Learning Objectives:
After studying this chapter, you should be able to:
·
appreciate the
concept of capital budgeting.
·
explain the
nature and role of capital budgeting decisions.
·
identify and
discuss the main methods of appraising and ranking investment proposals used in
practice (NPV, IRR, PI, ARR, and PBP).
·
discuss the
strengths and weaknesses of the methods of ranking investment proposals.
·
appreciate the
necessity of capital budgeting in long term decision making.
13.1 Capital Budgets and Decision Making
13.1.1 The Concept of Capital Budgeting
Capital budgeting
is the planning of expenditure whose returns extend beyond one year; it is the
process of deciding whether or not to commit resources to a project whose
benefits would be spread over several time periods. It considers proposed
capital outlays and their financing. The main exercise involved in capital
budgeting is to relate the benefits to costs in some reasonable manner which
would be consistent with the profit maximizing objective of the business.
Capital budgeting decisions belong to the most important areas of managerial
decisions as they involve more extended estimation and prediction of things to
come requiring a high order of intellectual ability for their economic
analysis.
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Capital budgeting
involves taking decisions on projects with long gestation periods. These
projects might on tangible or intangible assets whose benefits would continue
to be enjoyed beyond the year of account. The decision on the projects to be
financed for the long time benefits to be enjoyed by the investing organization
is purely managerial in nature.
13.1.2The Objectives of Capital Budgeting
Where outlays of
funds are made and benefits continue to be enjoyed over an extended period of
time, several implications of far reaching importance follow and these
implications constitute the rationale of capital budgeting.
Firstly, by
making a capital investment, the decision-maker makes a commitment into future
losing some of his financial flexibility in the process. Thus, the purchase of
an asset with an economic life of ten years, for example, requires a long
period of waiting before the result of this action works itself out and the
moment the benefits start coming up, the organization would be more than
compensated for the amount invested.
Secondly, as
asset expansion is related to future sales, the economic life of the asset
purchased represents an indirect forecast of sales for the duration of its
economic life. Any failure to accurately make such a forecast would result in
over-investment or under investment in fixed assets. An erroneous forecast of
asset needs can result in serious consequences for the firm. If a firm has too
much investment in fixed assets, it will be burdened with avoidable heavy
expenditure and, if it has not spent enough on such assets, its productive
operations would be affected by inadequate capacity.
Thirdly, proper
capital budgeting would also lead to better timing of asset acquisition and
improvement in quality of assets purchased. This is due to the nature of demand
for and supply of capital goods. The former does not arise until sales impinge
on productive capacity and such situations occur only intermittently; on the
other hand, production of capital goods involves a relatively long period of
time so that the business would ordinarily have to wait for about a year or so
before new capital goods become available.
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The matching of
the need for capital goods with their availability is one of the functions of
capital budgeting.
Finally, asset
expansion requires substantial funds which might not be immediately and
automatically available. Therefore a determined effort would have to be made to
procure them. It is natural that capital expenditure programme of a sizeable
amount would entail arrangements for finance well in advance to ensure their
availability at the right time.
Thus, the size of
funds involved in asset expansion and the fact that expenditures are designed
to be recovered in future, which is distant and seemingly imperceptible, makes
capital budgeting one of the most critical, crucial, delicate and difficult
areas of managerial decisions. This is also due to the fact that so many
variables - changes in the quality of the product, changes in the quantity of
output, changes in the quality and quantity of direct labour, changes in the
amount and cost of scrap, changes in the maintenance expenses, down-time,
safety, flexibility, etc., are involved in capital budgeting decisions.
This is not a
routine clerical task to be performed on a mechanical basis though the
electronic equipment has facilitated the same to some extent. It requires a
continuous monitoring and evaluation of a conglomeration of factors by
engineers, cost analyst, economists and other individuals in an undertaking who
are competent to make such an evaluation.
13.1.3 Data for Capital
Expenditure Decisions
The type of costs
required in capital investment decisions differ from those required for
accounting purposes because only future costs are relevant for such decisions.
Recorded costs may be useful in investment decision but only to the extent that
they furnish a starting-point for future costs projections.
All estimated
costs pertinent to the project under consideration should be included; any
expected savings in material costs, particularly those arising from an expected
reduction
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in scrap, should
be reflected; prospective changes in direct labour, materials, handling,
inspection, etc., should be reckoned; anticipated increases or decreases in
specific overhead costs, such as taxes, insurance, power, maintenance, repairs,
supplies, etc, must be considered.
The use of plant
overhead rate should be avoided. Very often, the new equipment is more
automatic than the old and a different cost pattern will emerge. Thus, there is
a reduction in supervision, overtime premiums and other overhead costs which
have a tendency to vary with direct labour while there is an increase in
repairs, maintenance, power and other costs varying with machinery usage.
13.1.4Opportunity and Interest Costs
Opportunity cost
plays an important role in capital budgeting decisions. It represents the loss
of alternative income as a consequence to actions adopted. For example, in an
expansion project, the economic rather than the book value of the space
required for expansion should be taken into account against a proposed
investment. In a replacement decision, the realizable value of the existing
asset should be treated as a reduction of the cost of replacement.
Accounting
reports and statements typically give recognition to contractual interest but
ignore imputed interest on capital. While the inclusion of interest is
indispensable in investment studies, the determination of an appropriate rate
presents difficulties. Interest sometimes is misunderstood as return on
investment which consists of two elements: interest and profit.
The former
represents the cost of money while the latter is the reward for risk and
uncertainty. Interest cost constitutes the minimum acceptance criterion for
capital investment projects undertaken for profit. A firm must at least recover
its money costs before it can realize a profit on its own investment. On the
other hand, the minimum acceptance criterion that can be considered as a reward
for risk and uncertainty varies with the nature of the risk assumed.
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Depreciation is
another cost whose treatment in capital investment analysis differs from other
cost accounting reports and analysis. In calculations designed to reveal the
desirability of replacing existing machinery and equipment, depreciation of the
unabsorbed book value of an existing asset is a sunk cost and is not relevant
except for its tax effects. It is only the economic value of the assets that
has relevance in replacement decisions.
In capital
project decisions, differential revenue, where measurable, can not be ignored.
There are two facets to this problem - the potentiality or capacity of the
asset under consideration and the marketability of increased output.
13.1.5 Capital Budgeting Procedure
Capital budgeting
decisions are generally broken down into two levels - departmental level and
the organizational level - in any firm preparing a capital budget. However,
two-level capital budgeting procedure is found to be in vogue in most business
enterprises.
Every departmental
head usually determines the various possible capital expenditures which are
considered economically desirable for his department. This is bound to result
in a number of conflicting proposals being mooted. For example, the sales
manager may propose for the conversion of available space into a seminar room
for the sales force, while on the other hand the production manager may opt for
the use of the space as a canteen and so on. Every departmental head is
required to submit sound arguments in support of his particular proposal and
these may be so couched as to bring out their anticipated contribution to
efficiency, employee morale, their welfare, etc.
It is quite
observed that the two proposals can not be effectively reconciled within the
space available and, therefore, top management has to decide and select the
alternative to be implemented. The important point to note is that the
proposals happen to be mutually exclusive in as much as, if one is adopted,
others are rejected. Such a difficult situation can be explained by the example
of the management of a department store deciding to discontinue the operations
of its cafeteria and to allocate the space to children's wear, whereupon the
managers of higher priced as well as low priced wear file their proposals for
the space thus made available.
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On the other
hand, competing proposals are not mutually exclusive in the same manner as
conflicting proposals are but they may not be equally desirable from the point
of view of the larger interests of the enterprise. It, therefore, becomes
necessary for the departmental head to rank the various competing proposals in
some order before submitting his proposal to top management.
For example, the
factory manager may put in a proposal for the installation of sophisticated
equipment; the store manager may request for an additional crane for handling
heavy equipment; and the accounting department stakes its claim for a brand new
computer to facilitate record-keeping operations. Taken in isolation, every
proposal seems worth implementing to the extent that it would affect sizeable
savings in the present labour cost of the respective departments.
It is at this
stage that the financial manager would enter into the picture with the
objective of bringing to bear a rational attitude on the consideration of the
competing proposals. He examines not only the prospective profit but also the
feasibility and desirability of making the proposed investments in terms of the
cost of funds.
Towards this end,
he puts the following questions to himself and attempts to answer them:
·
What are the
contemporary terms for borrowing fund (regarding interest and repayment)?
·
Are these costs
constant irrespective of the quantum of fund required?
·
Can any one of
the proposed expenditures be postponed and, if so, for how long?
·
Are there any
prospects of change in the conditions of capital market during the next few
years?
The answers to these questions are very vital
for the guidance to be provided by the finance
manager to the top management in capital
budgeting decisions.
13.2 Capital Budgeting Methods
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In most business
firms there are more proposals for capital projects than the firm is able and
willing to finance. Some proposals are good while others are bad. A screening
process has to be devised for finding out the real content of such proposals;
methods of differentiating between them have to be developed and, for this
purpose, a ranking procedure has to be evolved. Essentially, the ranking
procedure envisaged should relate a stream of future earnings to the cost of
obtaining those earnings. Among the many methods of ranking investment
proposals, the following are very widely used:
(i)
Payback Period
method
(ii)
Accounting Rate
of Return method
(iii) Net Present Value method
(iv)
Profitability
Index method
(v)
Internal Rate of
Return method
13.2.1 Pay Back Period ( PBP) Method
The payback,
sometimes called pay-out or payoff, method represents the number of years
required to return the original investments by savings before depreciation but
after the payment of taxes. It is about the length of time it takes a project
to recoup its investment. Thus the method attempts to measure the period of
time it takes for the original cost of a project to be recovered from the
earnings of the project itself. If an investment of N100,000 earns N50,000
cash proceeds in each of its first two years, its PBP is, therefore, two years.
The available investments are then ranked according to the length of their
payback periods so that an investment with a payback of two years is bound to
be considered more desirable than an investment with a payback of three years.
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