Financial Management

Capital Budgeting Decision / Capital Investment Management

• Purpose, Distinguishing features, Objectives & Process, Understanding different types of

projects
• Concept of Cash flow; Cash flow vis-à-vis Profit and determination of Cash flow
• Techniques of Decision making: Non-discounted and Discounted Cash flow Approaches
• Payback Period method, Accounting Rate of Return and their relative merits and demerits
 Financial Management- Capital Budgeting Decision
Capital Budgeting is the process of making investment decision in fixed assets or capital expenditure.
Capital Budgeting is also known as investment, decision making, planning of capital acquisition,
planning and analysis of capital expenditure etc.
Purpose:
1. To find out the profitable capital expenditure.
2. To know whether the replacement of any existing fixed assets gives more return than earlier.
3. To decide whether a specified project is to be selected or not.
4. To find out the quantum of finance required for the capital expenditure.
5. To assess the various sources of finance for capital expenditure.
6. To evaluate the merits of each proposal to decide which project is best.

Distinguishing features:
1. Capital budgeting involves the investment of funds currently for getting benefits in the future.
2. Generally, the future benefits are spread over several years.
3. The long term investment is fixed.
4. The investments made in the project is determining the financial condition of business
organization in future.
5. Each project involves huge amount of funds.
6. Capital expenditure decisions are irreversible.
7. The profitability of the business concern is based on the quantum of investments made in the
project.
 Financial Management- Capital Budgeting Decision
Objectives :
1. Investment decisions affecting revenue
2. Investment decisions reducing costs
3. Determine Product Scope
4. Determine Funding Sources
5. Determine Payback Method
6. Control Project Costs
7. Ongoing Projects
8. Shareholder’s wealth maximization:
9. Evaluation of proposed capital expenditure:
10. Controlling costs:
11. Determining priority:

Process:
A) Project identification and generation:
B) Project Screening and Evaluation:
C) Project Selection:
D) Implementation:
E) Performance review:
 Financial Management- Capital Budgeting Decision
FACTORS AFFECTING CAPITAL BUDGETING:
1. Availability of Funds 7. Accounting methods
2. Working Capital 8. Government policy
3. Structure of Capital 9. Taxation policy
4. Capital Return 10. Earnings
5. Management decisions 11. Lending terms of financial institutions
6. Need of the project 12. Economic value of the project

CAPITAL BUDGETING DECISIONS:

A) Accept / Reject decision
B) Mutually exclusive project decision
C) Capital rationing decision
 Financial Management
Understanding different types of projects:
a) By project size : Small projects and large project.
b) By type of benefit to the firm :
· an increase in cash flow
· a decrease in risk
· an indirect benefit (showers for workers, etc).
c) By degree of dependence :
· mutually exclusive projects (can execute project A or B, but not both)
· complementary projects: taking project A increases the cash flow of project B.
· substitute projects: taking project A decreases the cash flow of project B.
d) By degree of statistical dependence :
· Positive dependence
· Negative dependence
· Statistical independence.
e) By type of cash flow :
· Conventional cash flow: only one change in the cash flow sign e.g. -/++++ or +/----, etc
· Non-conventional cash flows: more than one change in the cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.
 Financial Management
Concept of Cash flow:
Cash Flow (CF) is the increase or decrease in the amount of money a business,
institution, or individual has. In finance, the term is used to describe the amount of cash
(currency) that is generated or consumed in a given time period. There are many types of CF,
with various important uses for running a business

Types of Cash Flow

There are several types of Cash Flow, so it’s important to have a solid understanding of what
each of them is. When someone refers to CF, they could mean any of the types listed below, so
be sure to clarify which cash flow term is being used.
Types of cash flow include:
Cash from Operating Activities – Cash that is generated by a company’s core business activities
– does not include CF from investing. This is found on the company’s Statement of Cash Flows
(the first section).
Free Cash Flow to Equity (FCFE) – FCFE represents the cash that’s available after reinvestment
back into the business (capital expenditures). Read more about FCFE.
Free Cash Flow to the Firm (FCFF) – This is a measure that assumes a company has no leverage
(debt). It is used in financial modelling and valuation. Read more about FCFF.
Net Change in Cash – The change in the amount of cash flow from one accounting period to the
next. This is found at the bottom of the Cash Flow Statement.
 Financial Management
Uses of Cash Flow
Cash Flow has many uses in both operating a business and in performing financial analysis. In
fact, it’s one of the most important metrics in all of finance and accounting.
The most common cash metrics and uses of CF are the following:
Net Present Value – calculating the value of a business by building a DCF Model and calculating
the net present value (NPV)
Internal Rate of Return – determining the IRR an investor achieves for making an investment
Liquidity – assessing how well a company can meet its short-term financial obligations
Cash Flow Yield – measuring how much cash a business generates per share, relative to its share
price, expressed as a percentage
Cash Flow Per Share (CFPS) – cash from operating activities divided by the number of shares
outstanding
P/CF Ratio – the price of a stock divided by the CFPS (see above), sometimes used as an
alternative to the Price-Earnings, or P/E, ratio
Cash Conversion Ratio – the amount of time between when a business pays for its inventory
(cost of goods sold) and receives payment from its customers is the cash conversion ratio
Funding Gap – a measure of the shortfall a company has to overcome (how much more cash it
needs)
Dividend Payments – CF can be used to fund dividend payments to investors
Capital Expenditures – CF can also be used to fund reinvestment and growth in the business
 Financial Management
Nature of CF:
1. Positive cash flow indicates that a company is adding to its cash reserves, allowing it to
reinvest in the company, pay out money to shareholders, or settle future debt payments.
2. Cash flow comes in three forms: operating, investing, and financing.
3. Operating cash flow includes all cash generated by a company's main business activities.
4. Investing cash flow includes all purchases of capital assets and investments in other business
ventures.
5. Financing cash flow includes all proceeds gained from issuing debt and equity as well as
payments made by the company.
6. Free cash flow, a measure commonly used by analysts to assess a company's profitability,
represents the cash a company generates after accounting for cash outflows to support
operations and maintain its capital assets.
 Financial Management
Cash flow vis-à-vis Profit:
“Cash flow is the difference between actual cash received and actual cash used in the process of doing
business (from core operations). Each day, month, quarter, and year, a company receives a certain amount
of cash and pays out a certain amount of cash. It’s that simple. Analysts look at cash flow carefully because
it’s a very real measure of how a company is doing (whether it will be able to pay its bills tomorrow or next
week or next month).
Profit, on the other hand, is revenue from the sale of services and products — whether
payment in the form of cash has been received yet or not — minus all expenses (expenses paid in cash,
expenses to be paid in cash at a later date, and expenses accounted for in other ways).
While you could say that the profit isn’t 'real' because the cash hasn’t moved in and out of the
company, it’s still important to know whether a company is earning income — or making more than it’s
spending — from its daily operations over a period of time. If we didn’t calculate profit (or income) this
way, a company could appear to not earn any income one month, be hugely profitable the next, and so on,
depending on when its bills are due and when its customers pay their debts. But that wouldn’t be a very
good indicator of how consistently it’s earning income from its core operations, would it? Even if its
financial performance was steady overall, it might seem erratic if we didn’t follow this type of accounting
system, which is called accrual-basis accounting.
An easy way to think of accrual-basis accounting is that it tracks transactions. Sales, expenses,
and profits are recorded when the transaction is made. Apple records the sale of a computer when the
customer picks it up at the store and the expense for making the computer at the same time, even if the
customer arranges to pay for it over several months and the cost of putting the computer together was
paid a few months before the sale was ever made. Small companies may use cash-based accounting, in
which you record a sale when cash is received and expenses when they are paid.”
 Financial Management
Determination of Cash flow: Cash flow formula:
Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital
Expenditure
Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital
Cash Flow Forecast = Beginning Cash + Projected Inflows – Projected Outflows = Ending Cash
1. Free cash flow formula
One of the most common and important cash flow formulas is free cash flow (or FCF).
While a traditional cash flow statement gives you a picture of your business’ cash at a given
time, that doesn’t always help with planning and budgeting—because it doesn’t truly reflect the cash you
have available, or free to use.
Can you afford to invest in that new software? Do you have enough cash on hand to pay for that
virtual assistant when their invoice comes due? How much cash do you have free to spend on thank you
cards for your clients?
Calculating the cash you have available to spend (via the FCF formula) helps answer those
questions and others like them.
How to calculate free cash flow
Calculating your business’ free cash flow is actually easier than you might think. To start, company income
statement or balance sheet available to pull key financial numbers from.
Net income: The total income left over after you’ve deduced your business expenses from total revenue or
sales. You’ll find this on your Income Statement.
Depreciation/Amortization: Many of your business assets (like equipment) lose value over time.
Depreciation is the measurement of how that value decreases. Amortization, on the other hand, is a
method of breaking down the initial cost of an asset over its lifetime. You’ll find depreciation and
amortization on your Income Statement.
 Financial Management
Working Capital: Working capital is the difference between your assets and liabilities and represents the
capital used in the day-to-day operation of your business. You can calculate your working capital using the
total assets and liabilities on your Balance Sheet.
Capital Expenditure: Capital expenditures include money your business spends on fixed assets, like land,
real estate, or equipment. You can find your capital expenditure on the Statement of Cash Flows.
With that knowledge in hand, the basic formula for free cash flow looks like this:
Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital
Expenditure
Let’s take a look at an example of that formula in the real world. Randi’s a freelance graphic designer—she
needs to calculate her free cash flow to see if hiring a virtual assistant (for 10 hours a month) to handle
client admin tasks is financially feasible.
Her financials for the year look like this:
Net income = Rs.80,000
Depreciation/Amortization = Rs.0
Change in Working Capital = – Rs.10,000
Capital Expenditure = Rs.2,500 (Randi bought a new iMac last year)
So Randi’s free cash flow is represented by:
[Rs.80,000] + [Rs.0] – [Rs.10,000] – [Rs.2,500] = Rs.67,500
That means she has Rs.67,500 in available cash to reinvest back into her business.
Looking for more details on Free Cash Flow formula?
2. Operating cash flow formula
While free cash flow gives you a good idea of the cash available to reinvest in the business, it doesn’t always
show the most accurate picture of your normal, everyday cash flow. That’s because the FCF formula doesn’t
account for irregular spending, earning, or investments. If you sell off a large asset, your free cash flow
would go way up—but that doesn’t reflect typical cash flow for your business.
 Financial Management
When you need a better idea of typical cash flow for your business, you want to use the operating cash flow
(OCF) formula.
For example, if you’re looking to secure outside funding from a bank or venture capital firm,
they’re more likely to be interested in your operating cash flow. The same goes if you begin working with an
accountant or financial consultant — so it’s important to understand what OCF looks like for you before
seeking funding.
How to calculate operating cash flow:
Just as with our free cash flow calculation above, you’ll want to have your balance sheet and income
statement at the ready, so you can pull the numbers involved in the operating cash flow formula.
There’s one other financial metric you’ll need to know for this calculation.
Operating Income: Also called Earnings Before Interest and Taxes (or EBIT) and profit, your operating
income subtracts operating expenses (like wages paid and cost of goods sold) from total revenue. You can
find operating income on your Income Statement.
The basic OCF formula is:
Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital
To apply the OCF formula to our previous example (Randi, our favorite freelance graphic
designer), let’s say her financials for the year look like this:
Operating Income = Rs.85,000
Depreciation = Rs.0
Taxes = Rs.9,000
Change in Working Capital = – Rs.10,000
Randi’s operating cash flow formula is represented by:
[Rs.85,000] + [Rs.0] – [Rs.9,000] + [-Rs.10,000] = Rs.66,000
That means, in a typical year, Randi generates Rs.66,000 in positive cash flow from her typical operating
activities.
 Financial Management
Techniques of Decision making: Non-discounted and Discounted Cash flow Approaches
 Financial Management
Payback Period method
The payback period (PBP) is the amount of time that is expected before an investment will be returned in
the form of income. When comparing two or more investments, business managers and investors will
typically compare the projects to see which one has the shorter PBP. Projects with longer PBP are usually
associated with higher risk.

Merits : Demerits:
1. It Is a Simple Process. 1. Only Focuses on Payback Period.
2. Fewer Numbers to Crunch. 2. Short-Term Focused Budgets.
3. Can Help Small Businesses. 3. It Doesn’t Look at the Time Value of Investments.
4. Reinvest Earnings Faster. 4. Time Value of Money Is Ignored.
5. Can Tip the Scales for a Difficult Decision. 5. Payback Period Is Not Realistic as the Only
6. Keeps Financial Liquidity. Measurement.
7. Can Prevent Major Losses. 6. Doesn’t Look at Overall Profit.
8. Manage Multiple Options. 7. Only Short-Term Cash Flow Is Considered.
9. Short-Term and Long-Term Opportunities. 8. Too Simple for Most Investments.
9. Investments Are Not Assessed Properly.
 Financial Management
Accounting Rate of Return :
Accounting rate of return (ARR) is also known as average rate of return. ARR is based upon accounting
information rather than on cash flow. In other words, Accounting rate of return (ARR) refers to the rate of
earning or rate of net profit after tax on investment.
ARR consider profitability rather than liquidity. Under ARR technique, the average annual expected book
income is divided by the average book investment in the project.
ARR = (Average net income/Average investment) x 100 Where,
Average net income= Total net income/No. of years
Average investment= Net investment/2
Calculation Of Accounting Rate Of Return (ARR)
Illustration: The initial investment of the project is $30,000. The net profit after tax is as follows:
Year............................Net profit after tax($)
1....................................25000
2....................................30000
3.....................................20000
4......................................25000
5......................................40000
Required: Accounting rate of return.
Solution
Calculation of ARR: ARR = (Average net income/Average investment) x 100
= (28000/15000) x 100 = 18.67%.
Where, Average net income = Total net income/No, of years = 25000+30000+20000+25000+40000/5
= 28000 Average Investment = Net investment/2 = 30000/2 = 15000
 Financial Management
Decision Rules Of Accounting Rate Of Return (ARR)
A. If projects 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 highest ARR
Reject other projects.

Merits :
1. It is very easy to calculate and simple to understand like pay back period. It considers the
total profits or savings over the entire period of economic life of the project.
2. This method recognizes the concept of net earnings i.e. earnings after tax and depreciation.
This is a vital factor in the appraisal of a investment proposal.
3. This method facilitates the comparison of new product project with that of cost reducing
project or other projects of competitive nature.
4. This method gives a clear picture of the profitability of a project.
5. This method alone considers the accounting concept of profit for calculating rate of return.
Moreover, the accounting profit can be readily calculated from the accounting records.
6. This method satisfies the interest of the owners since they are much interested in return on
investment.
7. This method is useful to measure current performance of the firm.
 Financial Management
Demerits:
1. The results are different if one calculates ROI and others calculate ARR. It creates problem in
making decisions.
2. This method ignores time factor. The primary weakness of the average return method of
selecting alternative uses of funds is that the time value of funds is ignored.
3. A fair rate of return can not be determined on the basis of ARR. It is the discretion of the
management.
4. This method does not consider the external factors which are also affecting the profitability
of the project.
5. It does not taken into the consideration of cash inflows which are more important than the
accounting profits.
6. It ignores the period in which the profits are earned as a 20% rate of return in 10 years may
be considered to be better than 18% rate of return for 6 years. This is not proper because
longer the term of the project, greater is the risk involved.
7. This method cannot be applied in a situation when investment in a project to be made in
parts.
8. This method does not consider the life period of the various investments. But average
earnings is calculated by taking life period of the investment. As a result, average investment or
initial investment may remain the same whether investment has a life period of 4 years or 6
years.
9. It is not useful to evaluate the projects where investment is made in two or more instalments
at different times.