Capital Budgeting

Sandeep Goel

• Publisher: Business Expert Press
• Year: 2015
• ISBN:
  9781606499870
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Capital budgeting is an important part of the financial management of a business organization. It is a process that business houses use to evaluate an investment proj-ect. The decision of whether to accept or deny an investment project is capital budgeting decision. Capital budgeting is important because it determines the long-term economic and nancial pro tability of any investment project. It lays down the future success of a business. Capital Budgeting aims to develop not only an understanding of the concepts of capital budgeting but also to provide its practical application to help students learn both theory and practice of capital budgeting used in the financial management of a business organization. It analyzes the capital budgeting practices of corporate enterprises in India in diverse sectors, on comparative basis, in order to provide the reader a better insight into the various issues and challenges regarding capital budgeting management.

SECTION 1

Introduction

CHAPTER 1

Nature of Financial Management

The Present Chapter

It discusses the concept of financial management, its scope with its importance and objectives. There is an overview of the various financial problems faced by business enterprises as well.

Introduction

Almost everything in life eventually boils down to the rupee sign, so the adage goes. Money, and therefore, finance, is an integral part of life.¹ Business is no exception to it. It needs to have an efficient financial management not only in totality but also in segmental performance. Hence, growth of every business enterprise is closely linked with efficient management of its finance.

Meaning of Financial Management

Financial management refers to the process of raising and allocation of funds. It is the sum total of planning, organizing, directing, and controlling the financial activities of the enterprise.

Elements

   1.   Investment decision: It refers to the allocation of funds in various assets. The investment in fixed assets is called as “capital budgeting decision.” The investment in current assets is called as “working capital decision.”

   2.   Financing decision: It involves funds’ raising from various sources based on various factors, like the cost of funds, time- period, flexibility, and so on. It is about determining the “financial structure” of an enterprise.

   3.   Dividend decision: It is the decision about distribution of net profit. The finance manager decides how much quantum of profits to be distributed as dividend to shareholders and how much to be retained for future contingencies.

Objectives of Financial Management

The main objectives of financial management are:

   1.   Profit maximization: It is considered to be the primary objective of financial management. Every business enterprise aims to earn maximum profit, both short-term and long- term.

   2.   Wealth maximization: Wealth maximization (shareholders’ value maximization) is the key objective of financial management which is preferred over profit maximization on account of shareholders’ value creation, particularly in case of a listed company. Wealth maximization implies both regular returns to shareholders in the form of dividend and increase in the market value of the shares by high performance of the company.

   3.   Liquidity: Cash is the king for any organization. Maintaining sound liquidity is one of the most important objectives of financial management. The firm must have a sound cash position for day-to-day expenses, like paying salaries, rent, electricity bills, etc. If the firm does not have enough liquidity, the survival of the firm is always under threat.

   4.   Solvency: Long-term soundness is the most important objective of financial management. The company must be solvent to pay interest and repay loans at regular intervals; only then the company will survive in the competitive world.

Functions of Financial Management

Following are the main functions of financial management:

   1.   Estimation of financial requirements: Proper estimation of financial requirements is a very important function of financial management. The finance manager must find out how much finance is required for the operations of the company, according to the fixed capital and working capital requirements.

   2.   Proper mobilization of funds: Mobilization (collection) of funds is another important function of financial management. After estimating the financial requirements, the finance manager must decide on the sources of finance. The finance can be raised from various sources such as shares, debentures, bank loans, and so on. There must be a proper balance between owned funds and borrowed funds.

   3.   Efficient utilization of finance: Once the funds are raised, the next task of finance manager is to utilize them efficiently. Long-term funds should be invested in fixed assets and short-term funds should be used for current assets. The company’s funds should not be invested in the unprofitable projects.

   4.   Distribution of profits: The distribution of net profit has to be decided by the finance manager. He has to decide between dividend and reinvestment of earnings, keeping in view the requirements of shareholders and expansion and diversification plans of the company.

   5.   Cash management: Finance manager also has to decide about the cash required for various requirements of the firm. Cash is required for many purposes like payment of wages and salaries, bills, meeting current liabilities, and so on.

   6.   Financial control: Maintaining financial controls is a very important function of a finance manager. This is exercised with the help of techniques like ratio analysis, budgetary control, cost analysis, and so on.

Financial Management for Businesses in India

Gone are the days when there used to be a single manager who would manage the entire operations of a business. With multinationals around, the finance function has become much more specialized and complex. There are specialists who look after specialized categories of operations.

Since liberalization in 1991, the face of Indian corporate has changed tremendously. Finance is the essence of management of any business. It is in this context financial management for businesses in India is seen. Today every company has specialist set of people shouldering the responsibility of finance manager in their organization. Different connotations are used for finance manager by different companies, viz. Director-Finance, President-Finance, Chief Finance Officer, Financial Controller, and so on.

Today’s finance manager does not perform the routine function of raising and disbursement of funds anymore. He has to do multitasking for the overall growth of the business. He has to safeguard the financial assets of the company, plan the business operations in a way so that there is a positive cash flow. In his day-to-day responsibilities, he has to look at the audit reports, and final accounts for analyzing the performance of the company.

Financial management is a process that is associated with both planning and control. As planning, it involves procuring and allocation of available funds in a most profitable manner. Control on the other hand refers to keeping an eye on the cash flow. A finance manager is thus responsible for the total management of funds in an enterprise. In nutshell, financial management for businesses has become very scientific in India with the latest techniques of management around.

In any organization, finance manager has to use the available resources in the most efficient manner so as to generate maximum profits for the company and keep shareholders happy. This leads to realization of the ultimate organizational objective of shareholders’ wealth maximization.

In conclusion, financial management has changed with the changing times and become very scientific for efficient management of business organizations with the latest principles and practices of management being followed.

Financial Management Problems & Solutions

The problems relating to the financial management faced by corporate enterprises and their possible solutions may be reiterated below:

   1.   The enterprises sometimes due to poor planning, fail to identify and maintain the desirable combination of sources of funds. They face the problem of shortage of equity and depend too much on the borrowed capital. Hence, there is a necessity of proper financial planning to make the financial structure optimal.

   2.   Likewise, the enterprises also maintain an inappropriate combination of assets. This results in the problem of either underinvestment or overinvestment in fixed assets on one hand and current assets, particularly in inventories and receivables, on the other hand. In such condition, the inventories and receivables are to be checked by way of adopting the appropriate inventory controlling techniques and altering credit and collection policies suitably. There should be a more efficient utilization of assets.

   3.   The enterprises fail in making proper future projection of revenues and costs which result in improper investment in inventories receivables, and additional plant capacity, and so on. All these factors ultimately account for poor earnings of the enterprises.

Hence, there is a need for a sound profit planning for ensuring better utilization of resources and enhanced earnings.

   4.   The enterprises lack a definite and stable dividend policy. No adequate balance is maintained between payment of dividends and retention of earnings. There should be more regularity and consistency in payment of dividends in proportion to their equity capital.

   5.   The enterprises should be managed by only professionally competent, qualified, and experienced personnel based on the practice of participative management and supported by an efficient information system.

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¹Douglas R. Emery, et al., Principles of Financial Management. (New Jersey: Prentice Hall, 1998), 2.

SECTION 2

Capital Budgeting Decision & Appraisal

CHAPTER 2

Capital Budgeting: Nature & Scope

The Present Chapter

It discusses the concept of capital budgeting, its process, techniques, and risk analysis of capital investment decisions by the business units.

Introduction

Capital budgeting decision relates to decision of investment in long-term projects. Capital budgeting is often used interchangeably with capital expenditure or capital investment. Any expenditure that generates a cash flow benefit for more than one year, it is a capital expenditure. For example, the purchase of new equipment, expansion of production capacity, buying another company, research & development, and so on. Capital budgeting involves large cash outlays for generating future return of the company. Once, a capital budgeting decision is committed, it is often difficult to reverse. Therefore, we need to carefully analyze and evaluate proposed capital budgeting decisions.

“Capital Budgeting is long-term planning for making and financing proposed capital outlays.”

—Charles T. Horngnen

“Capital budgeting is concerned with the firm’s formal process for the acquisition and investment of capital.”

—Hamption, John. J.

In a capital investment decision, the major criterion f...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Contents
• Preface
• Section 1 Introduction
• Section 2 Capital Budgeting Decision & Appraisal
• Section 3 Capital Budgeting Management
• Section 4 Financing Decision
• Section 5 International Perspective
• Section 6 Case Studies
• Key Terms
• Review Questions
• Test Yourself —Problems & Solutions
• References
• Index