Accounting for capital Budgeting

Accounting for capital Budgeting

Introduction
The resource of a business firm is invested in current and fixed assets. Current assets are acquired for the smooth running of business whereas fixed assets are purchased for generating revenue. The profitability of a firm depends upon the productive capacity of the fixed assets. Furthermore, the decision of investing in fixed assets has far-reaching impact because it requires huge capital for long period. The failure of any project may lead the firm in the door or liquidation. Therefore, the cost, benefit and probable risk of the proposed project should be analyzed systematically before making the investment.

Concept and meaning of capital budgeting decision
Capital budgeting decision comprises of their words "capital", "budgeting" and "decision". Capital means the fund or resource available for investment. Budgeting is the numerical aspect of planning (i.e. thinking in advance the future source of action). Decision or decision making is the process of deciding whether alternative action is to be untaken or not. In this way, capital budgeting decision is the process under which difference investment alternative are evaluated and the best alternative is selected. In other words, capital budgeting decision is concerned with the long term investment decision i.e. making capital expenditure. The expenditure on fixed asset such as land and building, furniture and fixtures, plant and machinery vehicles etc. is called expenditure. The life of these fixed assets is more than one year. So capital budgeting decision is convened with long-term planning. Capital budgeting is also decision making for an investment which included the process of investment, evaluating, planning and financing major investment project of an organization.

"Capital budgeting is long-term planning for making financing proposed capital outlay." –C.T. Horngreen

"Capital budgeting is the decision making process by which evaluated the purchase of major fixed assets including building, machinery and equipment. It also covers decision to acquire other firms, either through the purchase of their common stock or groups of assets that can b conduct an ongoing business." John j. Hampton

"Capital budgeting is converted with the allocation of the firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future stream of earnings from a project, with immediate and subsequent stream of expenditure of it." G.C. Philipatos

"Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditures alternative." –L.J. Gitman

From the above definitions, it is clear capital budgeting is convened with the allocation of the firm's financial resources among the available investment alternatives. It is a part of long-term planning and comprises the evaluating and selection of investment project.

Need and importance of capital budget
Capital budgeting is the process of evaluating and selecting long-term investment that is consistent with the goal of the firm. The need importance of capital budgeting has been explained as follows:

Long-term implication: capital expenditure decision affects the company's future cost structures over a long term span. The investment in fixed assets increases the fixed cost of the firm which must be recovered from the benefit of the same project. If the investment turns out to be unsuccessful in future or given less profit than expected, the company will have to bear the extra budget of fixed costs. Such risk can be minimized through the systematic analysis of project which is the integer part of investment decision.

Irreversible decision: Capital investment decisions are not easily reversible without much financial loss to the firm because there may be not market for second-hand plant and equipment and their conversion to other uses may not be financially viable. Hence, capital investment decisions are to be carried out performed carefully and effectively in order to save the company from such financial loss. The investment decision which is undertaken carefully and effectively can save the firm from huge financial loss aroused due to the selection of unfavorable projects.

Long-term commitments of funds: capital budgeting decision involves the funds for the long-term. So it is a long-term investment decision. Long-term commitment of financial risk as much as possible.

Types of proposal
Capital project can be classified as followings:
Mutually exclusive project: the project, under which the selection of any project eliminates the possibility of selecting another project, is called mutually exclusive project. For example, if project A, B and C are mutually exclusive and suppose a firm selects project B. the selection project B means that projects A and C are automatically rejected. All replacement projects (replacement of existing project by purchasing new project) are mutually exclusive.
Mutually related (independent) projects: the project under which the selection of any project does not affect the possibility of selecting project is called mutually related or in depended projects. Independent project are evaluated on the basis of the cost and benefit of the related project rather than comparing with other projects.
New projects: the investment in a new alternative is called new project. The establishment of a new sugar factory is an example other project.
Replacement projects: The projects in which the existing assets are replaced by new assets are known are replacement projects. Generally, manual based and outdated projects are replaced by new and automatic assets. Such projects help to increase the efficiency and reduction cost. Te replacement of manual machine by the automatic machine is an example of replacement project.
Expansion project: when the capacity of existing project is expanded for the purpose of increasing the revenue generating capacity, such project is called expansion project. In other words, it refers to increase the present capacity of a project according to the demand of the project.
Diversification projects: diversification project are those project where investment is made is such alternative which is not identical with the existing project. Investing in pharmaceutical sector by a computer manufacture is an example of diversification project. The purpose of such project is to minimize the risk.


Capital budgeting processes
The extent to which the capital budgeting needs to be formalized and systematic procedures established depends on the size of the organization, number of projects to be considered; direct financial benefit of each project consider by itself; the completion of the firm's existing assets and management's desire to change that composition, timing of expenditures associated with the projects that are finally accepted.

Panning: the capital budgeting process with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm's fortunes is acceded and the ability of the management of the firm to exploit the opportunity is determined. Oopertuninties having little merit are rejected and promising opportunity is advanced in the form of a proposal to enter the evaluation phase.

Evaluation: this phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The techniques selected should be the one that enables to manger to make to best decision in the light of prevailing circumstances.

Selection: considering the returns and risks associated with the individual project as well as the cost of capital to the organization, the organization will choose among projects so as to maximize shareholders' wealth.

Implementation: when the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.

Control: the progress of the projects is monitored with the aid of feedback reports. These reports will include capital expenditures progress reports, performance reports comparing actual performance against pans set and post completion audits.

Review: when a project terminates, or even before, the organization should review the entire project to explain its successes or failure. This phase may have implication for firms planning and evaluation procedures. Further, the review may producer ideas for new proposals to be undertaken in the futures.
In brief, capital budgeting processes included:
Step I: estimation of initial investment
Step II: estimation of cash inflows
Step III: evaluation of projects
Step IV: selection of projects



Cash flow
It is an essential concept that plays an importance role in capital budgeting. It also plays a vital role to analyze and decide about the investment because it is impossible to do so without an estimation of cash flows. When a project is approved, it is necessary to invest huge amount of funds in different sectors like to purchase cost, installation cost, transaction cost, custom duties etc. sometimes, there is the possibility of increment in the working capital when an investment proposal is accepted. Such investments are known as outflow. The project is expected to provide the benefit every year after the fund is invested. Such benefit is known as cash inflow. Thus cash flow is a stream of inflows and outflows, cash inflow can be defined as the income or saving cost. It is also known as the current income as well as increasing income.


Procedures of cash flows estimation
Cash flow indicates a cash outflow and cash inflow. It is necessary to estimate the cash flow in the process of analysis investment proposal. While analyzing the cash flow, it is also necessary to estimate the cash outflow as well inflow. Estimation of the net cash flow sing a investment project should cover.

Step 1: determination of net investment or initials cash outlay or net cash outlay.
Initial investment or star-up costs are net cash outflow at present cost. It refers to the sum of all cash outflows and cash inflow occurring at zero time periods. Net investment refers to the amount which will be required for the accusation of fixed assets. Thus, initial investment of a new fixed assets or project comprises cost, freight, installation changes, custom duty etc.

Determination of net investment is replacement case is different than investment of new proposal. The following factors also effect on the determination of net investment of a replacement proposal.tje various factors are as follows:
Salvage value: salvage value means the value which is estimated to be realized on account of the sales of assets at the end of its useful life. To calculate the amount of depreciation, it is deducted from to cost of assets. It is also known as savage value, residual value etc.
i.    Book salvage value: remaining value of the fixed assets after charging depreciation is known as book salvage value. It can be determined as follows:
Book salvage value= cost of assets – accumulated depreciation
ii.    Cash salvage value is more than book salvage value but less than original cost: when company sells fixed assets more than book value less than original cost these more value is known as normal gain. In normal gain company has to pay tax.
iii.    Cash salvage value is more book salvage as well as original value: the difference between cash salvage value and original value of assets is known as capital gain and different between original value and book value is non as normal gain. It should be cleared as follows:
Normal gain = original value – book salvage value
Capital gain= cash salvage – original value

iv.    Cash salvage value is less than book salvage value: some times company sales fixed assets less than book salvage value. Company suffers from loss. In this situation, it can save the tax. In other words, when company faces loss, the taxes need not to be paid. As a result, the taxable amount comes to be surplus at a certain percentage.


Working capital: working capital may be defined as the funds required with in a business for supporting day to business activities. Working capital may increase in case of the new proposal. These increase working capital increase cash outflow. Sometimes working capital may decrease these decrease working capital increase cash inflow. In other worked reduction refers to the returning investment. It should be clear as follows:

Increase in working capital = cash outflow (-)
Decrease in working capital = cash inflow (+)

Investment tax credit: in order to encourage the industry sometimes government may provider facilities of tax credit. It reduces to initial cash outlay. There are many methods of determining the investment tax credit allowance, however, following method is considered more appropriate:
Investment tax credit = original cost of assets x ITC rate/ 100

Estimation of cash flows for replacement decision
Step 1: calculation of net cash outlay (NCO)
Step 2: calculation of annual differential depreciation
Step 3: calculation of annual difference CFAT
Step 4: calculation of difference CFST for final year:
Step 5: tabulation of cash flows:
Step 6: evaluation and decision
Evaluation techniques
Capital budgeting is making long-run planning decision for investment in project. Evaluation techniques of capital budgeting can be classified into two categories.
1.    Traditional methods
2.    Discounted cash flow method

Traditional methods
Traditional method does not consider the time value of money. It assumes that present value is equal of future value. Traditional method is also known as on discounted or unsophisticated method. There are two method of evaluation.
i.    Pay book period (PBP)
The payback period is the traditional method of evaluating investment proposals under capital budgeting? It is to simple ad perhaps that most widely employed quantitative method for appraising capital expenditure decision. It is also called payout or pay off period. It calculated the period of return back of investment. Payback period is the time period to remove the investment made in a project. Thus, PBP measure the number of years to pay back the original outlay from the cash inflows generated by an investment proposal. There are two way of calculating PBP.

Even cash flow: even cash flow is also known as equal amount of cash flow during the life period of project. The following formula is used to calculated PBP if cash flow is equal.
PBP= investment (cash outlay)/ constant annual cash flow ater tax (CFSAT)

Uneven cash flow: The amounts of cash flow are different is known as uneven cash flow. In such a situation, PBP is calculating by the process of accumulating cash flow still the time when cumulative cash flow becomes equal to the original investment outlay. The following formula is used to calculate BPB when cash flow is not equal:
PBP= minimum year + amount to be recovered investment/ CFAT of next year

Decision rules:
a.    If project are independent:
Accept: the project whose payback period is less than the life or standard payback period.
Reject: the project whose payback period is more that the life or standard payback period.
b.    If project are mutually exclusive:
Accept: the project with lowest payback period.
Reject: other project.
Advantages
i.    It is very simple and easy to understand and computer.
ii.    It is universally used and easy to understand.
iii.    It gives more importance on liquidity for making decision about the investment proposals.
iv.    It deals with risk. The project with a shortest payback period has less that with project with longest payback period.
v.    The short-term approach of payback pied is considered. Cash flow occurred after the payback period is not considered.
Disadvantages
i.    Time value of money is not recognized.
ii.    It gives high emphasis on liquidity and ignores profitability.
iii.    Only the cash flow before the payback period is considered. Cash flow occurred after the payback period is not considered.
Accounting rate of return (ARR)
ARR is also known as the average rate of return method. It is based upon accounting   information rather than on cash flow. In another words, ARR refers to the rate of earning or rate of next profit after tax on investment.

 ARR consider profitability rather than liquidity. Under ARR technique, the average annual expected book income is dividend by the average book investment in the project.
ARR= average net income/ average investment x 100

Advantages
i.    ARR is based on accounting information, therfore; other special reports are not required for determining ARR.
ii.    This method is also easy to calculate and simple to understand.
iii.    This method is based on accounting profit hence measure the profitability of investment.
Disadvantages
i.    ARR ignores the time value of money.
ii.    These methods ignore the cash flow from investment.
iii.    This method does not consider terminal value of the project.
Decision rules:
a.    Of project are independent:
Accept: the project which has higher ARR than standard
Reject: the project which has lower ARR than standard
b.    If projects are mutually exclusive:
Accept: the project which has higher ARR
Reject: other projects

Discounted cash flow method
Discounted cash flow method is based on the concept of the time value of money. It is more practicable concepts of decision making. The discounted cash flow method assumes that present value of any amount is not equal to footer value. The present value is much more worth future value. A rupee receiving after a year is not equivalent of a rupee received today because the use of money has a value. So before evaluating any project, first of all estimated cash flows must be converted into present value. To convert into present value from the future value is known as discount value. On the basis of discount value, it makes decision. So it is known as discount cash flow method.

The following methods are used under discounted cash flow method:
i.    Net present value
ii.    Profitability index
iii.    Internal rate of return

Net present value (NPV)
NPV is a discounted technique, which considers the time value of money. It consider different period ash flow value differ in their values. So, estimated cash flow must be converted into present value. It can be define as the difference between total present value and net cash outlay. It is determined as following:
Net present value = total present value – net cash outlay

Decision rules
a.    If project are independent:
Accept: the project with positive NPV.
Reject: the project with negative NPV.
b.    If project are mutually exclusive:
Accept: the project with higher NPV.
Reject: other project.
Advantages of NPV
i.    It gives important to the time value of money.
ii.    Both after cash flow and before cash flow over the life span of the project are considered.
iii.    Profitability and risk of the project given high priority.
iv.    If helps in maximizing the firm's value.
Disadvantages of NPV
i.    It is difficult to use.
ii.    It cannot give accurate decision if the amounts of investment of mutually exclusive project are not equal.
iii.    It is difficult to calculate the appropriate discount rate.
iv.    It also may not give correct decision when the projects are of unequal life.
Net present value when CFST is equal:
NPV= total present value – net cash outlay

Profitability index (PI)
The profitability index is known as benefit cost ratio. It is similar to the NPV approach. The profitability index approach measure the present value of return per rupee invested, while the NPV is based on the difference between the present value of future cash inflow and present value of cash outlay. It is calculate by dividend it present value of future cash inflow by present value of cash outlay:
PI = TPV/NCO

Decision rules:
a.    If project are independent:
Accept: the project when PI is higher than one.
Reject: the project when PI is less than one.
b.    If project are mutually exclusive:
Accept: the project which has higher PI.
Reject: other projects

Advantages of profitability index
i.    It considered the time value of money
ii.    It considered analysis all cash flows of entire life.
iii.    It makes the right in the case of different amount of net cash outlay of different project.
iv.    It ascertains the exact rate of return of the project earns.
Disadvantages of profitability index
i.    It is difficult to understand interest rate of discount rate
ii.    It is difficult to calculate profitability index if two project having different uses lives.

Internal rate of return (IRR)
The IRR is used when the cost of the investment and the annual cash flow are known and the unknown rate of earning is to be determined. The IRR is described as that rate which equates the present value of the future cash flows with the cost of the investment which produce them IRR technique is also known as yield- on investment margin efficiency of capital, time adjusted rate of return, yield on investment, marginal efficiency of capital marginal productivity of capital, rate of return and so on.

The IRR is the discounted rate that equals the aggregate present value of CFAT with the aggregate present value of cash outflows required for a new investment. The project will be accepted only if IRR is higher than cost of capital.

The following steps are taken in determining IRR for an annuity:
i.    Determine PBP of the proposed investment.
ii.    In table a-2, (present value of an annuity) look for the year i.e. equal to or closet of the life of the project.
iii.    In the year row, find to PV value or discount factor closet to PBP period one bigger and other smaller than it.

 Advantages of IRR
i.    IRR method also considers the time value of money.
ii.    Discloses the maximum rate the project can give.
iii.    Considers and analyses all cash flows of entire project.
iv.    Ascertains the exact rate of return the project earns.

Disadvantages of IRR
i.    Difficult to understand, complicates due to trial and error method.
ii.    The important drawback of IRR is that it recognizes the cash inflows generated by project is reinvested to internal rate of project, but NPV recognizes such cash inflow are reinvested to cost of reinvest  to internal rate of project, but NPV recognizes such cash inflow are reinvest to cost of capital of the organization.
iii.    Single discount rate ignores the varying future interpret rate.

Decision rules:
a.    If project are independent:
Accept: the project which has higher IRR than cost of capital
Reject: the project which has lower IRR cost of capital
b.    If project are mutually exclusive:
Accept: the project which has higher IRR.
Reject: other projects



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