Question

In Chapter 10 p.312, the authors use GE as an example to explain the importance of making capital investment decisions. In 500 words or more, discuss the four criteria that are commonly used for determining the relevant cash flows for a proposed project. Make sure you provide some details and examples.  

Answer 1

The entire process of investment decisions is also known as ‘CAPITAL BUDGETING’ or ‘CAPITAL EXPENDITURE DECISION’.

According to Milton H. Spencer: Capital budgeting involves the planning of expenditures for assets , the returns from which will be realized in future time period

Features of capital budgeting:

1. Only the long term investment proposals are subject to capital budgeting techniques.
2. Proposed investments are made in the present, but the returns of such investments accured over number of years in future.
3. While undertaking the exercise of capital budgeting in respect of an investment proposal, expenditure and projected return are measured in terms of cash flow,i.e cash inflow and cash outflow respectively.
4. The business may take investment decisions on single project proposal or two or more project proposals which are mutually exclusive simultaneously.
5. Maximisation of value of business organization should be sole criteria for selecting or dropping of an investment proposal.

Significance of Capital Investment Investment decisions require special attention because of the following reasons:

· They influence the firm’s growth in the long run.

· They affect the risk of the firm.

· They involve commitment of large amount of funds.

· They are irreversible, or reversible at substantial loss.

· They are among the most difficult decisions to make.

Types of capital budgeting:

1. Expansion and Diversification : : A company may add capacity to its existing product lines to expand existing operations. For example, a fertilizer company may increase its plant capacity to manufacture more urea. Expansion of a new business requires investment in new products and a new kind of production activity within the firm. If a package manufacturing company invests in a new plant and machinery to produce ball bearings, which the firm has not manufactured before, this represents expansion of new business or diversification. Sometimes a company acquires existing firm to expand its business. In, either case, the firm makes investment in the expectation of additional revenue. Investments in existing or new products may also be called as revenue – expansion investments.

2. Replacement and Modernization: The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firm’s revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets that operate more economically. If a cement company changes from semi – automatic drying equipment to fully automatic drying equipment, it is an example of modernization and replacement. Replacement decisions helps to introduce more efficient and economical assets and therefore, are also called cost – reduction investments. However, replacement decisions which involve substantial modernization and technological improvements expand revenue as well as reduce costs.

3. Mutually Exclusive Investments: Mutually exclusive investments serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company may, for example, either use a more labor – intensive, semi – automatic machine, or employ a more capital intensive, highly automatic machine for production. Choosing the semi – automatic machine precludes the acceptance of the highly automatic machine.

4. Independent investments : Independent investments serve different purpose and do not compete with each other. For example, heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a new product – light commercial vehicles. Depending on their profitability and availability of funds, the company can undertake both investments.

5. Contingent investments : Contingent investments are dependent projects; the choice of one investment necessitates undertaking one or more other investments. For example, if a company decides to build a factory in a remote, backward area; it may have to invest in houses, roads, hospitals, schools etc. for employees to attract the work force. Thus, building of factory also requires investment in facilities for employees. The total expenditure will be treated as one single investment.

Need for capital budgeting:

1.Maintaining firms competitiveness

2.Planning for future needs of the firm

3.Coordinating

4.cost control

5.Companys effectiveness

Capital Budgeting process:

1. Investment screening and selection
2. Capital budgeting proposal
3. Budgeting approval and authorization
4. Project tracking
5. Post complete Audit

Importance of capital budgeting:

Capital budgeting for taking an investment decision is the most effective and powerful tool. The importance of capital budgeting may be gauged from following points

1. Long term effect
2. Risk and uncertainty
3. Large funds
4. Corporate image

Difficulties in capital budgeting:

1. Future uncertainty
2. Time element
3. Measurement problem

For example , implementation of project to launch a new project by company may result in increase or decrease of the sales of the companies other products (which are already in the market). However, the amount of such increase / decrease (due to new product launching)is not easy to determine because phenomenon of such increase/decrease may not be necessarily due to launching of the new product, it may also result of some other issue.

Developing cash flow data:

Cash flow is dynamic process in which the money moves into add or out of business. Its significance lies in its timing especially in case of small entrepreneurs, who have to concentrate more on ‘cash management’ rather than profitability.

Cash flow concerned with

cash outflows: The investment to be made in a project at beginning stage and at various stages from time to time needs to be estimated with utmost care. Besides cost of core assets required for the project, other miscel. Exp involved in the project implementation, like transportation charges,installation cost etc.

Cash inflows: This is the most important aspect of project, as viability of a project hinges upon the steam of cash inflows accruing as the return of the investment made in the project. As the cash inflows can only be projected on the basis of certain historical data, its estimations require an extremely caution approach. The benefit reaped by the investing entity depends upon the difference between the cash outflows and estimated cash inflows likely to accrue during the life time of the project.

Cash flows as profit:

Following adjustment s may be applied to convert the ‘Accrual Net Profit’ into ‘Net Cash Flow’

Accured Net Profit

(+) depreciation

(-)increase(or + decrease ) in accounts receivable

(-) increase (or +decrease ) in inventories

(+) increase(or- decrease ) in accounts payable

(-) decrease (or+increase ) in notes payale(bank loans)

Net cash flow

Components of cash flows:

1. Initial investment
2. Operating cash inflows
3. Terminal cash inflows