CAPITAL BUDGETING THEORY

Q.1. What do you mean by capital Budgeting?
(a) Decision Making with regard to investment in fixed assets (capital projects); or
(b) Decision Making with regard to investment of money in long-term projects; or
(c) Evaluation of expenditure decisions, which involve current outlays/outflows but are likely to produce benefits over a longer period of time; or
(d) Forecast of likely or expected returns from a new investment project and to determine whether returns are adequate.

Q.2. Bring out the Importance of Capital Budgeting decisions.

Capital Budgeting decisions should be taken after careful analysis and review. The importance of Capital Budgeting can be understood from the following points
(a) Cost: Initial Investment is substantial. Hence commitment of resources should be made properly.
(b) Time: The effect of decision is known only in the near future and not immediately.
(c) Irreversibility : Decisions are irreversible and commitment should be made on proper evaluation.
(d) Complexity : Decisions are based on forecasting of future events and inflows. 
Quantification of future events involves application of statistical and probabilistic techniques. Careful judgement and application of mind is necessary.

Q.3. Besides financial considerations, there are other factors, while capital budgeting evaluations. Discuss.

Generally, RISK and RETURN are the two factors analysed in any Capital Budgeting proposal. Since these are directly related, the higher the returns, the greater will be the risk. But, in addition to financial considerations, there are many other factors, which are important in making capital budgeting decisions. Some of the non-financial considerations include :

(a) The need to establish one's foothold in the market -new product launch decisions.
(b) To contribute to the better welfare of the society as a whole -setting up a unit in a backward area.
(c) To increase the safety and welfare of workers and employees -installation of safety improvement and accident control measures in the factory.
(d) To conform to legal requirements -operation of unit in economically backward areas or in industrial parks.
(e) Emotional reasons -setting up projects in promoter's home towns even when alternative better locations are available.

Q.4. List some techniques of evaluating a project's financial viability.

The following are some techniques of Project Evaluation:
(a) Simple Payback
(b) Discounted Payback
(c) Payback Reciprocal
(d) Accounting or Average Rate of Return (ARR)
(e) Net Present Value (NPV)
(f) Internal Rate of Return (I RR)
(g) Profitability Index (PI) / Desirability Factor

Q.5. What are the merits and demerits of the NPV method?

MERITS:
(a) It considers the time value of money, Hence it satisfies the basic criterion for project valuation.
(b) Unlike payback period, all cash flows are considered.
(c) NPV constitutes addition to the wealth of shareholders and thus focuses on the basic objective of financial management.
(d) Since all cash flows are converted into present value (current rupees), different projects can be compared on NPV basis, Thus, each project can be evaluated independent of others on-US own merit.

LIMITATIONS:
(a) It involves complex calculations.
(b) It involves forecasting cash flows and application of discount rate, Thus accuracy of NPV depends on accurate estimation of these two factors which may be quite difficult in practice.
(c) NPV and ranking of project may differ at different discount rates, causing inconsistency in decision making.
(d) It ignores the difference in initial outflows, size of different proposals etc, while evaluating mutually exclusive projects.

Q.6. How are decisions taken in case of differential project lives ?

In case of evaluation based on NPV method, comparison of two projects is possible only if initial investment and project lives are the same. If project lives are different, e.g. Machine A operates for 7 years whereas Machine B operates for 10 years, the following procedure is adopted.

Step	Procedure
1	Compute the Initial Investment of each alternative.
2	Determine the project lives of each alternative.
3	Determine the annuity factor relating to the project life of each alternative.
4	Compute Equivalent Annual Investment (EAI) = Initial Investment / Relevant Annuity Factor
5	Compute CFAT per annum or Cash Outflows per annum, of each alternative.
6	Compute Equivalent Annual Benefit (EAB) = CFAT per annum less EAI OR Compute Equivalent Annual Costs (EAC) = Cash Outflows per annum + EAI
7	Select Project with Maximum EAB or Minimum EAC, as the case may be.