As we have already discussed the firm's value is the present value of all the future cash flows. In order to assess whether the capital investments are adding value to the firm we have to look at the future cash flows associatedwith capital investment and the discount rate that would equate these cash flows to their present values.
Capital Budgeting: Capital budgeting is the process of identifying and selecting investments in the long-lived assets or the assets which are expected to produce benefits over more than a year. Business is all about exploring avenues for growth and innovation, which requires continuous evaluation of possible investment opportunities. Capital budgeting to a large extent depends upon the corporate strategy.
Capital Budgeting: Capital budgeting is the process of identifying and selecting investments in the long-lived assets or the assets which are expected to produce benefits over more than a year. Business is all about exploring avenues for growth and innovation, which requires continuous evaluation of possible investment opportunities. Capital budgeting to a large extent depends upon the corporate strategy.
Stages in Capital Budgeting Process
There are four stages in the capital budgeting process:
Stage 1: Investment Screening and Selection – Projects consistent with the corporate strategy are identified by the various functional units (production,marketing, research and development) of the firm. Once the projects are identified, projects are evaluated and screened by an investment committee comprising of senior managers. The main focus of this process is to estimate how the investment proposal will affect the future cash flows of the firm and hence the value of the firm.
Stage 2: Capital Budgeting Proposal – Once the investment proposal survives the scrutiny of the investment committee, a capital budget is proposed for the project. The capital budget lists the amount of investment required for each investment proposal. This proposal may start with estimates of expected revenue and costs. At a later stage inputs from marketing, purchasing engineering, production and accounting and finance functions are put together.
Stage 3: Budgeting Approval and Authorisation Projects included in the capital budgets are authorised, which allows further fact gathering research and analysis as a result of which the capital budget proposal is refined and put up for approval. The approval allows the expenditure on the project. In some firms, the projects are authorised and approved concurrently, where as in others a project is first authorize so that the estimates can be refined. It is then approved. Large expenditures require formal authorisation and approvals whereas capital expenditures within a certain limit can be approved by the managers themselves.
Stage 4: Project Tracking – Once the project is approved the next step is to execute it. The concerned managers periodically report the progress of the project as well as any variances from the plan. The managers also report about time and cost overruns. This process of reporting is known as project tracking.
Classifying Investment Project
Investment projects are classified according to their economic life. The economic life or useful life of an asset is determined by its:
• Physical decoration
• Obsolescence
• The degree of competition in the market for a product
The economic life of an asset is an estimate of the length of time that the asset would provide benefits to the firm. After its useful life, the revenues generated by the assets decline rapidly and expenses on the assets increase in a disproportionate manner.Generally, an investment requires an immediate commitment of funds (cash outflows) and the benefits are received over a period in the form of cash inflows.If cash inflows are limited to current period, only these types of investments are known as short-term investments. If these benefits are spread over many years, these types of investments are referred to as long-term investments and expenditure on these investments is known as capital expenditure.
Importance of Capital Investment Decisions
Investment decisions are vital and crucial for any company and merit special attention because of the following reasons:
• They influence the firm's growth in the long run
• They affect the risk of the firm
• They involve commitment of large amount of funds
• They are irreversible or reversible at substantial loss
• They are among the most difficult decisions to make
Growth: Investment decisions affect the growth rate of the firm. A firm's decisions to invest in long-term assets will have a bearing on the rate and direction of its future growth. The assumptions on which capital investment decisions are based have to be estimated with a fair degree of precision;otherwise, this may lead to the creation of excessive capacity and simultaneous increase in interest and other costs. On the other hand,inadequate investments would lead to a loss of market share.
Risk: The risk complexion of the firm may also change with long-term commitment of funds for capital assets. The capital assets are financed by a mix of internal accruals, long-term borrowings and issue of fresh equity. The firms using borrowings to finance capital projects become more risky as the future cash flows associated with the capital projects are uncertain.
Funding: Investment decisions generally require large amount of funds, which make it imperative for the firms to plan their investment programme very carefully and make an advance arrangement for procuring finances internally or externally.
Irreversibility: Most of the capital investments are irreversible or reversible at very significant costs. Once the funds are committed for a capital project it becomes imperative for the firm to complete the project, abandoning it mid way would cause heavy losses to the firm as it is difficult to find a market for such custom made plant and machinery.
Complexity: Investment decisions are among the firm's most difficult decisions. The reasons for the complexity of these decisions are that they involve estimating the future cash flows of an investment, decisions, which in turn are depended on economic, political, social and technological variables.
Types of Investment Decisions
There are many ways of classifying investments, which are briefly described as follows:
(a) Expansion and Diversification
Increasing economic activities may lead the company in adding new capacity to its existing product lines to expand existing operations. For example, most of the steel companies have increased their plant capacity to meet increased steel demand. Some of these companies have installed additional capacity to produce specialised products like cold rolled sheets, flat products, etc. These types of expansion are known as related diversification. On the other hand, the companies may go for unrelated diversification, which requires investment in new products and a new kind of production activity within the company. For example,Reliance Industries Ltd. (RIL) primarily a textile and petrochemical Company diversified into telecommunication. These types of diversification are known as unrelated diversification. In either case, the objective of the investment is to generate additional revenue. Investment in existing or new products is also known as revenue-expansion investments.
There are four stages in the capital budgeting process:
Stage 1: Investment Screening and Selection – Projects consistent with the corporate strategy are identified by the various functional units (production,marketing, research and development) of the firm. Once the projects are identified, projects are evaluated and screened by an investment committee comprising of senior managers. The main focus of this process is to estimate how the investment proposal will affect the future cash flows of the firm and hence the value of the firm.
Stage 2: Capital Budgeting Proposal – Once the investment proposal survives the scrutiny of the investment committee, a capital budget is proposed for the project. The capital budget lists the amount of investment required for each investment proposal. This proposal may start with estimates of expected revenue and costs. At a later stage inputs from marketing, purchasing engineering, production and accounting and finance functions are put together.
Stage 3: Budgeting Approval and Authorisation Projects included in the capital budgets are authorised, which allows further fact gathering research and analysis as a result of which the capital budget proposal is refined and put up for approval. The approval allows the expenditure on the project. In some firms, the projects are authorised and approved concurrently, where as in others a project is first authorize so that the estimates can be refined. It is then approved. Large expenditures require formal authorisation and approvals whereas capital expenditures within a certain limit can be approved by the managers themselves.
Stage 4: Project Tracking – Once the project is approved the next step is to execute it. The concerned managers periodically report the progress of the project as well as any variances from the plan. The managers also report about time and cost overruns. This process of reporting is known as project tracking.
Classifying Investment Project
Investment projects are classified according to their economic life. The economic life or useful life of an asset is determined by its:
• Physical decoration
• Obsolescence
• The degree of competition in the market for a product
The economic life of an asset is an estimate of the length of time that the asset would provide benefits to the firm. After its useful life, the revenues generated by the assets decline rapidly and expenses on the assets increase in a disproportionate manner.Generally, an investment requires an immediate commitment of funds (cash outflows) and the benefits are received over a period in the form of cash inflows.If cash inflows are limited to current period, only these types of investments are known as short-term investments. If these benefits are spread over many years, these types of investments are referred to as long-term investments and expenditure on these investments is known as capital expenditure.
Importance of Capital Investment Decisions
Investment decisions are vital and crucial for any company and merit special attention because of the following reasons:
• They influence the firm's growth in the long run
• They affect the risk of the firm
• They involve commitment of large amount of funds
• They are irreversible or reversible at substantial loss
• They are among the most difficult decisions to make
Growth: Investment decisions affect the growth rate of the firm. A firm's decisions to invest in long-term assets will have a bearing on the rate and direction of its future growth. The assumptions on which capital investment decisions are based have to be estimated with a fair degree of precision;otherwise, this may lead to the creation of excessive capacity and simultaneous increase in interest and other costs. On the other hand,inadequate investments would lead to a loss of market share.
Risk: The risk complexion of the firm may also change with long-term commitment of funds for capital assets. The capital assets are financed by a mix of internal accruals, long-term borrowings and issue of fresh equity. The firms using borrowings to finance capital projects become more risky as the future cash flows associated with the capital projects are uncertain.
Funding: Investment decisions generally require large amount of funds, which make it imperative for the firms to plan their investment programme very carefully and make an advance arrangement for procuring finances internally or externally.
Irreversibility: Most of the capital investments are irreversible or reversible at very significant costs. Once the funds are committed for a capital project it becomes imperative for the firm to complete the project, abandoning it mid way would cause heavy losses to the firm as it is difficult to find a market for such custom made plant and machinery.
Complexity: Investment decisions are among the firm's most difficult decisions. The reasons for the complexity of these decisions are that they involve estimating the future cash flows of an investment, decisions, which in turn are depended on economic, political, social and technological variables.
Types of Investment Decisions
There are many ways of classifying investments, which are briefly described as follows:
(a) Expansion and Diversification
Increasing economic activities may lead the company in adding new capacity to its existing product lines to expand existing operations. For example, most of the steel companies have increased their plant capacity to meet increased steel demand. Some of these companies have installed additional capacity to produce specialised products like cold rolled sheets, flat products, etc. These types of expansion are known as related diversification. On the other hand, the companies may go for unrelated diversification, which requires investment in new products and a new kind of production activity within the company. For example,Reliance Industries Ltd. (RIL) primarily a textile and petrochemical Company diversified into telecommunication. These types of diversification are known as unrelated diversification. In either case, the objective of the investment is to generate additional revenue. Investment in existing or new products is also known as revenue-expansion investments.
(b) Replacement and Modernisation
Rapid technological advancements have necessitated the replacement and modernisation of existing plants and machinery. The main objective of replacement is to improve operating efficiency and reduce costs. Cost savings may lead to increased profits but the revenue may remain unchanged. In cases where replacement decisions lead to substantial technological and operational improvements, it may also lead to increase in revenues. Replacement investments are also referred to as cost reduction investment.
(c) Forward and Backward Integration
All companies require raw materials for production and the final product manufactured may be used as raw material for another company. When the companies integrate the source of raw material/inputs it is known as backward integration, for example, a cloth weaving company investing in yarn spinning, a petroleum product refining company investing in hydrocarbon exploration. In the same way when the intermediate product manufactured is further processed to make another product having a higher value it is known as forward integration, for example, a petroleum product refining company investing in manufacturing petrochemicals. The basic objective of forward and backward integration is to be present at every stage of the value chain.Another way to classify investments is as follows:
(i) Mutually Exclusive Investments
These types of investment decisions involve choosing among different alternatives. Choosing one alternative will exclude all otheralternatives. For example, for capital power generation a company may either choose between a gas based or coal based power generator.Choosing any one of the alternatives will automatically exclude all the other available alternatives.
(ii) Independent Investments
In these types of investments, the decision regarding one project is dependent on the decision regarding another project. For example,a steel company contemplating investments in a blast furnace. The decision regarding this project would be contingent upon the investment in iron ore mines.
(iii) Contingent Investments
In these types of investments, the decision regarding one project is dependent on the decision regarding another project. For example, a steel company contemplating investments in a blast furnace. The decision regarding this project would be contingent upon the investment in iron ore mines.
Rapid technological advancements have necessitated the replacement and modernisation of existing plants and machinery. The main objective of replacement is to improve operating efficiency and reduce costs. Cost savings may lead to increased profits but the revenue may remain unchanged. In cases where replacement decisions lead to substantial technological and operational improvements, it may also lead to increase in revenues. Replacement investments are also referred to as cost reduction investment.
(c) Forward and Backward Integration
All companies require raw materials for production and the final product manufactured may be used as raw material for another company. When the companies integrate the source of raw material/inputs it is known as backward integration, for example, a cloth weaving company investing in yarn spinning, a petroleum product refining company investing in hydrocarbon exploration. In the same way when the intermediate product manufactured is further processed to make another product having a higher value it is known as forward integration, for example, a petroleum product refining company investing in manufacturing petrochemicals. The basic objective of forward and backward integration is to be present at every stage of the value chain.Another way to classify investments is as follows:
(i) Mutually Exclusive Investments
These types of investment decisions involve choosing among different alternatives. Choosing one alternative will exclude all otheralternatives. For example, for capital power generation a company may either choose between a gas based or coal based power generator.Choosing any one of the alternatives will automatically exclude all the other available alternatives.
(ii) Independent Investments
In these types of investments, the decision regarding one project is dependent on the decision regarding another project. For example,a steel company contemplating investments in a blast furnace. The decision regarding this project would be contingent upon the investment in iron ore mines.
(iii) Contingent Investments
In these types of investments, the decision regarding one project is dependent on the decision regarding another project. For example, a steel company contemplating investments in a blast furnace. The decision regarding this project would be contingent upon the investment in iron ore mines.
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