Capital Budgeting

CAPITAL BUDGETING DECISIONS

Investment decisions of a firm are generally known as the capital budgeting or capital expenditure decisions. A capital budgeting is the firms decisions o invest its current funds most efficiently in the long term assets.

In anticipation of an expected flow of benefits over a series of years. Examples of capital budgeting decisions are:-

-Expansion of existing business.

-Acquisition of another firm.

-Replacement and modernization investments.

-Research and development program.

-Purchase of new assets.

-Development of new products lines.

i)The steps involve in capital budgeting process are

Project generation

Project evaluation

Project selection

Project execution

ii)Difficulties faced in capital budgeting in the real world

* It is not possible to have full data or information relating to a project.

* Uncertainty on the cost of capital (minimum rate of return required by the investors.

* It is difficult to estimate a projects future cash flow.

* There are many qualitative considerations that would need to be taken into account e.g. availability of power, labour, effect on environment, expected changes in technology, displacement of labour etc. it is not possible to take into account all the qualitative factors.

* It is not possible to estimate the economic useful life of the project accurately.

* Conflicts between some of the investment appraisal techniques e.g. the Net Present Value (NPV) and Internal Rate of Returns (IRR) conflict in ranking of some of the mutually exclusive projects.

iii)Classification of Investments

a)Mutually Exclusive Investments

These are alternative options which serve the same purpose and compete with each other. If the firm is for instance considering three mutually exclusive investment and one of them is selected, the other two would automatically be rejected irrespective of their viability.

b)Independent Investments

These investments serve different purposes and do not compete with each other. If the firm is for instance considering 5 independent projects, all of them can be undertaken at the same time subject to their viability and availability of funds.

c)Contingent Investment

These are dependent projects. The choice of one investment necessitates that one or more other investments should also be undertaken e.g. if a company decides to build a factory in a remote area, it may have to invests in houses, roads, hospitals, schools etc for employees so as to attract the work force.

CAPITAL BUDGETING TECHNIQUES

The capital budgeting techniques may be grouped into categories

a)Non discounted cash flow techniques (traditional method)

These are:-

Accounting rate of return (ARR)

Payback period (PBP)

b)Discounted cash flow techniques (modern Methods)

These are:

o Net Present value (NPV)

o Internal Rate of return (IRR)

* Profitability Index (PI)

NON DISCOUNTED CASH FLOW TECHNIQUES

i)Accounting rate of return (ARR)

It is also known as return on investment (ROI). This technique uses accounting information as revealed by financial statement. ( P & L balance sheet) to measure the profitability of an investment.

ARR = Average Income x100

Average Investment

Acceptance Rule

The management establishes or fixes the minimum acceptable accounting rate of return. A project with an ARR above the rate fixed by the management would be rejected. The project with the highest ARR is ranked as number 1 while the project with the lowest ARR comes last.

Advantages of ARR

* It is simple to understand and use

* It is calculated from accounting data which is ready available from the financial statement of a business organization.

* It uses returns occurring from the entire life of the project in calculating the project profitability.

* It is cheap to use as it does not require use of computers since the computation is easy.

Disadvantages of ARR

* It ignores the time value of money. Income is averaged without regard of its timing.

* It uses accounting profits and not cash flows in appraising the projects. Accounting profits are based on arbitrary assumptions and choices and also include non cash item.

There is no universally acceptable way of computing accounting rate of return which means that different parties can come up with different rates depending on the formula used.

Growth firms earning very high rates of returns on their existing assets may reject profitable projects while the less profitable firms earning very low rate of returns on their existing assets may accept bad projects (project with a negative NPV)

It is incompatible with the firm's objectives of maximizing the market value of the shares. Share values do not depend on accounting rate of return.

It does not allow for the fact that profits can be re invested. Use of ARR as an investment criterion is undesirable because it can lead to unprofitable allocation of capital. If it should be used, it should be supplemented by two or more other method.

ii) Pay back period

These refer to the number of years taken by a project to generate cash inflows