion to rank these decisions, and the discounted payback

method is vastly superior. In addition, small businesses should also be using the net present value

method for ranking projects. The net present value method is more easily understood and

computed by small business owners than the internal rate of return, and is generally felt to be

superior. If small businesses utilize these two methods in their capital budgeting decisions, they

should become more profitable, more long-term oriented, and have a higher level of profitability.

Corporate manager have obligation to owners i.e. stockholders to increase company’s

profitability i.e. long-term profitability. Successful capital projects are fundament of efficient

company. Main problem that emerges from capital budgeting is risk and insecurity. Regard to

characteristic of capital projects; long period of time implementing and long period of project

life, risk and insecurity is very high. Using just traditional methods and techniques managers

can’t determine with certainly risk. Combining traditional methods and techniques for

determination risk process of selecting optimal projects manager can get much better and

stronger projects calculations. Using scenario, sensitivity, Monte Carlo and decision tree analysis

manager can get better decisions. Enumerate techniques provide miscellaneous information that

manager can use in decision process. In paper trough example of widget factory its argument that

using techniques for risk determination manager can perform better because from stand-alone

risk techniques they get information’s necessary for risk analysis. Trough risk analysis manager

could predict cash flow values, and could predict how different decisions affect on project

values. In addition to traditional techniques methods like scenario, sensitivity, decision tree and

Monte Carlo provide additional view on possible variables that have impact on profitability of

project. Using these methods corporate managers can decide with better about acceptance or

rejection of the project, because all methods are observing and using in the account risk and

probability. For conclusion we determine that successful selection of optimal project can’t be

conducted without implementation of at least two or more of techniques for risk managing in

capital budgeting.

Articles References:

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Jeryl L. Nelson, Wayne State College Roy A. Cook, Fort Lewis College. “CAPITAL

BUDGETING TECHNIQUES FOR SMALL FIRMS”

Prof. R.Madumathi ,Indian Institute of Technology ,Madras, “CAPITAL BUDGETING”

Sean Donohue and Lina M Downing “CAPITAL BUDGETING: DO PRIVATE

SECTOR METHODS OF BUDGETING FOR CAPITAL ASSETS HAVE

APPLICABILITY TO THE DEPARTMENT OF DEFENSE.”

Shelton Weeks,THE DEVALUATION OF CAPITAL BUDGETING IN REAL ESTATE

DEVELOPMENT FIRMS” Journal of Real Estate Portfolio Management Vol. 9, No. 3,

2003

Mohd Amy Azhar B. Hj. Mohd Harif, Ph.D, C.A.(M) & Harizal B. Osman

“FINANCIAL MANAGEMENT PRACTICES: AN INDEPTH STUDY AMONG THE

CEO OF SMALL AND MEDIUM ENTERPRISE (SMEs)”

Gyorgy Andor , Sunil K. Mohanty & Tamas Toth CAPITAL BUDGETING PRACTICES: A SURVEY OF CENTRAL AND EASTERN EUROPEAN FIRMS.”

Don Dayananda, Richard Irons, Steve Harrison, John Herbohn and Patrick Rowland

“CAPITAL BUDGETING: AN OVERVIEW.”

CBO paper ,may 2008

Kashyap Soni, Nottingham University Business School ,”CAPITAL BUDGETING

PRACTICES IN INDIA.”

Peter A. Brous, “INTEGRATING THEORY AND PRACTICE: THE CAPITAL

BUDGETING PROCESS REPORT”

Morris G. Danielson Jonathan A. Scott “THE CAPITAL BUDGETING DECISIONS OF

SMALL BUSINESSES”

Howard Lawrence, “THE USE OF MODERN CAPITAL BUDGETING

TECHNIQUES”

The institute of cost & works accountants of India

Web References :

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http://en.wikipedia.org

http://www.mbaknol.com

http://www.answers.com

http://www.brainmass.com

http://www.accountingformanagement.com

www.investopedia.com

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