CAPTIAL & CAPTIAL BUDGETING Types & Sources - JNTU MEFA Notes - JNTU Meterial

CAPTIAL & CAPTIAL BUDGETING

Types & Sources

Capital:

Wealth, which is created over a period of time to spend it.

(Or)

Total amount of finances by the business to conduct its business operations both in Long-run & Short-run.

Need For Capital:

• To promote a business.
• To pay taxes.
• To replace the assets.
• To support welfare programmers: Literary, health, camps, donates charitable trusts, Educational institutions: Public Sector.
• To wind up.

Types of Capitals:

• Fixed Capital
• Working Capital

Fixed Capital:

• It is used in acquiring Long-term assets such as

• Land & Buildings,
• Plant & Machinery,
• Furniture & Fixtures & so on.

• Fixed capital forms the skeleton of business.
• It provides the basic assets as per the business needs.
• These assets are not meant for resale.
• They are intended to generate revenues.

Features of Fixed Assets:

• Permanent in Nature.
• Profit Generation.
• Low liquidity – Fixed assets cannot be converted into cash quickly.
• Nature of Business.
• Methods of Production etc.

• Utilized for Promotion & Expansion-Business.

Types of Fixed Capital:

• Tangible Fixed Assets: These can be seen and touched

• Ex: Land, Buildings, Machinery, Motor Vehicles, Furniture etc.

• Intangible Fixed Assets: They don’t have physical form, Can’t be seen & touched.

• Ex: Goodwill, Brand names, Trademarks, Patents, Copyrights, so on.

• Financial Fixed Assets: These can be inverted in shares, foreign currency deposits, Government Bonds.

Working Capital:

• Working capital is the flash & blood of the business.
• It makes a company to work.

Features of working Capital:

• Short life span- Cash, Stock, Debtors.
• Smooth flow of operations.
• Liquidity- Cash.
• Amount of working capital: Depends size, nature of business.
• Utilized for payment of current expenses.

Ex:

• Wages,
• Salaries,
• Rent &
• Other Expenses.

Components of Working Capital: Current Assets-Current Liability.

Ex:

• Current Assets: Cash, Stocks, Debtors, Prepaid expenses & Bills receivable.
• Current Liabilities: Creditors, Bills Payable.

Working Capital Cycle:

Methods of Sources of Finance:

• Long-term Finance (3 Years & above).

Ex:

• Lands & Buildings.
• Plant & Machinery.

• Medium-term Finance (1 Year & below 3 Years).

Ex:

• Interest,
• Bank & Hire Purchase Installment,
• TV, Motor Cycle etc.

• Short-term finance (Less than 1 year).

Ex:

• Bank over credit,
• Trade credit,
• Advance from customers.

CAPITAL BUDGETING

Capital Budgeting:

“According to ‘Charles T Horngren’, the Long-term planning to make and finance proposed capital outlays”.

Capital budgeting decisions:

1. Construction of new building or renovation of existing old building.
2. Purchasing of technology from a foreign country.
3. Building a production facility.
4. To buy a new track.
5. Sponsoring a local football or cricket team.
6. Building a bridge.
7. Buying an airline.
8. Making a new product (Producing a new product).
9. Starting a new business.
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10. Expansion of Plant & Machinery equipments.
11. Advertising the company products.
12. Labor agreements.

Why is Capital Budgeting necessary?

1. Projects that reduce the costs.
2. Projects that Increase the revenues (income).

Estimation of cash inflows & outflows:

• Cash inflows = Cash receipts.
• Cash outflows = Cash going out of business.
• It may be calculated for a particular project (or) for the whole business for one year (or) series of years.

Ex:

Problem: Suppose an asset costing Rs.25, 000 has 5 years of life and is expected to yield Rs.20, 000; 30,000; 35,000; 30,000; 25,000. Its operating cash expenses are 40% of the estimated revenues of each year. The asset is subjected to 30% of income tax. The company is subjected to 30% of income tax. Estimate the cash inflows for 1 to 5 years.

Solution:

Depreciation = 25,000/5 = 5,000/-

Year	Cash Revenue	Cash expenses 40% of receipts	Cash outflow before taxes	Depreciation 20%	Taxable income	Taxes 30%	Cash flow after taxes	Cash inflows
a	b	C	d = (b-c)	e	f = (d-e)	g	h = (f-g)	I = (h+e)
1	20,000	8,000	12,000	5,000	7,000	2,100	4,900	9,900
2	30,000	12,000	18,000	5,000	13,000	3,900	9,700	14,700
3	35,000	14,000	21,000	5,000	16,000	6,400	9,600	14,600
4	30,000	12,000	18,000	5,000	13,000	3,900	9,700	14,700
5	25,000	10,000	15,000	5,000	10,000	3,000	7,000	12,000

Long term investments proposals involve large cash outlays while evaluating capital budgeting proposals, the following steps are considered:

• Generating investment proposals.
• Estimating cash flows for the proposals.
• Evaluating cash flows.
• Selection of projects.
• Monitoring & re-evaluating, on a continuous basis the investment projects, once they are accepted.

Kinds of Capital budgeting decisions:

• Replacement = to replace worn out or obsolete fixed assets.
• Expansion = to add capacity to existing product.
• Research & Development = where technology is rapidly changing, large sums need to be spent on research & development for investing on new products.
• Diversification = to reduce the risk of failure by operating in more than one market.
• Others = miscellaneous proposals.

Methods of Capital Budgeting:

These can be classified as follows,

• Traditional methods:

• Payback Period.
• Accounting rate of return method (A.R.R.).

• Discounted cash flow methods:

• Internal rate of return method (I.R.R.).
• Net present value method (N.V.P.).

Payback Method:

• Under this method, the decision to accept or reject a proposal is based on its payback period. It means the original cost is recovered.
• It is calculated by:

Payback Period = (cost of the project)/ (annual cash inflows)

• The shorter is the payback period. The better is the project in terms of paying back the original investment.
• The companies favor this method. The earlier the original investment is recovered.

Problem 1:

The cost of project is 50,000/- , the annual cash inflows for the next 4 years are 25,000/-. What is the payback period for the project?

Solution:

Payback Period = (cost of the project)/ (annual cash inflows)

=50,000/25,000

=2 Years.

Problem 2:

The cost of a project is 50,000/-, which has an expected life of 5 years. The cash inflows for next 5 years are 24,000; 26,000; 20,000; 17,000; 16,000/-. Determine payback period, cash inflows& cumulative cash inflows for the project?

Solution:

Year	Cash inflows (Rs)	Cumulative Cash inflows (Rs)
1 2 3 4 5	24,000 26,000 20,000 17,000 16,000	24,000 50,000 70,000 87,000 1,03,000

• Note: The original investment can be recovered by the end of second year is pay back period.

Advantages:

• Easy to calculate & understand.
• Liquidity is emphasized.
• Reliable technique in volatile business.

Disadvantages:

• Post-payback earnings ignored:
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This method ignores earnings after the payback period.

It ignores the total life of the project & total profitability of investment.

• Emphasized (by choosing only cash inflows) liquidity is over-emphasized.
• Timing of cash flows ignored. This method does not consider the timing of cash flows. All the cash flows are given equal weight age.

Accounting rate of return (ARR) Method:

Problem 1: ARR:-

A firm is considering two projects each with an initial investment of 20,000/- & a life of 4 years. The following is the list of estimated cash inflows after taxes.

YEAR	PROPASAL 1	PROPOSAL 2	PROPOSAL 3
1	12,500	11,750	13,500
2	12,500	12,250	12,500
3	12,500	12,500	12,250
4	12,500	13,500	11,750
Total	50,000	50,000	50,000

Determine ARR on:

• Average capital.
• Original capital employed.

Solution:

• ARR on Average Capital:

• On Original Investment:

Proposal 1	Proposal 2	Proposal 3
(12,500/10,000)*100= 125%	(12,500/10,000)*100= 125%	(12,500/10,000)*100= 125%

Proposal 1	Proposal 2	Proposal 3
(12,500/2000)*100=62.5%	(12,500/2000)*100=62.5%	(12,500/2000)*100=62.5%

ARR gives equal priority to all the proposals through the t imings of the cash flows is different.