Principles of Capital
Budgeting
Capital budgeting has five principles that play a crucial role in the allocation of
money and the process of capital budgeting. The five principles are;
(1) decisions are based on cash flows, not accounting income,
(2) cash flows are based on opportunity cost,
(3) The timing of cash flows are important,
(4) cash flows are analyzed on an after tax basis,
(5) financing costs are reflected on project’s required rate of return.
(1) Relevant cash flows are based on incremental cash flows.
This represents the changes in cash flow if the project is undertaken.
Aspects of cash flow that affect capital budgeting are sunk costs and externalities.
These are both costs that cannot be avoided.
Sunk costs are costs that are unavoidable, even if the project is undertaken.
Externalities are side effects of a project that affect other firm cash flows.
(2) Cash flows are based on opportunity cost.
In other words, it is the cash flow that will be lost due to the financing of a
project.
These are cash flows that are accumulated by assets the firm already owns and
would be sunk if the project under consideration is undertaken.
(3) The timing of cash flow is crucial because it is dependent on the time value
of money.
Cash flow that is received now will be worth more in the future if it were to be
received later.
(4) Cash flows are measured on an after tax basis.
It is useless to measure cash flow before taxes because it is not its present value.
Firm’s value is based on cash flow that a firm gets to keep, not the money that is
sent to the government.
(5) Financing costs are reflected on project’s required rate of return. Rate of
return is an aspect of financing that has potential risks. Project’s that are expected
to have a higher rate of return than their cost of capital will increase the value of
the firm.
Importance of Capital Budgeting:
Capital budgeting decisions have given the primary importance in financial de
cision-making since they are the most crucial and critical business decisions and
they have significant impact on the profitability aspect of the firm.
As the capital budgeting/expenditure decision affects the fixed asset only which
are the sources of earning revenue, i.e. in other words, the profitability of the firm,
special attention must be given in their treatment.
(a) Capital budgeting has long-term
implications:
The most significant reason for which the capital budgeting decisions is taken is
that it has long-term implications, i.e. its effects will extend into the future, and
will have to be endured for a longer period than the consequences of current
operating expenditure. Because, an opportune investment decision can yield
spectacular returns whereas a wrong investment decision can endanger the very
survival of the firm.
That is why, it may be stated that the capital budgeting decisions determine the
future destiny of the firm. Moreover, it also changes the risk complexion of the
enterprise. When the average benefits of the firm increases as a result of an
investment proposal which may cause frequent fluctuations in its earnings that
will become a more risky situation.
(b) They require large amounts of
funds:
Capital investment decisions require large amounts of funds which the majority of
the firms cannot provide since they have scarce capital resources. As a result, the
investment decisions must be thoughtful, wise and correct. Because, a
wrong/incorrect decision would result in losses and the same prevents the firm
from earning profits from other investments as well due to scarcity of resources.
(c) They are not reversible:
Once the capital budgeting decisions are taken, they are not easily reversible. The
reason is that there may neither be any market for such second hand capital goods
nor there is any possibility of conversion of such capital assets into other usable
assets, i.e., the only remedy is to dispose of the same sustaining a heavy loss to
the firm.
(d) They are actually the most difficult
decisions:
Capital investment decisions are, no doubt, the most significant since they are
very difficult to make. It is because of the fact that their assessment depends on
the future uncertain events and activities of the firm. Similarly, it is practically a
difficult task to estimate the accurate future benefits and costs in terms of money
as there are economical, political and technological forces which affect the said
benefits and costs.
Types of Capital Budgeting Decisions:
Since capital budgeting includes the process of generating, evaluating, selecting
and following up on capital expenditure alternatives, allocation of financial
resources should be made by the firm to its new investment projects in the most
efficient manner.
(i) Mutually exclusive projects:
It means if a firm accepts one project, it may rule out the necessity for other, i.e.
the alternatives are mutually exclusive and only one is to be chosen.
For example, if there is a need to transport supplies from a loading dock to
the warehouse, the firm may adopt two proposals, viz.,
(a) Fork lifts to pick up the goods and move them, or,
(b) A conveyer belt may be connected between the dock and the warehouse.
If one proposal is accepted it will eliminate the other
(ii) Accept—reject decisions or
acceptance rule:
The proposals which yield a higher rate of return in comparison with a certain rate
of return or cost of capital are accepted and naturally, the others are rejected. For
example, if the minimum acceptable return from a project is say 10%, after tax
and an investment proposal which shows a return of 12%, may be accepted and
another project which gives a return of 8% only may be rejected.
In other words, using Net Present Value Method Criterion an investment
opportunity will be accepted if NPV>0, or, the same will be rejected if NPV< 0.
That is, all independent projects are accepted under this criterion.
It is to be noted that independent projects are those which do not compete with
one another, i.e. the acceptance of one precludes the acceptance of other. At the
same time, those projects which will satisfy the minimum investment criterion
should be taken into consideration.
(iii) Capital rationing decision:
Capital rationing is normally applied to situations where the supply of funds to the
firm is limited in some way. As such, the term encompasses many different
situations ranging from that where the borrowings and lending rates faced by the
firm differ to that where the funds available for investments are strictly limited In
other words, it occurs when a firm has more acceptable proposals than it can
finance.
At this point, the firm ranks the projects from highest to lowest priority and as
such, a cut-off point is considered. Naturally, those proposals which are above the
cut-off point will be accepted and those which are below the cut-off point are
rejected, i.e. ranking is necessary to choose the best alternatives.
Illustration:
Minimum acceptable rate of return (after-tax) is 10%.
Investments to be made Rs. 12,00,000.
Four alternative investment opportunities, are there viz. A, B, C and-D.
Expected returns from the above alternatives are:
A — 8%,
B — 11%,
C — 13% and
D — 12%.
Solution:
Since alternative a shows a return which is less than the standard return laid down
by the firm, it should be totally rejected Among the remaining three, Proposals C
is the most profitable project and hence, it may be accepted.
The time period should be determined in the context of the
following major consideration which are:
(a) The type of industry:
For example, a pharmaceutical firm is to make plans for a shorter period since its
equipment’s are short-lived whereas a mining firm has to make a plan for a longer
period.
(b) The general economic conditions:
At the time of prosperity, the planning time gets longer whereas at the time of
crisis the same is shorter.
(c) The degree of faith the executives have in long-range planning:
If they believe in it, there will be longer time period and in the opposite case, it
will be reversed.
However, there are some authors who prefer to classify the time
horizon in investment decisions into two following groups:
(i) Long period:
Which may include a period from 5 to 20 years.
(ii) Short period:
Which is considered for inclusion in the next annual budget period.
Generally, investments in long-term assets require a plan for several years ahead for
a number of reasons, which are noted below:
(a) Long-term investment expresses a framework for the future development of
the firm which must be visualised in advance;
(b) A long gestation period lies between the time of planning the project and the
actual operation of the plant;
(c) Arrangement must be made for required fund from different sources in
advance which needs careful planning.
Short-term budgets, on the other hand, may be influenced by the financial resourc
es. Of course, in case of an emergency need, the funds are to be procured /
arranged from different source so that the project may be taken up.
Kinds of Investment:
Generally, two types of investments are made, viz.:
(i) The replacement of existing assets; and
(ii) The purchase of completely new assets for expansion.
It may also be mentioned that there may be other types of investment as
well which are considered as a matter of policy.
They are:
(a) Welfare projects:
Investment is made in order to promote the morale of the employees and/or staffs.
(b) Educational and training projects:
Investment is also to be made for educational and training projects for improving the efficiency of the
employees although it is very difficult to evaluate the result from it.
(c) Research and development projects:
The research projects may be successful but it is very difficult to measure the benefits which are derived in
future.
(d) Projects to be complied with statutory requirements:
According to the Factories Act, 1948, every employee should make proper provisions for accidents, fire-
fighting devices, rest room etc., which is obligatory on the part of the employer.
(e) Prestige-valve projects:
In order to create a favourable image among the public, this type of investment is to be made, e.g. to construct
a guest house.
