There are several factors and considerations which make the capital budgeting decisions as the most important decision of finance manager. The relevance and significance of capital budgeting may be stated as follows:
Long term effect: Perhaps, the most features of a capital budgeting decisions and which makes the capital budgeting so significant is that these decisions have a long terms effects on the risk and return composition of the firm. These decision affect the future position of the firm to a considerable extent as the capital budgeting decisions have a long term implications and consequences. By taking a capital budgeting decision, a finance manager in fact makes a commitment into the future , both by committing to the future needs of funds of the projects and by committing to its future implications. The disguising feature between short term decisions and capital budgeting decisions is the time.
Substantial Commitment: the capital budgeting decisions generally involve large commitment of funds and as a result substantial portion of capital funds are block in the capital budgeting decisions. More attention is required for capital is required for capital budgeting decision. In terms therefore, more attention is required for capital budgeting decisions , otherwise the firm may suffer from the heavy capital losses in time to come. It is also possible that the return from a projects may not be sufficient enough to justify the capital budgeting decision.
Irreversible decisions: most of the capital budgeting decisions are irreversible decisions. Once taken, the firm may not be in a position to revert back unless it is ready to absorb heavy losses which may result due to abandoning a project in midway. Therefore, the capital budgeting decisions should be taken only after considering and evaluating each minute detail of the project, otherwise the financial consequences may be far reaching.
Affect the capacity and strength to compete: the capital budgeting decisions affect the capacity and strength of a firm to face the competition. A firm may lose competitiveness if the decision to modernize is delayed or not rightly taken. Similarly, a timely decision to take over a minor competitor may ultimately result even in the monopolistic position of the firm.
Problems and Difficulties in Capital Budgeting
The problem in capital budgeting decisions may be as follows:
Future uncertainty: all capital budgeting decisions involve long term which is uncertain. Even if every care is taken and the project is evaluated every minute detail, still 100% correct and certain forecast is not possible. The finance manager dealing with the capital budgeting decisions, therefore, should try to be as analytical as possible. The uncertainty of the capital budgeting decisions may be reference to cost of the project, future, legal provisions, political situation etc.
Time Element: The implications of a capital budgeting decision are scattered over a long period, the cost and benefit of a decision may occur at different point of time. as a result, the cost and benefits of a capital budgeting decision are generally not comparable unless adjusted for the time value of money. The cost of a project is incurred immediately; however, it is recovered in number of years. These total returns may be more than the cost incurred, still the net benefit cannot be ascertained unless the future benefits are adjusted to make them comparable with the cost. Moreover, the longer the time period involved, the greater would be the uncertainty.
Measurement Problem: sometimes a finance manager may also face difficulties in measuring the cost and benefits of projects in quantitate terms. For example: the new product produced to be launched by a firm may result in increase or decrease due to other factor also.
Types Of Capital Budgeting Decisions
The project may also be classified as revenue generating projects or cost reducing projects. In general, the projects can be categorized as follows:
From the point view of firms existence: the capital budgeting decisions may be taken by a newly incorporated firm or by an already existing firm.
New Firm: A new incorporated firm may be required to take different decisions such as selection of a plant to be installed, capacity utilization at initial stages, to set up or not simultaneously the ancillary unit etc.
Existing Firm: A firm which is already existing may also be required to take various decisions from time to time to meet the challenges of competition or changing environment.
From the point of view of decision situation: The capital budgeting decisions may also be classified from the point of view of the decision situation as follows:
Mutually Exclusive Decisions: Two or more alternative proposals are said to be mutually exclusive when acceptance of one alternative result in automatic rejection of all other proposals. The mutually exclusive decisions occur when a firm has more than one alternative but competitive proposal before it. For example, selecting one adversity agency to take care of the promotional campaign out rightly rejects all other competitive agencies. Similarly, selection of one location out of different feasible locations is a mutually exclusive decision.
Accept-Reject Decisions: An Accept-Reject decision occurs when a proposal is independently accepted or rejected without regard to any other alternative proposal. This type of decision is made when proposal is cost and benefits neither effect nor are affected by the cost and benefits of other proposals.
Contingent Decisions: sometimes, a capital budgeting decision is contingent to some other decision. For example, computerization of a bank branch may require not only air-conditioning but also transfer of some staff member to other branches. Similarly, installing a project at some remote location may require expenditure or development of infrastructure also.
SOLUTION
CALUCATION OF CASH FLOWS
| Particulars | Amount | ||
| Profit before tax and depreciation(PBT) | -Depreciation (w.note) | 2,00,000 | -1,53,343 |
| Profit before tax | -Tax@50% | 46,657 | -23,329 |
| Profit after tax (PAT) | 23,328 |
Cash inflow (each year) = Profit after tax (PAT) + depreciation= 23,328 + 1,53,343 = Rs.1,76,671
Terminal inflow in the 7th year = Rs.30,000 (scrap value)
WORKING NOTES":
Calculation of depreciation = Cost of plant + installation cost " scrap value
Economic life = 11,00,000 + 3,400 " 30,000
7yrs = Rs.1,53,343
CALCULATION OF NET PRESENT VALUE
| Year | Cash inflow | PVF(10%,n) | Total PVF (Rs.) |
| 1 | 1,76,671 | 0.909 | 1,60,594 |
| 2 | 1,76,671 | 0.826 | 1,45,931 |
| 3 | 1,76,671 | 0.751 | 1,32,680 |
| 4 | 1,76,671 | 0.683 | 1,20,667 |
| 5 | 1,76,671 | 0.621 | 1,09,713 |
| 6 | 1,76,671 | 0.564 | 99,643 |
| 7 | 1,76,671 + 30,000 = 2,06,671 | 0.513 | 1,06,022 |
Total of inflows 8,75,250
Less: cash outflow (at time 0) - 11,03,340
(Plant cost +installation charges)
NPV (2,27,975)
NPV = PRESENT VALUE OF CASH INFLOW - PRESENT VALUE OF CASH OUTFLOW
Conclusion
Since the NPV of the proposal is negative, the proposal needs to be rejected.
