Financial Management UNIT-1

Financial Management UNIT-1 

CHAPTER - 3 Investment Decisions

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We have 3 chapters in UNIT-1
Notes for other two chapters are here

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Capital budgeting

Investment decision pertaining to long term assets for the purpose of generating revenue for the business entity is termed as capital budgeting.
Moreover, capital expenditure differs from revenue expenditure in the sense that the benefits from capital expenditure are necessarily generated after a long gestation period which is generally beyond one year.

"Capital budgeting is a long term planning for making and financing capital expenditures of a company or a business."

Components of capital budgeting

  • Cash outflows (Investment to be made)
  • Cash  Inflows (Return on the investment made)
  • Cut off rate (The minimum level of return expected on an investment)
  • Ranking the proposal (In case of many investment options, ranking of the best option becomes necessary in order to invest in the best proposal)
  • Risk and uncertainty
  • Non-monetary view (For example, goodwill or reputation of the company in market)

Objectives of capital budgeting

●Maintaining firm's competitiveness
Modernization of plants and replacement of obsolete plant and machinery are necessary for a company in order to survive and grow in the market, which is done through capital budgeting.
●Planning for future needs of funds
●Coordinating
Capital budgeting is done in order to achieve the maximum output through the available resources of a business.
●Cost control
Capital budgeting involves the comparison of budgeted expenditure and actual expenditure which helps in controlling the unnecessary expenditures.
●Capital budgeting improvises company's effectiveness

Process of capital budgeting investment 

  1. Screening and selection
  2. Capital budget proposal
  3. Budgeting approval and authorization
  4. Project tracking
  5. Post-completion audit

Factors influencing capital budgeting

  • Availability of funds
  • Future earnings
  • Compliance with statutory provisions
  • Risks involved
  • Urgency
  • Research and development
  • Obsolescence
  • Competitors activities
  • Integral factors (For example, Employee welfare schemes, safety measures,etc)

Importance of capital budgeting

1. Long term effects

Decision which are taken through capital budgeting are generally irreversible. The outcome of a wrong capital decision can cause heavy losses but on the very same hand an effective capital decision is always profitable in the long run for a company.

2. Risk and uncertainty

Capital budgeting decisions are based on 2 most important components which is investment and return. Uncertainty and risk are directly proportional to the period of project. Hence, a proper and calculated capital budgetinv decision helps to deal with risk and uncertainty in an effective manner.

3. Larger funds

While investing in large products huge amount of money is required and hence capital budgeting is given the most importance before taking the investment decision.

4. Corporate image

An effective or ineffective capital budgeting decision affects the image of a company in the market.

Difficulties in capital budgeting

  • Future uncertainty
  • Time element
  • Measurement problems (inaccurate estimates)

Moving on to our next heading

Cash flows

Cash flow is a dynamic process in which the money moves into or outto of a business.
Thus, significance of cash flow lies in the time element.
In simple language, cash flow refers to incoming and outgoing of the cash in any business.
A proper cash management is highly recommended in order to lead a profitable business.
Cash flows are of to type which is:
○Cash outflow (investment made) and
○Cash inflow (return on investment made)

Note:
Cash flows as profit
Cash flows of a company are completely different from profits of a company.
As cash flows means the incoming or outgoing of any kind of cash in a business but profit means the net income of a business which is calculated after deducting interests, taxes, depreciation and many other non cash items.

Components of cash flow

1. Initial investment

Which can be defined as, net taxes+net working capital

2. Operating cash inflows

The cash inflow across from the operations of a project in which a business has invested is known as operating cash inflows.

3. Terminal cash inflows

During the process of liquidation, at the end of project's economic life, the accrued cash inflow is known as terminal cash inflows.

Techniques of capital budgeting

1. Traditional/Non-discounting Cash Flow techniques or methods

  • Payback period
  • Accounting Rate of Return(ARR)

2. Time adjusted/Discounted Cash Flow techniques or methods

  • Net Present Value(NPV)
  • Internal Rate of Return(IRR)
  • Profitibality index(PI)

Payback period method

Number of years required to make the cumulative cash outflows equal to cumulative cash inflows for a project is its payback period.
In simple terms, payback period in investment recovery time duration.

Payback period = Intial outflow of the project / Annual cash inflow

Decision Rule

If computer payback period is less than standard target period, then project is favourable and vice versa.

Advantages

  • No expertize required
  • Liquidity indication
  • Indicates risk with time factor

Disadvantages

  • Overlooks cash inflows
  • Time value of money is not considered
  • Overlooks slavage value
  • Only focuses on initial investment's recovery

Accounting Rate of Return(ARR) method

ARR is also known as Return on Investment (ROI).
ARR=Avg profit(after tax)/Avg investment

Advantages

  • Easy calculation
  • Considers entire cashflows

Disadvantages

  • Overlooks time value of money
  • Use of only accounting data
  • Problem of comparability

Net Present Value (NPV) method

This method anticipated discounting (by applying suitable discount factors for each year) of the cash inflows(likely to accrue in future year) to get the present value.
The discounting rate in this method is also known as required return, cost of capital or opportunity cost.

Decision rule

NPV>0 Proposal can be accepted
NPV<0 Proposal can be rejected
NPV=0 Breakeven 

Advantages

  • Time value of money is recognised
  • Sound method of project appraisal

Disadvantages

  • Difficult to understand
  • May not be completely accurate

Internal Rate of Return (IRR)

IRR is defined as discount rate which equates cumulative present value of inflows to outflows a project.
It is also known as :
Yeild on investement
Marginal efficiency of capital
Marginal productivity of capital
Rate of returb
Time adjusted rate of return

Decision rule

IRR>K Proposal can be accepted
IRR<K Proposal can be rejected
IRR=K Break even

Advantages

  • Consideration of time value
  • Easy to understand
  • Indicates profitability or loss in a project

Disadvantages

  • Difficult calculation
  • Confusion in multiple rates

Profitability Index(PI) method

Also known as Benefit-cost ratio or Cost-benefit ratio.
This method basically assesses the profitability related to an investment proposal helpful in the purpose of comparison.
PI = Present value of cash inflows/Present value of cash outflows

Decision rule

PI>1 Proposal acception
PI<1 Proposal rejection
PI=0 Break even

Advantages

  • Conforms with objective of shareholders' wealth maximization
  • Considers time value of money

Disadvantages

  • Indept of long term projections needed
  • Determination of IR is not easy in it.

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