In the words of Charles T Horngren, Capital budgeting is a long term planning for making and financing proposed capital outlays.

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1 Capital budgeting I) Meaning of Capital Budgeting: Capital budgeting can be defined as the planning, evaluation and selection of capital expenditure proposals. Capital budgeting is important for firms for achieving their objectives related to profitability growth. The meaning of capital budgeting can be understood from the definitions given below. According to James C Van Horne, Capital budgeting involves a current investment in which the benefits are expected to be received beyond one year in the future. Herold Bierman and T R Dyckman defines Capital budgeting as the process of deciding whether or not to commit resources in projects whose costs and benefits are spread over several time periods. In the words of Charles T Horngren, Capital budgeting is a long term planning for making and financing proposed capital outlays. According to Max D Richard and Paul S Greenlaw, Capital budgeting refers to acquiring inputs with long run returns. Thus is can be concluded from the above definitions that capital budgeting it is a as long term investment analysis. Capital expenditure is the process of planning for investment expenditure for which the benefits or returns are realized at different times in future. If generally involves large sum of money incurred at different points of time. Capital expenditure decisions are seldom reversible as there is no second hand market for many types of capital goods.

2 II) Need for Capital Budgeting Capital budgeting is required for a number of reasons. Capital budgeting is the prerequisite for the running of any industrial unit. Some of the important needs of capital budgeting are as follows:- a) Future development of business can be visualized by preparing a framework for long term investments. Modern firms raise a lump sum amount on money from the financial market, required for setting up plants. If the funds are not utilized judiciously then the firm will incur losses. Thus it is necessary for the management to make appropriate investments for the future profitability. b) Heavy investments: Capital budgeting is needed for securing adequate return from the heavy investment. c) Long term commitment of funds: different investment proposals have difference in the degree of risk and uncertainties. The managements decision becomes Irreversible and the huge investments cannot be transferred and the firm s investments will sink. With the help of Capital budgeting all these uncertainties can be avoided. d) Capital budgeting is required for prioritization and for building capacity in view of future growth of demand. e) Difficulties arising out of long gestation period can be avoided with the capital budgeting. f) Long term impact on profitability and vital for managements reputations. All these arguments make it clear that capital budgeting is necessary for the long term investment. Given the firms objectives, the survival of the firm depends upon the management s ability to conceive, analyse and invest in the most profitable project. 2. Demand for capital:

3 Since the objective of capital budgeting is to make profit, the demand or need should be evaluated by the prospective of profitability.this involves a) Survey of opportunities for profitable internal investment, and b) Implies some system of screening requests on the basic of prospective profitability. Demand for capital or the proposals related to capital expenditure are shown in chart 3.1. Demand for Capital Identical New Machines Replacement Expansion Old Product lines Allied Lines Diversifi - cation Enhanc ing welfare Modernisation Nonallied Lines Strategic Reduction of Risk Defensive Aggressive Chart 5.1: Demand for Capital Capital expenditure on replacement includes replacement of phased out machines with similar or new machines or replacement of obsolete machines

4 with modern plants. This expenditure is undertaken by existing firms only. Replacement investments are made generally to reduce the unit cost. Modernisation includes improved products bringing in new product or changed product in the market. Certain investments are necessary to bring about modernization. These expenditures include expenditure on research and development, market research, advertising etc. Rent or buy - A firm may decide to lease equipment rather than invest huge amount of funds for buying a new equipment or machinery. Capital expenditure for expansion consists of increasing the existing line or new lines of production. The ultimate objective is to reduce the unit cost of production thereby increasing the profitability of the firm. Capital expenditure of strategic nature includes those on improving employee s welfare such as providing better facilities to employees, and reducing the risk of the business. This includes - Defensive In anticipation of rough weather ahead the firm may require funds for storing inventories for unusually longer period in order to meet the contingencies like shortages. Aggressive The firm will become proactive and invest in research & development to improve its products and be innovative. 3. Sources of supply of capital: A firm may obtain capital from various sources. The sources of funds for capital investment can be broadly divided into the following two categories. I) Internal Sources and II) External Sources

5 The sources of capital depend upon the nature of the demand for capital. If the capital is demanded for short term a firm may seek its own internal sources of finances. On the other hand if the nature of demand for capital is long term a firm may borrow funds from external sources. Further, for starting a new company one has to depend upon external sources of Finance. However, an existing company can generate finance with the help of its internal sources. The internal and external sources of supply of capital are given in the flow chart 5.2 Sources of Finance Internal Sources External Sources Depreciation Retained Earnings Short term sources Long Term Sources 1) Trade Credit 2) Bank Credit 3) Public Deposits 4) Factoring 5) Accrual Account 6) Indigenous Bankers 7) Advances from Customers 1) Security Financing A) Shares B) Debentur es 2) Merchant Banking 3) Term Loans Chart 5.2: Sources of Finance

6 I) Internal Sources: There are two most important sources of internal finance namely depreciation and retained earnings. We shall discuss these two internal sources of financing in detail. a) Depreciation: Depreciation means reduction in the value of a producing asset due to wear and tear, lapse of time, obsolescence etc. If the amount of depreciation is not used for buying new assets, it can increase the size of cash flows. Therefore the sum of depreciation may be treated as internal financing. Depreciation is calculated in the following way- Depreciation = Cost of asset - scrap value / Economic life of the assets The producer can calculate the fixed sum of money and invest the same on easily realizable securities. Once the economic life of the asset is over he can all these securities can be sold to buy the new asset. Hence a firm charging the depreciation to profit and loss account, there is no outflow of cash. Therefore, the amount of depreciation deducted can be used as a means of internal finance. b) Retained Earnings: Retained earnings are also known as retained surplus. t is commonly known as internal financing or ploughing back of profits. According the provisions of the company Act, a company can transfer a certain percentage of it s the net profits after tax to a reserve.this percentage can not exceed 10.Once this transfer is done then the company proceeds to declare dividends for the financial.thus

7 the retained earnings means the ploughing back of profit before declaring the dividends. Benefits of retained earning- This method is useful because the firm does not have to pay any cost for the capital. It is beneficial because it carries no fixed obligations regarding payment of interest and dividends. Therefore this method of financing is more economical and less burden sum II) External sources: External sources can be divided into short term and long term sources of finance. A) Short term: Short term financing includes borrowing funds for a short period of time. Usually short term finance deals with commercial bank, trade credit and other sources of funds, for a period of less than one year. The sources of short term financing are explained below - a) Trade Credits: arise when tangible goods are sold by one business establishment to another business establishment on the basic of differed payment. Such credit is not cash loan. Trade credit occurs from the sale of goods or services which need not be paid for immediately after the sale takes place. b) Bank Credit: Commercial banks are a major source of financing industrial and commercial activities. Modern banks have introduced many innovative and attractive schemes for the disbursement of credit. Cash credits, overdrafts and other schemes which enable a borrower to withdraw funds as and when needed. The credit limit is determined by the bank against the security of the stock of commodity. Overdraft is

8 allowed on personal or joint current accounts. Bill of finance is another popular method of providing short term finance. Loans- a kind of advance made with or without security. A banker credits lump sum payment to borrowers account for a fixed period at an agreed rate of interest. Cash Credit- is an arrangement where the banker allows customers to borrow money up to certain limit, usually made against the securities of commodities hypothecated or pledged with the bank. Hypothecation- Hypothecation means the goods are with the customer but bank is given the access, whenever it so desires. Pledge-In case of pledge, goods are in the custody of bank, with its name on the godown (store house) where the goods are stored continued on page Overdrafts- It is facility wherein the customer is allowed to overdraw his current, with or without security for temporary needs. Bills discounted & purchased is another facility, where bank provides advances against discounting of the bills. c) Public Deposits: Acceptance of deposits for short periods from the members, directors of the company and general public is a popular method of raising finance as bank credit is becoming more costlier

9 1. Finance companies- These companies are important source of finances for the industry in following ways 2. i) Leasing and Hire Purchase- Industry are helped by finance companies in acquisition of capital assets such as plant & machinery, office equipments, vehicles etc through leasing or hire purchase. d) Factoring: A study group appointed by international Institute for the unification of private Law (UNIDROIT) during 1988 defined factoring as an arrangement between a factor and his client which includes at least two of the following services to be provided by the factor. -Finance -Maintenance of accounts -Collection of debts -Protection against credit risks. (Source Report of international institute for Unification of private law (UNIDROIT)) It is also defined as an agreement in which receivables arising out of sale of goods or services are sold the factor as a result of which the title of such goods and services passes on to the factor. e) Accrual Accounts: These are self generating spontaneous source of financing. Common source of accrual accounts are wages and taxes. In these cases the amount is paid much later than its due time. For example wages are pain only in the first week of the month next to the month in which the services has been rendered. Similarly, the provision if tax is created out of the profit of the firm at the end of the financial year and the tax is actually paid only after assessment is over. Financing through accrual account is interest free. However this is not a

10 discretionary source of financing as the company cannot postpone the payment of wages and taxes indefinitely. f) Indigenous Bakers: Private individuals engaged in the business of financing small and local business are known as indigenous bankers. According to the Indian Central Banking Enquiry Committee, an indigenous banker is defined as an individual or private firm which receives deposits, deals in hundies or engages itself in lending money. They are important source of short term or medium term loans. However they charge very high interest rates. g) Advances from Customers: Advances from customers' represents cash received for products or services not yet provided to the customers. Many a times firms producing costly goods, demand advances from the customers at the time of accepting their orders for supplying the goods at future date. This is a cost free source of finance. B) Long term sources: 1) Security financing Two sources of long term financing available to a company for availing capital arei) Shares and ii) Debentures i) Shares: shares can be defined as one of the units into which the share capital of a company is divided. Further, shares can be divided into (ii) preference shares and (ii) ordinary shares and (iii) equity shares.

11 1) Ordinary Shares:- Represent the ownership possession of a company. The holders of ordinary shares are commonly called shareholders. The shareholders are the legal owners of the company. Infact, ordinary shares are considered as the permanent capital since they do not have maturity date. The ordinary share holders are entitled for dividends. The capital raised in this way is also known as share capital or equity capital. 2) Preference Shares:- These shares carry fixed dividend or fixed rate. It can be cumulative or non cumulative, participating or non-participating (companies (Amendment) Act 1996). Preference shares have the following featuresa) Claim on income and asset b) Fixed dividend, c) Cumulative dividend d) Redemption e) Call features/ buy back etc iii) Equity shares:- Equity shares do not carry any preferential right. It is the most important source of long term finance. Public issue of equity means increasing of share capital directly from the general public. For example Reliance Power Corporation made a public issue of equity shares, shares can be issued at par premium or discount. a company may issue shares at par without many restrictions, by following the rules and laid down by the companies Act 1956 and the Amended companies Act 1999.premium means a value higher than the face value of shares, where as discount means issue of shares for a consideration less than the nominal value of shares.

12 ii) Debenture: A debenture is a document issued by a company as an evidence of a debt due from the company. It is therefore along term promissory note for raising loan capital. A company promises to pay interest and principal in the stipulated period. The one who buys debenture is called debenture holder.in India the alternative form of debenture is bond. Debentures have following features - a) Interest rate: on a debenture is fixed and made known to the public. The payment of interest rate is binding on the company regardless of what happens to the market price of debentures. b) Maturity: Usually debentures are issued for a specific period of time. The maturity period for debenture in India is 7 to 10 years. c) Redemption: debentures can be redeemed with call or put options. Call means it can be redeemed earlier than the redemption date at a pre determined price. Whereas put option means holder has the right to demand back the money earlier than the redemption date. 2) Merchant Banking is an attractive source of raising long term finance. It is basically service banking, providing non fund based services of arranging funds rather than providing them. The merchant banker merely acts as an intermediary, who helps in transferring funds from who own it to those who need it. The services of merchant bankers include- Profit counseling Sponsor of issue Credit syndication Investment Management Arrangement for fixed deposits. Corporate counseling for financial institution

13 Rehabilitation and reconstruction of old or oiling or silk industrial units. Assistance in negotiations of foreign collaboration. Arranging technology, finance and venture capital 3) Term Loans: Two major sources of term loans are i) Specialized financial institutions or Development banks and ii) Commercial banks. i) Specialised Financial Institutions or development banks: To meet the specific term financial needs a large number of specialized financial institutions have been set up in the country. a development bank works as a development catalyst by mobilizing scarce resources such as capital, technology, entrepreneurial and managerial talents & channelize them into industrial activities as per plan priorities some of these banks are- a) Industrial Development Bank of India Ltd b) Export Import Bank of India. c) Industrial Investment Bank of India d) Industrial Finance Corporation of India (IFCI) e) Industrial Credit and Investment Corporation of India Ltd (merged with ICICI Bank Ltd) f) Small Industries Development Bank of India (SIDBI) g) State Finance Corporations (SFCS) h) State Industrial Development Corporation (SIDCS) i) North Eastern Development Finance Corporation Ltd (NEDFI) j) Life Insurance Corporation of India (LIC) k) General Insurance Corporation of India (GIC) l) Unit Trust of India (UTI) (Reorganized Effective from February 1,2003) m) Infrastructure Development Finance Company (IDFC) Ltd

14 ii) Commercial banks: With effect from April 1997 the credit limits of 50 Crores is withdrawn and banks are free to lend need based finance to borrowers.

MVSR ENGINEERING COLLEGE MBA DEPARTMNET. Concepts in Financial Services and Systems

MVSR ENGINEERING COLLEGE MBA DEPARTMNET Concepts in Financial Services and Systems 1. Financial System: The Financial system is a broader term which brings under its fold the financial markets and the