UNIT- V

CAPITAL AND CAPITAL BUDGETING

Introduction

Finance is the prerequisite to commence and vary on business. It is rightly said to

be the lifeblood of the business. No growth and expansion of business can take
place without sufficient finance. It shows that no business activity is possible without
finance. This is why; every business has to make plans regarding acquisition and
utilization of funds.

However efficient a firm may be in terms of production as well as marketing if it

ignores the proper management of flow of funds it certainly lands in financial crunch
and the very survival of the firm would be at a stake.

Function of finance

According to B. O. Wheeler, Financial Management is concerned with the acquisition

and utiliasation of capital funds in meeting the financial needs and overall objectives
of a business enterprise. Thus the primary function of finance is to acquire capital
funds and put them for proper utilization, with which the firm’s objectives are
fulfilled. The firm should be able to procure sufficient funds on reasonable terms and
conditions and should exercise proper control in applying them in order to earn a
good rate of return, which in turn allows the firm to reward the sources of funds
reasonably, and leaves the firm with good surplus to grow further. These activities
viz. financing, investing and dividend payment are not sequential they are
performed simultaneously and continuously. Thus, the Financial Management can be
broken down in to three major decisions or functions of finance. They are: (i) the
investment decision, (ii) the financing decision and (iii) the dividend policy decision.

Investment Decision

The investment decision relates to the selection of assets in which funds will be
invested by a firm. The assets as per their duration of benefits, can be categorized
into two groups: (i) long-term assets which yield a return over a period of time in
future (ii) short-term or current assents which in the normal course of business are
convertible into cash usually with in a year. Accordingly, the asset selection decision
of a firm is of two types. The investment in long-term assets is popularly known as
capital budgeting and in short-term assets, working capital management.
1. Capital budgeting: Capital budgeting – the long – term investment decision –
is probably the most crucial financial decision of a firm. It relates to the selection
of an assent or investment proposal or course of action that benefits are likely to
be available in future over the lifetime of the project.

The long-term investment may relate to acquisition of new asset or replacement

of old assets. Whether an asset will be accepted or not will depend upon the
relative benefits and returns associated with it. The measurement of the worth of
the investment proposals is, therefore, a major element in the capital budgeting
exercise. The second element of the capital budgeting decision is the analysis of
risk and uncertainty as the benefits from the investment proposals pertain the
future, which is uncertain. They have to be estimated under various assumptions
and thus there is an element of risk involved in the exercise. The return from the
capital budgeting decision should, therefore, be evaluated in relation to the risk
associated with it.

The third and final element is the ascertainment of a certain norm or standard
against which the benefits are to be judged. The norm is known by different
names such as cut-off rate, hurdle rate, required rate, minimum rate of return
and so on. This standard is broadly expressed in terms of the cost of capital is,
thus, another major aspect of the capital; budgeting decision. In brief, the main
elements of the capital budgeting decision are: (i) The total assets and their
composition (ii) The business risk complexion of the firm, and (iii) concept and
measurement of the cost of capital.

2. Working Capital Management: Working capital management is concerned

with the management of the current assets. As we know, the short-term survival
is a pre-requisite to long-term success. The major thrust of working capital
management is the trade-off between profitability and risk (liquidity), which are
inversely related to each other. If a firm does not have adequate working capital
it may not have the ability to meet its current obligations and thus invite the risk
of bankrupt. One the other hand if the current assets are too large the firm will
be loosing the opportunity of making a good return and thus may not serve the
requirements of suppliers of funds. Thus, the profitability and liquidity are the
two major dimensions of working capital management. In addition, the individual
current assets should be efficiently managed so that neither inadequate nor
unnecessary funds are locked up.
WORKING CAPITAL ANALYSIS

Finance is required for two purpose viz. for it establishment and to carry out the day-
to-day operations of a business. Funds are required to purchase the fixed assets such
as plant, machinery, land, building, furniture, etc, on long-term basis. Investments in
these assets represent that part of firm’s capital, which is blocked on a permanent of
fixed basis and is called fixed capital. Funds are also needed for short-term purposes
such as the purchase of raw materials, payment of wages and other day-to-day
expenses, etc. and these funds are known as working capital. In simple words working
capital refers that part of the firm’s capital, which is required for financing short term or
current assets such as cash, marketable securities, debtors and inventories. The
investment in these current assets keeps revolving and being constantly converted into
cash and which in turn financed to acquire current assets. Thus the working capital is
also known as revolving or circulating capital or short-term capital.

Concept of working capital

There are two concepts of working capital:

1. Gross working capital

2. Net working capital

Gross working capital:

In the broader sense, the term working capital refers to the gross working capital. The
notion of the gross working capital refers to the capital invested in total current assets
of the enterprise. Current assets are those assets, which in the ordinary course of
business, can be converted into cash within a short period, normally one accounting
year.

Examples of current assets:

1. Cash in hand and bank balance

2. Bills receivables or Accounts Receivables
3. Sundry Debtors (less provision for bad debts)
4. Short-term loans and advances.
5. Inventories of stocks, such as:
(a) Raw materials
 (b) Work – in process
(c) Stores and spares
(d) Finished goods
6. Temporary Investments of surplus funds.
7. Prepaid Expenses
8. Accrued Incomes etc.

Net working capital:

In a narrow sense, the term working capital refers to the net working capital.
Networking capital represents the excess of current assets over current liabilities.

Current liabilities are those liabilities, which are intend to be paid in the ordinary course
of business within a short period, normally one accounting year out of the current
assets or the income of the business. Net working capital may be positive or negative.
When the current assets exceed the current liabilities net working capital is positive and
the negative net working capital results when the liabilities are more then the current
assets.

Examples of current liabilities:

1. Bills payable
2. Sundry Creditors or Accounts Payable.
3. Accrued or Outstanding Expanses.
4. Short term loans, advances and deposits.
5. Dividends payable
6. Bank overdraft
7. Provision for taxation etc.

Classification or kinds of working capital

Working capital may be classified in two ways:

a. On the basis of concept.

b. On the basis of time permanency

On the basis of concept, working capital is classified as gross working capital and
net working capital is discussed earlier. This classification is important from the
point of view of the financial manager. On the basis of time, working capital may be
classified as:
 1. Permanent or fixed working capital
2. Temporary of variable working capital

1. Permanent or fixed working capital: There is always a minimum level of

current assets, which is continuously required by the enterprise to carry out its
normal business operations and this minimum is known as permanent of fixed
working capital. For example, every firm has to maintain a minimum level of raw
materials, work in process; finished goods and cash balance to run the business
operations smoothly and profitably. This minimum level of current assets is
permanently blocked in current assets. As the business grows, the requirement
of permanent working capital also increases due to the increases in current
assets. The permanent working capital can further be classified into regular
working capital and reserve working capital. Regular working capital is the
minimum amount of working capital required to ensure circulation of current
assets from cash to inventories, from inventories to receivables and from
receivable to cash and so on. Reserve working capital is the excess amount over
the requirement for regular working capital which may be provided for
contingencies that may arise at unstated period such as strikes, rise in prices,
depression etc.
2. Temporary or variable working capital : Temporary or variable working capital
is the amount of working capital, which is required to meet the seasonal
demands and some special exigencies. Thus the variable working capital can be
further classified into seasonal working capital and special working capital. While
seasonal working capital is required to meet certain seasonal demands, the
special working capital is that part of working capital which is required to meet
special exigencies such as launching of extensive marketing campaigns, for
conducting research etc.

Temporary working capital differs from permanent working capital in the sense
that it is required for short periods and cannot be permanently employed
gainfully in the business. Figures given below illustrate the different between
permanent and temporary working capital.

Importance of working capital

Working capital is refereed to be the lifeblood and nerve center of a business. Working
capital is as essential to maintain the smooth functioning of a business as blood
circulation in a human body. No business can run successfully with out an adequate
amount of working capital. The main advantages of maintaining adequate amount of
working capital are as follows:
 1. Solvency of the business: Adequate working capital helps in maintaining
solvency of the business by providing uninterrupted flow of production.
2. Good will: Sufficient working capital enables a business concern to make
prompt payment and hence helps in creating and maintaining good will.
3. Easy loans: A concern having adequate working capital, high solvency
and good credit standing can arrange loans from banks and others on
easy and favorable terms.
4. Cash Discounts: Adequate working capital also enables a concern to avail
cash discounts on the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures
regular supply of raw materials and continuous production.
6. Regular payments of salaries wages and other day to day
commitments: A company which has ample working capital can make
regular payment of salaries, wages and other day to day commitments
which raises the morale of its employees, increases their efficiency,
reduces wastage and cost and enhances production and profits.
7. Exploitation of favorable market conditions: The concerns with
adequate working capital only can exploit favorable market conditions
such as purchasing its requirements in bulk when the prices are lower.
8. Ability to face crisis: Adequate working capital enables a concern to face
business crisis in emergencies.
9. Quick and regular return on Investments: Every investor wants a quick
and regular return on his investment. Sufficiency of working capital
enables a concern to pay quick and regular dividends to its investors, as
there may not be much pressure to plough back profits. This gains the
confidence of its investors and creates a favorable market to raise
additional funds in the future.
10. High morale: Adequacy of working capital creates an environment of
security, confidence, and high morale and creates overall efficiency in a
business. Every business concern should have adequate working capital to
run its business operations. It should have neither redundant excess
working capital nor inadequate shortage of working capital. Both, excess
as well as short working capital positions are bad for any business.
However, out of the two, it is the inadequacy of working capital which is
more dangerous from the point of view of the firm.

The need or objectives of working capital

The need for working capital arises mainly due to the time gap between production and
realization of cash. The process of production and sale cannot be done instantaneously
and hence the firm needs to hold the current assets to fill-up the time gaps. There are
time gaps in purchase of raw materials and production; production and sales: and sales
and realization of cash. The working capital is needed mainly for the following
purposes:

1. For the purchase of raw materials.

2. To pay wages, salaries and other day-to-day expenses and overhead cost such
as fuel, power and office expenses, etc.
3. To meet the selling expenses such as packing, advertising, etc.
4. To provide credit facilities to the customers and
5. To maintain the inventories of raw materials, work-in-progress, stores and
spares and finishes stock etc.

Generally, the level of working capital needed depends upon the time gap (known as
operating cycle) and the size of operations. Greater the size of the business unit
generally, larger will be the requirements of working capital. The amount of working
capital needed also goes on increasing with the growth and expansion of business.
Similarly, the larger the operating cycle, the larger the requirement for working capital.
There are many other factors, which influence the need of working capital in a business,
and these are discussed below in the following pages.

Factors determining the working capital requirements

There are a large number of factors such as the nature and size of business, the
character of their operations, the length of production cycle, the rate of stock turnover
and the state of economic situation etc. that decode requirement of working capital.
These factors have different importance and influence on firm differently. In general
following factors generally influence the working capital requirements.

1. Nature or character of business : The working capital requirements of a firm

basically depend upon the nature of its business. Public utility undertakings like
electricity, water supply and railways need very limited working capital as their
sales are on cash and are engaged in provision of services only. On the other
hand, trading firms require more investment in inventories, receivables and cash
and such they need large amount of working capital. The manufacturing
undertakings also require sizable working capital.
2. Size of business or scale of operations: The working capital requirements of
a concern are directly influenced by the size of its business, which may be
 measured in terms of scale of operations. Greater the size of a business unit,
generally, larger will be the requirements of working capital. However, in some
cases, even a smaller concern may need more working capital due to high
overhead charges, inefficient use of available resources and other economic
disadvantages of small size.
3. Production policy: If the demand for a given product is subject to wide
fluctuations due to seasonal variations, the requirements of working capital, in
such cases, depend upon the production policy. The production could be kept
either steady by accumulating inventories during stack periods with a view to
meet high demand during the peck season or the production could be curtailed
during the slack season and increased during the peak season. If the policy is to
keep the production steady by accumulating inventories it will require higher
working capital.
4. Manufacturing process/Length of production cycle : In manufacturing
business, the requirements of working capital will be in direct proportion to the
length of manufacturing process. Longer the process period of manufacture,
larger is the amount of working capital required, as the raw materials and other
supplies have to be carried for a longer period.
5. Seasonal variations: If the raw material availability is seasonal, they have to
be bought in bulk during the season to ensure an uninterrupted material for the
production. A huge amount is, thus, blocked in the form of material, inventories
during such season, which give rise to more working capital requirements.
Generally, during the busy season, a firm requires larger working capital then in
the slack season.
6. Working capital cycle: In a manufacturing concern, the working capital cycle
starts with the purchase of raw material and ends with the realization of cash
from the sale of finished products. This cycle involves purchase of raw materials
and stores, its conversion into stocks of finished goods through work–in progress
with progressive increment of labour and service costs, conversion of finished
stock into sales, debtors and receivables and ultimately realization of cash. This
cycle continues again from cash to purchase of raw materials and so on. In
general the longer the operating cycle, the larger the requirement of working
capital.
7. Credit policy: The credit policy of a concern in its dealings with debtors and
creditors influences considerably the requirements of working capital. A concern
that purchases its requirements on credit requires lesser amount of working
capital compared to the firm, which buys on cash. On the other hand, a concern
allowing credit to its customers shall need larger amount of working capital
compared to a firm selling only on cash.
 8. Business cycles: Business cycle refers to alternate expansion and contraction in
general business activity. In a period of boom, i.e., when the business is
prosperous, there is a need for larger amount of working capital due to increase
in sales. On the contrary, in the times of depression, i.e., when there is a down
swing of the cycle, the business contracts, sales decline, difficulties are faced in
collection from debtors and firms may have to hold large amount of working
capital.
9. Rate of growth of business: The working capital requirements of a concern
increase with the growth and expansion of its business activities. The retained
profits may provide for a part of working capital but the fast growing concerns
need larger amount of working capital than the amount of undistributed profits.

SOURCE OF FINANCE

Incase of proprietorship business, the individual proprietor generally invests his own
savings to start with, and may borrow money on his personal security or the security of
his assets from others. Similarly, the capital of a partnership from consists partly of
funds contributed by the partners and partly of borrowed funds. But the company from
of organization enables the promoters to raise necessary funds from the public who
may contribute capital and become members (share holders) of the company. In course
of its business, the company can raise loans directly from banks and financial
institutions or by issue of securities (debentures) to the public. Besides, profits earned
may also be reinvested instead of being distributed as dividend to the shareholders.

Thus for any business enterprise, there are two sources of finance, viz, funds
contributed by owners and funds available from loans and credits. In other words the
financial resources of a business may be own funds and borrowed funds.

Owner funds or ownership capital:

The ownership capital is also known as ‘risk capital’ because every business runs the
risk of loss or low profits, and it is the owner who bears this risk. In the event of low
profits they do not have adequate return on their investment. If losses continue the
owners may be unable to recover even their original investment. However, in times of
prosperity and in the case of a flourishing business the high level of profits earned
accrues entirely to the owners of the business. Thus, after paying interest on loans at a
fixed rate, the owners may enjoy a much higher rate of return on their investment.
Owners contribute risk capital also in the hope that the value of the firm will appreciate
as a result of higher earnings and growth in the size of the firm.
The second characteristic of this source of finance is that ownership capital remains
permanently invested in the business. It is not refundable like loans or borrowed
capital. Hence a large part of it is generally used for a acquiring long – lived fixed
assets and to finance a part of the working capital which is permanently required to
hold a minimum level of stock of raw materials, a minimum amount of cash, etc.

Another characteristic of ownership capital related to the management of business. It is

on the basis of their contribution to equity capital that owners can exercise their right of
control over the management of the firm. Managers cannot ignore the owners in the
conduct of business affairs. The sole proprietor directly controls his own business. In a
partnership firm, the active partner will take part in the management of business. A
company is managed by directors who are elected by the members (shareholders).

Merits:

Arising out of its characteristics, the advantages of ownership capital may be briefly
stated as follows:

1. It provides risk capital

2. It is a source of permanent capital
3. It is the basis on which owners ‘acquire their right of control over management
4. It does not require security of assets to be offered to raise ownership capital

Limitations:

There are also certain limitations of ownership capital as a source of finance. These are:

The amount of capital, which may be raised as owners fund depends on the number of
persons, prepared to take the risks involved. In a partnership confer, a few persons
cannot provide ownership capital beyond a certain limit and this limitation is more so in
case of proprietary form of organization.

A joint stock company can raise large amount by issuing shares to the public. Bus it
leads to an increased number of people having ownership interest and right of control
over management. This may reduce the original investors’ power of control over
management. Being a permanent source of capital, ownership funds are not refundable
as long as the company is in existence, even when the funds remain idle.
A company may find it difficult to raise additional ownership capital unless it has high
profit-earning capacity or growth prospects. Issue of additional shares is also subject to
so many legal and procedural restrictions.

Borrowed funds and borrowed capital: It includes all funds available by way of loans or
credit. Business firms raise loans for specified periods at fixed rates of interest. Thus
borrowed funds may serve the purpose of long-term, medium-term or short-term
finance. The borrowing is generally at against the security of assets from banks and
financial institutions. A company to borrow the funds can also issue various types of
debentures.

Interest on such borrowed funds is payable at half yearly or yearly but the principal
amount is being repaid only at the end of the period of loan. These interest and
principal payments have to be met even if the earnings are low or there is loss. Lenders
and creditors do not have any right of control over the management of the borrowing
firm. But they can sue the firm in a law court if there is default in payment, interest or
principal back.

Merits:

From the business point of view, borrowed capital has several merits.
1. It does not affect the owner’s control over management.
2. Interest is treated as an expense, so it can be charged against income and
amount of tax payable thereby reduced.
3. The amount of borrowing and its timing can be adjusted according to
convenience and needs, and
4. It involves a fixed rate of interest to be paid even when profits are very high,
thus owners may enjoy a much higher rate of return on investment then the
lenders.

Limitations:

There are certain limitations, too in case of borrowed capacity. Payment of interest and
repayment of loans cannot be avoided even if there is a loss. Default in meeting these
obligations may create problems for the business and result in decline of its credit
worthiness. Continuing default may even lead to insolvency of firm.

Secondly, it requires adequate security to be offered against loans. Moreover, high

rates of interest may be charged if the firm’s ability to repay the loan in uncertain.
Source of Company Finance

Based upon the time, the financial resources may be classified into (1) sources of long
term (2) sources of short – term finance. Some of these sources also serve the purpose
of medium – term finance.

I. The source of long – term finance are:

1. Issue of shares
2. Issue debentures
3. Loan from financial institutions
4. Retained profits and
5. Public deposits

II. Sources of Short-term Finance are:

1. Trade credit
2. Bank loans and advances and
3. Short-term loans from finance companies.

Sources of Long Term Finance

1. Issue of Shares: The amount of capital decided to be raised from members of

the public is divided into units of equal value. These units are known as share
and the aggregate values of shares are known as share capital of the company.
Those who subscribe to the share capital become members of the company and
are called shareholders. They are the owners of the company. Hence shares are
also described as ownership securities.
2. Issue of Preference Shares: Preference share have three distinct
characteristics. Preference shareholders have the right to claim dividend at a
fixed rate, which is decided according to the terms of issue of shares. Moreover,
the preference dividend is to be paid first out of the net profit. The balance, it
any, can be distributed among other shareholders that is, equity shareholders.
However, payment of dividend is not legally compulsory. Only when dividend is
declared, preference shareholders have a prior claim over equity shareholders.

Preference shareholders also have the preferential right of claiming repayment of

capital in the event of winding up of the company. Preference capital has to be
 repaid out of assets after meeting the loan obligations and claims of creditors but
before any amount is repaid to equity shareholders.

Holders of preference shares enjoy certain privileges, which cannot be claimed

by the equity shareholders. That is why; they cannot directly take part in
matters, which may be discussed at the general meeting of shareholders, or in
the election of directors.

Depending upon the terms of conditions of issue, different types of preference

shares may be issued by a company to raises funds. Preference shares may be
issued as:
1. Issue of Equity Shares: The most important source of raising long-term capital for
a company is the issue of equity shares. In the case of equity shares there is no
promise to shareholders a fixed dividend. But if the company is successful and the level
profits are high, equity shareholders enjoy very high returns on their investment. This
feature is very attractive to many investors even through they run the risk of having no
return if the profits are inadequate or there is loss. They have the right of control over
the management of the company and their liability is limited to the value of shares held
by them.
2. Issue of Debentures:
When a company decides to raise loans from the public, the amount of loan is dividend
into units of equal. These units are known as debentures. A debenture is the instrument
or certificate issued by a company to acknowledge its debt. Those who invest money in
debentures are known as ‘debenture holders’. They are creditors of the company.
Debentures are therefore called ‘creditor ship’ securities. The value of each debentures
is generally fixed in multiplies of 10 like Rs. 100 or Rs. 500, or Rs. 1000.
3. Loans from financial Institutions:

Government with the main object of promoting industrial development has set up a
number of financial institutions. These institutions play an important role as sources of
company finance. Besides they also assist companies to raise funds from other sources.

These institutions provide medium and long-term finance to industrial enterprises at a

reason able rate of interest. Thus companies may obtain direct loan from the financial
institutions for expansion or modernization of existing manufacturing units or for
starting a new unit.

Often, the financial institutions subscribe to the industrial debenture issue of companies
some of the institutions (ICICI) and (IDBI) also subscribe to the share issued by
companies.
All such institutions also underwrite the public issue of shares and debentures by
companies. Underwriting is an agreement to take over the securities to the extent there
is no public response to the issue. They may guarantee loans, which may be raised by
companies from other sources.

Loans in foreign currency may also be granted for the import of machinery and
equipment wherever necessary from these institutions, which stand guarantee for re-
payments. Apart from the national level institutions mentioned above, there are a
number of similar institutions set up in different states of India. The state-level financial
institutions are known as State Financial Corporation, State Industrial Development
Corporations, State Industrial Investment Corporation and the like. The objectives of
these institutions are similar to those of the national-level institutions. But they are
mainly concerned with the development of medium and small-scale industrial units.
Thus, smaller companies depend on state level institutions as a source of medium and
long-term finance for the expansion and modernization of their enterprise.

4. Retained Profits:

Successful companies do not distribute the whole of their profits as dividend to

shareholders but reinvest a part of the profits. The amount of profit reinvested in the
business of a company is known as retained profit. It is shown as reserve in the
accounts. The surplus profits retained and reinvested may be regarded as an internal
source of finance. Hence, this method of financing is known as self-financing. It is also
called sloughing back of profits.

Since profits belong to the shareholders, the amount of retained profit is treated as
ownership fund. It serves the purpose of medium and long-term finance. The total
amount of ownership capital of a company can be determined by adding the share
capital and accumulated reserves.
5. Public Deposits:

An important source of medium – term finance which companies make use of is public
deposits. This requires advertisement to be issued inviting the general public of
deposits. This requires advertisement to be issued inviting the general public to deposit
their savings with the company. The period of deposit may extend up to three yeas.
The rate of interest offered is generally higher than the interest on bank deposits.
Against the deposit, the company mentioning the amount, rate of interest, time of
repayment and such other information issues a receipt.
Since the public deposits are unsecured loans, profitable companies enjoying public
confidence only can be able to attract public deposits. Even for such companies there
are rules prescribed by government limited its use.

Sources of Short Term Finance

The major sources of short-term finance are discussed below:

1. Trade credit: Trade credit is a common source of short-term finance available

to all companies. It refers to the amount payable to the suppliers of raw
materials, goods etc. after an agreed period, which is generally less than a year.
It is customary for all business firms to allow credit facility to their customers in
trade business. Thus, it is an automatic source of finance. With the increase in
production and corresponding purchases, the amount due to the creditors also
increases. Thereby part of the funds required for increased production is financed
by the creditors. The more important advantages of trade credit as a source of
short-term finance are the following:

It is readily available according to the prevailing customs. There are no special

efforts to be made to avail of it. Trade credit is a flexible source of finance. It can
be easily adjusted to the changing needs for purchases.

Where there is an open account for any creditor failure to pay the amounts on
time due to temporary difficulties does not involve any serious consequence
Creditors often adjust the time of payment in view of continued dealings. It is an
economical source of finance.

However, the liability on account of trade credit cannot be neglected. Payment

has to be made regularly. If the company is required to accept a bill of exchange
or to issue a promissory note against the credit, payment must be made on the
maturity of the bill or note. It is a legal commitment and must be honored;
otherwise legal action will follow to recover the dues.

2. Bank loans and advances: Money advanced or granted as loan by commercial

banks is known as bank credit. Companies generally secure bank credit to meet
their current operating expenses. The most common forms are cash credit and
overdraft facilities. Under the cash credit arrangement the maximum limit of
credit is fixed in advance on the security of goods and materials in stock or
against the personal security of directors. The total amount drawn is not to
exceed the limit fixed. Interest is charged on the amount actually drawn and
outstanding. During the period of credit, the company can draw, repay and again
 draw amounts with in the maximum limit. In the case of overdraft, the company
is allowed to overdraw its current account up to the sanctioned limit. This facility
is also allowed either against personal security or the security of assets. Interest
is charged on the amount actually overdrawn, not on the sanctioned limit.

The advantage of bank credit as a source of short-term finance is that the

amount can be adjusted according to the changing needs of finance. The rate of
interest on bank credit is fairly high. But the burden is no excessive because it is
used for short periods and is compensated by profitable use of the funds.

Commercial banks also advance money by discounting bills of exchange. A

company having sold goods on credit may draw bills of exchange on the
customers for their acceptance. A bill is an order in writing requiring the
customer to pay the specified amount after a certain period (say 60 days or 90
days). After acceptance of the bill, the company can drawn the amount as an
advance from many commercial banks on payment of a discount. The amount of
discount, which is equal to the interest for the period of the bill, and the balance,
is available to the company. Bill discounting is thus another source of short-term
finance available from the commercial banks.

3. Short term loans from finance companies : Short-term funds may be

available from finance companies on the security of assets. Some finance
companies also provide funds according to the value of bills receivable or amount
due from the customers of the borrowing company, which they take over.

CAPITAL BUDGETING

Capital Budgeting: Capital budgeting is the process of making investment decision in

long-term assets or courses of action. Capital expenditure incurred today is expected to
bring its benefits over a period of time. These expenditures are related to the
acquisition & improvement of fixes assets.

Capital budgeting is the planning of expenditure and the benefit, which spread over a
number of years. It is the process of deciding whether or not to invest in a particular
project, as the investment possibilities may not be rewarding. The manager has to
choose a project, which gives a rate of return, which is more than the cost of financing
the project. For this the manager has to evaluate the worth of the projects in-terms of
cost and benefits. The benefits are the expected cash inflows from the project, which
are discounted against a standard, generally the cost of capital.
Capital Budgeting Process:
The capital budgeting process involves generation of investment, proposal estimation of
cash-flows for the proposals, evaluation of cash-flows, selection of projects based on
acceptance criterion and finally the continues revaluation of investment after their
acceptance the steps involved in capital budgeting process are as follows.

1. Project generation
2. Project evaluation
3. Project selection
4. Project execution

1. Project generation: In the project generation, the company has to identify the
proposal to be undertaken depending upon its future plans of activity. After
identification of the proposals they can be grouped according to the following
categories:

a. Replacement of equipment: In this case the existing outdated

equipment and machinery may be replaced by purchasing new and
modern equipment.
b. Expansion: The Company can go for increasing additional capacity in the
existing product line by purchasing additional equipment.
c. Diversification: The Company can diversify its product line by way of
producing various products and entering into different markets. For this
purpose, It has to acquire the fixed assets to enable producing new
products.
d. Research and Development: Where the company can go for installation of
research and development suing by incurring heavy expenditure with a
view to innovate new methods of production new products etc.,

2. Project evaluation: In involves two steps.

a. Estimation of benefits and costs: These must be measured in terms of

cash flows. Benefits to be received are measured in terms of cash flows.
Benefits to be received are measured in terms of cash in flows, and costs
to be incurred are measured in terms of cash flows.
b. Selection of an appropriate criterion to judge the desirability of the
project.
3. Project selection: There is no standard administrative procedure for approving the
investment decisions. The screening and selection procedure would differ from firm to
firm. Due to lot of importance of capital budgeting decision, the final approval of the
project may generally rest on the top management of the company. However the
proposals are scrutinized at multiple levels. Some times top management may delegate
authority to approve certain types of investment proposals. The top management may
do so by limiting the amount of cash out lay. Prescribing the selection criteria and
holding the lower management levels accountable for the results.

4. Project Execution: In the project execution the top management or the project
execution committee is responsible for effective utilization of funds allocated for the
projects. It must see that the funds are spent in accordance with the appropriation
made in the capital budgeting plan. The funds for the purpose of the project execution
must be spent only after obtaining the approval of the finance controller. Further to
have an effective cont. It is necessary to prepare monthly budget reports to show
clearly the total amount appropriated, amount spent and to amount unspent.

Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of investment

proposal will help the company to decide upon the desirability of an investment
proposal depending upon their; relative income generating capacity and rank them in
order of their desirability. These methods provide the company a set of norms on the
basis of which either it has to accept or reject the investment proposal. The most widely
accepted techniques used in estimating the cost-returns of investment projects can be
grouped under two categories.

1. Traditional methods
2. Discounted Cash flow methods

1. Traditional methods

These methods are based on the principles to determine the desirability of an investment
project on the basis of its useful life and expected returns. These methods depend upon the
accounting information available from the books of accounts of the company. These will not
take into account the concept of ‘time value of money’, which is a significant factor to
determine the desirability of a project in terms of present value.

A. Pay-back period method: It is the most popular and widely recognized traditional
method of evaluating the investment proposals. It can be defined, as ‘the number of
years required to recover the original cash out lay invested in a project’.

According to Weston & Brigham, “The pay back period is the number of years it takes
the firm to recover its original investment by net returns before depreciation, but after
taxes”.

According to James. C. Vanhorne, “The payback period is the number of years required
to recover initial cash investment.

The pay back period is also called payout or payoff period. This period is calculated by
dividing the cost of the project by the annual earnings after tax but before depreciation
under this method the projects are ranked on the basis of the length of the payback
period. A project with the shortest payback period will be given the highest rank and
taken as the best investment. The shorter the payback period, the less risky the
investment is the formula for payback period is

Cash outlay (or) original cost of project

Pay-back period = -------------------------------------------
Annual cash inflow

Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the
books.

Demerits:
1. This method fails to take into account the cash flows received by the
company after the pay back period.
2. It doesn’t take into account the interest factor involved in an investment
outlay.
3. It doesn’t take into account the interest factor involved in an investment
 outlay.
4. It is not consistent with the objective of maximizing the market value of
the company’s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing
of cash in flows.

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the

financial statements to measure the probability of an investment proposal. It can be
determine by dividing the average income after taxes by the average investment i.e.,
the average book value after depreciation.

According to ‘Soloman’, accounting rate of return on an investment can be calculated as

the ratio of accounting net income to the initial investment, i.e.,

Average net income after taxes

ARR= ----]--------------------------------- X 100
Average Investment

Total Income after Taxes

Average net income after taxes = -----------------------------
No. Of Years
Total Investment
Average investment = ----------------------
2

On the basis of this method, the company can select all those projects who’s ARR is
higher than the minimum rate established by the company. It can reject the projects
with an ARR lower than the expected rate of return. This method can also help the
management to rank the proposal on the basis of ARR. A highest rank will be given to a
project with highest ARR, where as a lowest rank to a project with lowest ARR.

Merits:

1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.

Demerits:
 1. It is not based on cash flows generated by a project.
2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.

II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They
give equal weight age to the present and future flow of incomes. The DCF methods are
based on the concept that a rupee earned today is more worth than a rupee earned
tomorrow. These methods take into consideration the profitability and also time value
of money.

A. Net present value method (NPV)

The NPV takes into consideration the time value of money. The cash flows of different
years and valued differently and made comparable in terms of present values for this
the net cash inflows of various period are discounted using required rate of return
which is predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.”

NPV is the difference between the present value of cash inflows of a project and the
initial cost of the project.

According the NPV technique, only one project will be selected whose NPV is positive or
above zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must
be rejected. If there are more than one project with positive NPV’s the project is
selected whose NPV is the highest.
The formula for NPV is

NPV= Present value of cash inflows – investment.

C1 C2 C3 Cn
NPV = ------ + ------- + -------- + -------
(1+K)

Co- investment
C1, C2, C3… Cn= cash inflows in different years.
K= Cost of the Capital (or) Discounting rate
D= Years.

Merits:

1. It recognizes the time value of money.

2. It is based on the entire cash flows generated during the useful life of the asset.
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining
the present value.

Demerits:

1. It is different to understand and use.

2. The NPV is calculated by using the cost of capital as a discount rate. But the
concept of cost of capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different
amounts of investment.
4. It does not give correct answer to a question whether alternative projects or
limited funds are available with unequal lines.

B. Internal Rate of Return Method (IRR)

The IRR for an investment proposal is that discount rate which equates the present
value of cash inflows with the present value of cash out flows of an investment. The IRR
is also known as cutoff or handle rate. It is usually the concern’s cost of capital.

According to Weston and Brigham “The internal rate is the interest rate that equates
the present value of the expected future receipts to the cost of the investment outlay.

When compared the IRR with the required rate of return (RRR), if the IRR is more than
RRR then the project is accepted else rejected. In case of more than one project with
IRR more than RRR, the one, which gives the highest IRR, is selected.

The IRR is not a predetermine rate, rather it is to be trial and error method. It implies
that one has to start with a discounting rate to calculate the present value of cash
inflows. If the obtained present value is higher than the initial cost of the project one
has to try with a higher rate. Like wise if the present value of expected cash inflows
obtained is lower than the present value of cash flow. Lower rate is to be taken up. The
process is continued till the net present value becomes Zero. As this discount rate is
determined internally, this method is called internal rate of return method.

P1 - Q
IRR = L+ --------- X D
P1 –P2

L- Lower discount rate

P1 - Present value of cash inflows at lower rate.
P2 - Present value of cash inflows at higher rate.
Q- Actual investment
D- Difference in Discount rates.

Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of
return projects are selected, it satisfies the investors in terms of the rate of
return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.

Demerits:

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.

C. Probability Index Method (PI)

The method is also called benefit cost ration. This method is obtained cloth a slight
modification of the NPV method. In case of NPV the present value of cash out flows are
profitability index (PI), the present value of cash inflows are divide by the present value
of cash out flows, while NPV is a absolute measure, the PI is a relative measure.

It the PI is more than one (>1), the proposal is accepted else rejected. If there are
more than one investment proposal with the more than one PI the one with the highest
PI will be selected. This method is more useful incase of projects with different cash
outlays cash outlays and hence is superior to the NPV method.
The formula for PI is

Present Value of Future Cash Inflow

Probability index = ----------------------------------------
Investment

Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the
index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the
index.
5. It takes into consideration the entire stream of cash flows generated during the
useful life of the asset.

Demerits:

1. It is some what difficult to understand

2. Some people may feel no limitation for index number due to several limitation
involved in their competitions
3. It is very difficult to understand the analytical part of the decision on the basis of
probability index.