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INTRODUCTION:
For effective running of a business, management must know: where it intends to go , i.e. organizational objectives how it intends to accomplish its objective, i.e. plans overall

whether individual plans fit in the organizational objective. i.e. coordination

whether operations conform to the plan of operations relating to that period i.e. control Budgetary control is the device that a company uses for all these purposes.
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Introduction

A beer company is considering building a new brewery. An airline is deciding whether to add flights to its schedule. An engineer at a high-tech company has designed a new microchip and hopes to encourage the company to manufacture and sell it. A small college contemplates buying a new photocopy machine. A nonprofit museum is toying with the idea of installing an education center for children. 3 Newlyweds dream of buying a house.

Introduction

What do these projects have in common? All of them entail a commitment of capital and managerial effort that may or may not be justified by later performance. A common set of tools can be applied to assess these seemingly very different propositions. The financial analysis used to assess such projects is known as capital budgeting. How should a limited supply of capital and managerial talent be allocated among an unlimited number of possible projects and 4 corporate initiatives?

Capital Budgeting

Capital budgeting is the process of identifying, evaluating, planning, and financing an organizations major investment projects. Decisions to expand production facilities, acquire new production machinery, buy a new computer, or remodel the office building are all examples of capitalexpenditure decisions.
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Capital Budgeting

Capital-budgeting decisions made now determine to a large degree how successful an organization will be in achieving its goals and objectives in the years ahead. Capital budgeting plays an important role in the long-range success of many organizations because of several characteristics that differentiate it from most other elements of the
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BASIC FEATURES OF CAPITAL BUDGETING

Capital budgeting implications. decisions have long-term

These decisions involve substantial commitment of funds. These decisions are irreversible and require analysis of minute details. These decisions determine and affect the future growth of the firm.
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Capital Budgeting

Capital budgeting projects require relatively large commitments of resources. Major projects, such as plant expansion or equipment replacement, may involve resource outlays in excess of annual net income. Relatively insignificant purchases are not treated as capital budgeting projects even if the items purchased have long lives. For example, the purchase of 100 calculators at $15 each for use in the office would be treated as a period expense 8 by most firms, even though the calculators

Capital Budgeting

Most capital expenditure decisions are longterm commitments. The projects last more than 1 year, with many extending over 5, 10, or even 20 years. The longer the life of the project, the more difficult it is to predict revenues, expenses, and cost savings. Capital-budgeting decisions are long-term policy decisions and should reflect clearly an organizations policies on growth, marketing, industry share, social responsibility, and other 9 goals

CAPITAL BUDGETING DECISION INVOLVES THREE STEPS: 1. Estimation of costs and benefits of a proposal or of each alternative. 2. Estimation of the required rate of return, i.e., the cost of capital 3. Selection and applying the decision criterion.

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Project Cash Flows

A project creates wealth if it generates cash flows over time that are worth more in present-value terms than the initial setup cost. For example, suppose a brewery costs $10 million to build, but once built it generates a stream of cash flows that is worth $11 million. Building the brewery would create $1 million of new wealth. If there were no other proposed projects that would create more wealth than this, then the beer company would be well advised to build the new 11 brewery.

DECISION CRITERIA TECHNIQUES OF EVALUATION

Traditional or Non-discounting

Time-adjusted or Discounted cash flows

1. Payback period 2. Accounting Rate of Return

1. Net Present Value 2. Profitability Index 3. Internal Rate of Return

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Proposed Project
Bibba is evaluating a new project for her firm, Bibba Bakery (BB). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

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TRADITIONAL OR NON-DISCOUNTING TECHNIQUES

I . PAYBACK PERIOD: # The payback period is defined as the number of years required for the proposals cumulative cash inflows to be equal to its cash outflows. # The payback period is the length of time required to recover the initial cost of the project. # The payback period may be suitable if the firm has limited funds available and has no ability or willingness to raise additional funds.
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Payback Period (PBP)

-40 K 10 K 12 K 15 K 10 K

7K

PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.

Payback Solution (#1)

0
-40 K

1
(b) 10 K 10 K

2
12 K 22 K

(a)

15 K 37 K (c)

10 K(d) 7K 47 K 54 K

Cumulative Inflows

PBP

=a+(b-c)/d = 3 + (40 - 37) / 10 = 3 + (3) / 10 = 3.3 Years

The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]

PBP Acceptance Criterion

PBP Strengths and Weaknesses

Strengths: Weaknesses:
Easy to use and Does not consider understand cash flows beyond the PBP Easier to forecast ST than Cutoff period is LT flows subjective

Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the projects initial cash outflow (ICO). CF1 ICO = (1+IRR)1 CF2 CFn + +...+ 2 (1+IRR) (1+IRR)n

IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Rate is too

IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Rate is too

IRR Solution (Interpolate)

.05 X .10 ICO .15 $41,444 $1,444 $40,000 $4,603 $36,841

($1,444)(0.05) $4,603 X=

X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

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Discount rate

Thediscount ratecan mean an interest rate acentral bankchargesdepository institutionsthat borrowreservesfrom it, for example for the use of theFederal Reserve'sdiscount window. the same asinterest rate; the term "discount" does not refer to the common meaning of the word, but to the meaning in computations ofpresent value, e.g.net present
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The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted? No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ]

IRR Acceptance Criterion

IRR Solution
$10,000 $12,000 $40,000 = + + (1+IRR)1 (1+IRR)2 $15,000 $10,000 $7,000 + + (1+IRR)3 (1+IRR)4 (1+IRR)5 Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.

DISCOUNTED CASH FLOWS OR TIME ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at different point of time are not having same economic worth. I. NET PRESENT VALUE (NPV) METHOD:
The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with the proposal. The decision rule is Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative.
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Net Present Value (NPV)

(NPV) is the difference between the setup cost of a project and the value of the project once it is set up. If that difference is positive, then the NPV is positive and the project creates wealth. If a firm must choose from several proposed projects, the one with the highest NPV will create the most wealth, and so it should be the one adopted.
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Net Present Value

For example, suppose the car company can either build the new plant or, alternatively, can introduce a new product a mid segment car. There is not enough managerial talent to oversee more than one new project, or maybe there are not enough funds to start both. Let us assume that both projects create wealth: The NPV of the new plant is $1 million, and the NPV of the new-product project is $500,000. If it could, the car company should undertake both projects; but since it has to choose, building the new plant would be the right option because it has the higher NPV.

CAPITAL BUDGETING PRACTICES IN INDIA

Capital budgeting decisions are undertaken at the top management level and are planned in advance. The Corporates follow mostly top-down approach in this regard. Discounted cash flow techniques are more popular now. High growth firms use IRR more frequently whereas Payback period is more widely used by small firms. PI technique is used more by public sector units than by private sector units.

Capital budgeting decisions are of paramount importance as they affect the profitability of a firm, and are the major determinants of its efficiency and competing power.
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ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the payback period, which ignores the time value of money.
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ADVANTAGES AND DISADVANTAGES OF IRR AND NPV The main problem with the IRR method is

that it often gives unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy
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ADVANTAGES AND DISADVANTAGES OF IRR AND NPV Another problem with the IRR method is that

Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business
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WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS

When comparing two projects, the use of the NPV and the IRR methods may give different results. A project selected according to the NPV may be rejected if the IRR method is used. Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500. Project X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of $100, $200, $300, $400, $500,

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Using the trial and error method you find that the IRR of Project X is 17% and the IRR of Project Y is around 13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than the IRR of Project Y. But what happens to your decision if the NPV method is used? The answer is that the decision will change depending on the discount rate
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For instance, at a 5% discount rate, Project Y has a higher NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higher NPV. The purpose of this numerical example is to illustrate an important distinction: The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the
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II . ACCOUNTING RATE OF RETURN (OR) AVERAGE RATE OF RETURN (ARR)

# The ARR may be defined as the annualized net

income earned on the average funds invested in a project. # The annual returns of a project are expressed as a percentage of the net investment in the project. COMPUTATION OF ARR: Average Annual profit (after tax) ARR = x 100
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Accounting Rate of Return (Or) Average Rate Of Return (ARR)

A comparison of the profit generated by the investment with the cost of the investment Denominator is Book Value of Fixed Investment

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Accounting Rate of Return (Or) Average Rate Of Return (ARR)

Year Book Value of Fixed Investment 90000 80000 70000 60000 50000 Profit After Tax 1 2 3 4 5 20000 22000 24000 26000 28000
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1/ 5 ( 20000+ 22000+ 24000+26000+ 28000)/ 1/5( 90000+80000+70000+ 60000+ 50000) = 34 per cent

Accounting Rate of Return (Or) Average Rate Of Return (ARR)

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Accounting Rate of Return (Or) Average Rate Of Return (ARR)

Shows Profitability This method allows comparison in between Based on Accounting Profit & Income streams not time related Doesnt take into account time value of money.
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Key considerations for firms in considering use

Ease of use/degree of simplicity required Degree of accuracy required Extent to which future cash flows can be measured accurately Extent to which future interest rate movements can be factored in and predicted Necessity of factoring in effects of inflation

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Comparing Methods
Basis of measurement Measure expressed as Payback period Cash flows Number of years Easy to Understand Accounting rate of return Actual income Percent Easy to Understand Net present Internal rate value of return Cash flows Cash flows Profitability Profitability Rs Percent Amount Considers time Considers time value of money value of money

Strengths

Limitations

Allows Allows Accommodates Allows comparison comparison different risk comparisons across projects across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the projects project's life Doesn't consider cash flows after payback period Doesn't give annual rates over the life of a project

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WORKING CAPITAL MANAGEMENT Working capital management is concerned with the problems that arise in managing the current assets, current liabilities and the interrelationships between them.

GOAL: To manage the firms current assets and liabilities in such a way that a satisfactory level of working capital is maintained.
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CONCEPTS: GROSS WORKING CAPITAL The current assets which represent the proportion of investment that circulates from one form to another in the ordinary conduct of business.

NET WORKING CAPITAL The portion of current assets financed with long term funds or current assets current liabilities
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PURPOSE: The NWC is necessary because the cash outflows and inflows do not coincide. The purpose of NWC is to measure the liquidity of the firm.

DETERMINING FINANCING MIX: Financing mix is the choice of sources of financing of current assets.

SOURCES OF ASSET FINANCE: 1. Short term sources (Current liabilities) 2. Long term sources (Share capital, long term borrowings).
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INSTRUMENTS OF SHORT TERM FINANCING

Trade Credit Bill Discounting Inter Corporate Deposits Public deposits Commercial papers Factoring
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APPROACHES TO DETERMINE FINANCING MIX:

1. Hedging approach 2. Conservative approach 3. Trade off between the above mentioned two approaches.

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HEDGING APPROACH (MATCHING APPROACH):

This is the process of matching maturities of debt with the maturities of financial needs.

According to Hedging approach, the permanent portion of funds required should be financed with long term funds and the seasonal portion with short term funds.
Under this approach working capital = 0 since CA are not financed by long term funds (CA = CL).
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CONSERVATIVE FINANCING APPROACH: This is a strategy by which the firm finances all funds requirement, with long term funds and uses short term funds for emergencies or unexpected outflows. TRADE OFF BETWEEN HEDGING AND CONSERVATIVE APPROACHES: One possible trade off could be equal to the average of the minimum and maximum monthly requirements of funds during the given period of time. This level of requirement of funds may be financed through long run sources and for any additional financing need, short term funds may be used.
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FACTORS DETERMINING AMOUNT OF WORKING CAPITAL Purchase resources Payment for resource purchase Sell product on credit Receive cash

Inventory conversion period

Receivable conversion period

Payables period Operating cycle

Cash Conversion period

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 The length of the operating cycle is the most widely used method to determine working capital need. The longer the production cycle, the larger is the working capital need or vice versa. Manufacturing and trading enterprises require fairly large amount of working capital to support their production and sales activity. Service enterprises like hotels, restaurants etc., need less working capital. During boom conditions need for working capital is more. Growth industries and firms need more working capital. Working capital requirement are to be determined on the basis of cash cost i.e excluding depreciation. 53

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