Capital Budgeting Decision – An Overview

Capital Budgeting Decision – An Overview

Capital Budgeting Decision  – The investment decision of a firm is generally known as the capital expenditure decision. It is the whole process of the analyzing project and deciding whether they should be included in the capital project. According to I.M Pandey, a capital budgeting decision is define as the firm decision to invest its current fund in long-term asset in anticipation of an expected flow of benefit over a series of year. Capital budgeting decision has the following features.

It involve the exchange of current fund for future benefit

1. Fund involved are invested in long-term assets.
2. The future benefit from such investment will occur to the firm over a series of years

 IMPORTANCE OF CAPITAL BUDGETING DECISION

According I.M Pandey (1982) capital budgeting decision require special attention because of the following reason

They have long term implication for firm and can influence its risk for implementation

1. They involve commitment of large amount of fund]
2. They are irreversible decision
3. They are among the cost difficult decision to make

Unlike the consequences of current operating expenditure. The effect of capital budgeting decision extends into the future and to be endured for a long period of time. Beside it also affect the rate and the direction of the firms growth. While a wrong decision can prove to be disastrous for the continued survival of a firm, unwanted and unprofitable expense will result into a heavy expense expectation cost of the firm. On the other hand adequate investment of asset will not be difficult for the firm to emerge successfully and maintain its market share.

Investment decisions are among the final most difficult decision. They are and assessment of future invent which are difficult o predict is really is a complex problem to currently estimate future cash flow of an investment

TYPE OF CAPITAL BUDGETING DECISION

There are many ways for classifying investment. One of the classifications according to Benjamin C. Osisioma (1990) is as follows

1. Replacement: decision necessary to replace worn – out or damages equipment fall within the group. The purpose of such investment decision is to lower maintenance cost, minimize the decision to lower the maintained cost, minimize the material cost and labour coast and other variable cost item like the electricity bill.
2. Expansion of the existing product or markets: included in these categories is the expenditure to increase the output of the existing products or to expand outlet or the distribution facility in marketing new product being selected.
3. Environmental safety regulation: this involve expenditure necessary for the compliance with the government regulation, labour union requirements and the condition of the insurance policy. This are usually referred to as mandatory investment and non-revenue yielding projects.
4. Miscellaneous expenditure: these include expenditure on office building, packing lost and similar cash outlays. Based on the inter-relationships among proposed project, Benjamin C. Osisioma (1990) further classified investment decision as;

5.    Independent project: this exists when acceptance or the rejection of the project dose not affect the cash flow of another project. In other words, proposed budget serve different purpose and do not compete with each other.

6.    Dependent projects:  this is the reverse of the independent projects. It occur whenever the cash flow of on project affects or is influenced by the cash flow of another project and may appear in the following situation

(i)                            Mutually exclusive project: if the acceptance of one project prelude the acceptance of the another project, the project are said to be mutually exclusive

(ii)                         Complementary project: if the acceptance of one project enhances the cash flow of another project. The two projects are complementary.

(iii)                       Prerequisite of contingent project: if the acceptances of one project depend upon the prior acceptance of another project, the acceptance of the former is the prerequisite to the acceptance of the latter.

(iv)                       Mandatory project: this is project that must be accepted if the firm must remain in the business. The telephone manufactured the receiver, cable and other component parts.

(v)                         Discretionary project: this are project that are acceptable only of they are financially attractive.

PROBLEMS

Sale of is the pivot of all activity of firm. Sale is forecast due to the uncertainty that is surrounding modern economic activities; the forecast sale is put to many use in which the budgeting process is one.

Douglas Garbutto (1992) said that manager in budgeting for capital expenditure are traced with the whole series of problem which can be dealt with under four headings

(1)             The demand for capital

(2)             This supply of capital

(3)             The rationing of capital

(4)             The timing of investment

The researcher decided to write using the above heading in addition to other. The first to be treated is the demand for capital or financial capital as J.F Weston and E.F Brighan (1968) has it

 DEMAND FOR CAPITAL (FINANCIAL FORECASTING)

Haim Levy and Marchal Sarnat (1983) stated that at the end of very years, every company would like to know what their next year income statement and balance sheet would look like. With regard to this, each department of the company will like to estimate its total requirement for next year operation, they stated also that they will need to know how many additional machine will be required.

J.F Weston and E.F Brigham agree with the view made by Haim and Levy and Marchal Sarnate (1988) but add this to often necessitate by increase in the sale-by-sale forecast.

 SUPPLY OF CAPITAL

There are many source of capital to meet the financing of capital asset needed for the production of good when the demand are increasing, such sources of fund include the bank, financial and insurance companies to mention but few. Fund can be raised from the sourcing common stock, preferred stock, bonds, convertible bonds, and so on. The firm can also make use for the retail earning where it is much to finance its capital project.

THE RATIONING OF THE CAPITAL

The researcher find the following done by J.R frank and J.E Broye in the capital rationing very appealing and so adopted them. Of the capital available for project is expected to be budgeted or rationed for more than one period than the lacked profitability index will not always suffice as a means of selecting the most profitable combination of the project. Table 4.2 illustrate and example pf such choice for the project A, B, C, D which are in prospects each commencing in secretively marked distance periods. Only 1000.00 are available for all the four projects but fund earned from the project may be reinvested in other project. Idle fund may be reinvested in the money market as 100.00 unite required for the investment in a project. What combination of project is feasible within the period.

The financial planning problem can most be easily be solved by the method demonstrated in the table 2.4 3 which is derived from table 2.44.

Cash flow of four projective investments   and the capital budget

Table 2.45

Cumulate net fund requirement for the four prospective capital investments and the cumulative capital budget

All cumulative figure show that assumed idle cash is reinvested at 105 after the tax reduction of the earlier figure compounded at 10%. The expected rate of reinvestment take for example, the figure show for project A, the first figure is still 1000.00. The second figure is 900.00 which = 1000 X 1.1 + 200. 00. The third figure is – 790 – 900 X 1.1 + 200.00 and so on. The principle which can now be applied to the retied figure in selecting project is that the cumulative note commitment to the project must not exceed to the cumulative capital budget after allowing for opportunity for reinvestment of any idle cash.

The principle can be applied by companies sum left to write in the table 2.05 with the cumulative budget in the final column in the final mean, all feasible combination can be found, let us applied the method. Project A can be undertaken since the 1000.00 required dose not exceeds the budget of 1000.00. Can any other budget be undertaken along side with the project A? Consider he project B, since the combine cumulative net requirement of –900.00 for A and 500.00 for B exceed the cumulative budget of 1000.00, the combination of A and B is unfeasible. And it is true of A and C. Now let us consider the A and D. The cumulative requirement for is 1329 which is = 669 + 660, since 1329 dose not exceed the cumulative budget of 1331.00 at the stage, both A and B are feasible within the budget. The profitability of such a combination of project can be indicated by their combined net present value, both discounted to common date and the period is Zero. However, there may be other feasible combination of project B with other project other then A (already considered). Project B can be combined to project C since the cumulative net requirement for fund which is 1000.00 is = 450 + 550 dose not exceed the cumulative budget of 1210. Similarly, project B can be also combined to project D with the cumulative budget.

By the same method, we find that project B and C are also feasible together. A, D, B, C, B, D, C, D.

The immediate decision is whether to invest in project A sine investment in project A will prompt investment in any other project but D. if the project combination of B and C were more profitable, we will not think of investing in project A. to make the choice, we simply add the net present value as of the period 0 within each feasible combination of the project.

That feasible combination with the large total net present value provides the optional selection of project within the cumulative budget.

After the selection and expending of fund on the feasible project, the next step is the post auditing of the investment decision.

 THE TIMING OF THE INVESTMENT DECISION

Done T. Decoster et al (1988) said hat after the funds has been expended, the project is put in service as well as the rounded capital expenditure programme will focus on a positive audit of the investment.

Charles T. Horngren and Gorge Foster (1987) agree with the above statement. Both set of auditing is guided by the following reason (integrated) for post auditing investment in capita project

1. It foster a sense of responsibility in the originator of capital investment programme
2. To see that spending and specification conform to the plan as approved
3. To increase the likelihood that capital spending request are sharply conceived and honestly estimated.
4. To direct the management intention to the unsuccessful project so that additional action may be taking to attain the planed performance
5. To improve the estimation on the future capital budgeting project
6. To gain experience in evaluating, selecting and approving future capital expenditure proposal.

 ANALYSIS OF CAPITAL PROJECT

J.E Weston and E.F Brigham (1968) gave three basic steps and they are:

1. Estimate the cash outlay attributable to the new investment
2. Determine the present value of the incremental cash flow and
3. See if the internal rate of return exceed the cost of capital or of the net present value is positive

The researcher however has decided to consider the step two under the heading method of investigating alternative use of capital while the step three will be considered under the title selection of project.

—-This article is not complete———–This article is not complete————

This article was extracted from a Project Research Work Topic

“CAPITAL BUDGETING IN THE PRIVATE SECTOR

(A CASE STUDY OF THE NIGERIAN BREWERIES)”

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Capital Budgeting Decision – An Overview

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