Madan Mohan Malaviya University of

FINANCIAL
Technology, Gorakhpur (U.P.) India
MANAGEMENT
UNIT – 2

BBA – 3rd SEMESTER

Dr. Priyanka Rai

Assistant Professor
Department of Humnanities Management and Science
CONTENT
 Investment decisions:
 Meaning & Significance
 Capital budgeting :
 Concept, process & Significance
 Technique Of capital budgeting-
 Traditional Technique –( pay-back period, net present value , Internal rate of return
, profitability Index
 Capital Rationing:
 Concept
 Leverage :
 Concept, significance
 Types – operating , Financial, combined leverage
 INVESTMENT DECISIONS

Investment decision It relates to as how the funds of a firm are to be

invested into different assets, so that the firm is able to earn highest
possible return for the investors. Investment decision can be long-
term, also known as capital budgeting where the funds are commited
into long-term basis. Short-term investment decision also known as
working capital decision and it is concerned with the levels of cash,
inventories and debtors . Investment decision can be long-term and
short-term.
These assets fall into two categories
 Long Term Assets

• Capital Budgeting

The decision of investing funds in the long term assets is

known as Capital Budgeting. Thus, Capital Budgeting is the
process of selecting the asset or an investment proposal that
will yield returns over a long period.

The first step involved in Capital Budgeting is to select the

asset, whether existing or new on the basis of benefits that
will be derived from it in the future.

The next step is to analyze the proposal’s uncertainty and

risk involved in it. Since the benefits are to be accrued in the
future, the uncertainty is high with respect to its returns.
Finally, the minimum rate of return is to be set against which
the performance of the long-term project can be evaluated.
 Short-Term Assets

• Working Capital Management

The investment made in the current assets or short term

assets is termed as Working Capital Management. The
working capital management deals with the management of
current assets that are highly liquid in nature.

The investment decision in short-term assets is crucial for

an organization as a short term survival is necessary for the
long-term success. Through working capital management, a
firm tries to maintain a trade-off between the profitability
and the liquidity.

In case a firm has an inadequate working capital i.e. less

funds invested in the short term assets, then the firm may
not be able to pay off its current liabilities and may result in
bankruptcy. Or in case the firm has more current assets than
required, it can have an adverse effect on the profitability of
the firm.
Significance of investment decisions

(a) Investment Linked with Objectives :

An enterprise with an objective of survival and growth,
incurs capital expenditure every year and takes investment
decisions e.g., investment in fixed assets and inventory.

(b) Long Term Commitments :

A capital project, like hydroelectric project is expected to
bring benefits in future years. Such projects require the
commitment of funds for future years, and draw the future
direction by determining its product, markets, production
facilities and technology.

(c) No-Going Back:

It is difficult to reverse a capital project decision.

 CAPITAL BUDGETING
Capital budgeting is a company’s formal process used for evaluating potential
expenditures or investments that are significant in amount. It involves the decision to
invest the current funds for addition, disposition, modification or replacement of fixed
assets. The large expenditures include the purchase of fixed assets like land and building,
new equipments, rebuilding or replacing existing equipments, research and
development, etc. The large amounts spent for these types of projects are known
as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future
profits since most companies are able to manage only a limited number of large projects
at any one time.
Capital budgeting usually involves calculation of each project’s future accounting profit
by period, the cash flow by period, the present value of cash flows after considering time
value of money, the number of years it takes for a project’s cash flow to pay back the
initial cash investment, an assessment of risk, and various other factors.

Capital is the total investment of the company and budgeting is the art of
building budgets.
 FEATURES OF CAPITAL BUDGETING

• Large Investments
Capital Budgeting is related to taking decisions requiring large funds. It is a process used for selecting
the high-value capital projects by the management. Managers use capital budgeting for properly
analysing different investment opportunities and take decision with proper care.

• Irreversible Decision
The decisions taken through the capital budgeting process are irreversible in nature. This process
requires making choices for large fund investment in different capital projects available. A decision
once taken becomes difficult to be amended as it involves the allocation of large funds and affects
company growth. High-value asset once purchased can’t be sold at the same prices and at the same
time.

• High Risk
There is a high degree of risk involved in the capital budgeting process. Decisions taken in this process
are concerned with future return and the future is uncertain. Future unforeseen like change in fashion
and taste, technological and research advancement may lead to higher risk. It, therefore, involves
critical analysis before taking any decision as there are a large amount of funds allocated by business
through this process.
• Long Term Effect on Profitability
Capital Budgeting decisions have long term effects on the profit-earning capacity of the business. It
involves decisions regarding large investments providing return to business. Decisions taken
through capital budgeting affects both current and future earning potential of the company. Any
unwise decision may affect business growth adversely and may be fatal. Therefore capital budget
is termed us utmost function for every business which has great influence over its profitability.

• Impacts Cost Structure

The decisions taken through the capital budgeting process have a direct impact on the cost
structure of the business. Through decision taken in this process, business commits
themselves to costs like interest, insurance, rent, supervision etc. If the investment taken does
not generate the anticipated income for the business, then it would increase the cost
expenses and lead business to losses.

• Difficult Decisions
Decisions taken through the capital budgeting process are difficult in nature. Decisions taken
here are regarding the future which is uncertain and may have many unforeseen. It, therefore,
becomes difficult for managers to choose the most profitable investment providing better
return in future.
 CAPITAL BUDGETING PROCESS:

A) Project identification and generation:

The first step towards capital budgeting is to generate a proposal for investments. There could be various
reasons for taking up investments in a business. It could be addition of a new product line or expanding
the existing one. It could be a proposal to either increase the production or reduce the costs of outputs.

B) Project Selection:
There is no such defined method for the selection of a proposal for investments as different businesses
have different requirements. That is why, the approval of an investment proposal is done based on the
selection criteria and screening process which is defined for every firm keeping in mind the objectives of
the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to be
explored by the finance team. This is called preparing the capital budget. The average cost of funds has to
be reduced. A detailed procedure for periodical reports and tracking the project for the lifetime needs to be
streamlined in the initial phase itself. The final approvals are based on profitability, Economic constituents,
viability and market conditions.
C) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria’s to judge the desirability of a
proposal. This has to match the objective of the firm to maximize its market value.
The tool of time value of money comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash
inflow and outflow along with the uncertainties and risks associated with the
proposal has to be analyzed thoroughly and appropriate provisioning has to be done
for the same.

D) Implementation:
Money is spent and thus proposal is implemented. The different responsibilities like
implementing the proposals, completion of the project within the requisite time period
and reduction of cost are allotted. The management then takes up the task of monitoring
and containing the implementation of the proposals.

E) Performance review:
The final stage of capital budgeting involves comparison of actual results with the
standard ones. The unfavorable results are identified and removing the various
difficulties of the projects helps for future selection and execution of the proposals.
 SIGNIFICANCE OF CAPITAL BUDGETING:

• Capital budgeting is probably the most important single area of decision making for the finance
manager in respect of planning the fund requirements and allocating the funds and controlling its
uses. In capital budgeting, an estimate is made of an expenditure whose results will be available for
a number of years and it takes long period of working before the final results of the action can be
known.

• Thus, decision in respect of capital expenditure is going to affect the firm’s operations for years to
come. An erroneous forecast of assets can entail the firm in financial hardships. If a firm has
invested too much in fixed assets, it will be incurring unnecessarily heavy expenses.

• If it has not spent enough on fixed assets, it may not be able to produce competitively since its
equipment may not be sufficiently modern. Further, it may lose a portion of its share to rival firms.
Further, an ill-advised decision cannot be rectified frequently without seriously affecting the health
of the firm.
• Capital budgeting also saves the company from other problems which may otherwise
arise. For instance, workers who were hired for the project might be laid off if the
project fails, creating morale and unemployment problems. Many of the fixed costs will
still remain even if a plant is closed or is not producing. Advertising efforts will be
wasted. Stock prices could be affected by the decline in income.

• Another important reason for the importance of capital expenditure decision is that
acquisition of fixed assets involves substantial expenditure. Before a firm spends a
large amount of money, it must make the proper plans for raising large funds which
cannot come automatically. A firm contemplating a major capital expenditure
programme may need to arrange funds many years in advance to be sure of having the
funds when needed.

• Capital budgeting provides useful tool with the help of which the management
can reach prudent investment decision. It provides criterion of ranking
investment project in terms of economic desirability. Projects yielding highest
returns and involving less cost and risk may be given top priority.
• Capital budgeting provides quantitative evidence as to how much a firm should
expand its total assets. This is provided by cut-off point—a point where marginal
revenue and marginal cost equate. Not only is the capital budget a tool for decision
making, it also acts as a planning and control device. As a planning tool, it helps the
management to determine long-term capital requirements and timings of such
requirements.

• Capital budget becomes a control device when it is employed to control

expenditures. Planned outlays are limits to actual expenditure. The firm may also
use the projected cash inflows and outflows as a standard with which to match the
actual cash outflow and inflow of the capital budget. If costs deviate considerably,
the company should investigate the variation in order to keep expenditure under
control.

• In addition, other actions taken within the company regarding the project, such
as finding suppliers of raw materials, are wasted if the capital-budgeting decision
must later be revoked. Poor capital-budgeting decision may also harm the
company’s competitive position because the company will not have the most
efficient productive assets needed to compete in world market.
TECHNIQUE OF CAPITAL BUDGETING

Capital budgeting consists of various techniques used by managers such as:

Payback Period
Discounted Payback Period
Net Present Value
Accounting Rate of Return
Internal Rate of Return
Profitability Index

All of the above techniques are based on the comparison of cash inflows and outflow of a
project however they are substantially different in their approach.
A brief introduction to the above methods is given below:

Payback Period measures the time in which the initial cash flow is returned by the
project. Cash flows are not discounted. Lower payback period is preferred.

Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash
inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.

Accounting Rate of Return (ARR) is the profitability of the project calculated as

projected total net income divided by initial or average investment. Net income is not
discounted.

Internal Rate of Return (IRR) is the discount rate at which net present value of the
project becomes zero. Higher IRR should be preferred.

Profitability Index (PI) is the ratio of present value of future cash flows of a project to
initial investment required for the project.
 CAPITAL RATIONING

Capital rationing is defined as the process of placing a limit on the extent of new projects or
investments that a company decides to undertake. This is made possible by placing a much
higher cost of capital for the consideration of the investments or by placing a ceiling on a
particular proportion of a budget. A company might intend to implement capital rationing in
scenarios where the past revenues generated through investments were not up to the mark.

 Understanding Capital Rationing:

Capital rationing is necessarily an approach of management in allocating the funds available
across various opportunities of investment, thereby enhancing the bottom line of the
company. The company will go on the accept the blend of projects that have the net present
value (NPV) on the higher side. The primary intention of the capital rationing is to make sure
that a company is not going to invest heavily in assets. With insufficient rationing, a company
may go on to witness the returns provided by their investments going on the lower side and
may even reach a scenario where the company enter the stage of financial insolvency.
 Types of Rationing:

The first type of capital rationing is called as the hard capital rationing. This type of rationing
happens if a company is having issues with raising excessive funds, either by means of debt or
equity. The rationing happens from an external dependence in order to cut down on expenses
and may result in the shortage of capital to raise enough money for projects in future.

The second kind of capital rationing, is referred to as the soft capital rationing. It is also called
as the internal rationing. This happens because of the internal policies of an organisation. A
company that is financially conservative will have a high required return on the capital invested
in taking up projects in the coming days, thereby imposing self capital rationing.
 LEVERAGE

The word ‘leverage’, borrowed from physics, is frequently used in financial management.
The object of application of which is made to gain higher financial benefits compared to
the fixed charges payable, as it happens in physics i.e., gaining larger benefits by using
lesser amount of force.

 In short, the term ‘leverage’ is used to describe the ability of a firm to use fixed cost
assets or funds to increase the return to its equity shareholders. In other words,
leverage is the employment of fixed assets or funds for which a firm has to meet fixed
costs or fixed rate of interest obligation—irrespective of the level of activities
attained, or the level of operating profit earned.
 Leverage occurs in varying degrees. The higher the degree of leverage, the higher is
the risk involved in meeting fixed payment obligations i.e., operating fixed costs and
cost of debt capital. But, at the same time, higher risk profile increases the possibility
of higher rate of return to the shareholders.
Some definitions are given to have a clear idea about leverage:

According to Ezra Solomon:

“Leverage is the ratio of net returns on shareholders
equity and the net rate of return on capitalisation”.

According to J. C. Van Home:

“Leverage is the employment of an asset or funds for
which the firm pays a fixed cost of fixed return.”
 TYPES OF LEVERAGE
 Leverage are the three types:
(i) Operating leverage
(ii) Financial leverage and
(iii) Combined leverage

Operating Leverage:

Operating leverage refers to the use of fixed operating costs

such as depreciation, insurance of assets, repairs and
maintenance, property taxes etc. in the operations of a firm.
But it does not include interest on debt capital. Higher the
proportion of fixed operating cost as compared to variable
cost, higher is the operating leverage, and vice versa.
 Financial leverage

Financial leverage which is also known as leverage or

trading on equity, refers to the use of debt to acquire
additional assets. The use of financial leverage to control a
greater amount of assets (by borrowing money) will cause
the returns on the owner's cash investment to be amplified.

combined leverage

Combined leverage is a leverage which refers to high profits due

to fixed costs. It includes fixed operating expenses with fixed
financial expenses. It indicates leverage benefits and risks which
are in fixed quantity.