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    FM Unit 2 CB Part B Qa

    Uploaded by

    Vasugi Kumar

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd

    FM Unit 2 CB Part B Qa

    Uploaded by

    Vasugi Kumar
    13 views6 pages

    Original Title

    Fm Unit 2 Cb Part b Qa

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    PDF, TXT or read online from Scribd

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    Copyright:

    © All Rights Reserved
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    13 views6 pages

    FM Unit 2 CB Part B Qa

    Uploaded by

    Vasugi Kumar

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 6

    What is capital expenditure?

    State the importance of Capital Budgeting decisions in


    financial management.

    'Capital Expenditure (CAPEX)'

    Capital expenditure, or CapEx, are funds used by a company to acquire, upgrade, and maintain
    physical assets such as property, industrial buildings, or equipment. CapEx is often used to
    undertake new projects or investments by the firm. This type of financial outlay is also made
    by companies to maintain or increase the scope of their operations.

    Capital budgeting decisions are of paramount importance in financial decision. The


    profitability of a business concern depends upon the level of investment made for long period.
    Moreover, the investments are made properly through evaluating the proposals by capital
    budgeting. So it needs special care. In this context, the capital budgeting is getting importance.
    Such importance are briefly explained below.

    Importance of Capital Budgeting Decisions

    1. Long-term Implications of Capital Budgeting: A capital budgeting decision has its


    effect over a long time span and inevitably affects the company’s future cost structure
    and growth. A wrong decision can prove disastrous for the long-term survival of firm.
    On the other hand, lack of investment in asset would influence the competitive position
    of the firm. So the capital budgeting decisions determine the future destiny of the
    company.

    2. Involvement of large amount of funds in Capital Budgeting: Capital budgeting


    decisions need substantial amount of capital outlay. This underlines the need for
    thoughtful, wise and correct decisions as an incorrect decision would not only result in
    losses but also prevent the firm from earning profit from other investments which could
    not be undertaken.

    3. Irreversible decisions in Capital Budgeting: Capital budgeting decisions in most of


    the cases are irreversible because it is difficult to find a market for such assets. The only
    way out will be scrap the capital assets so acquired and incur heavy losses.

    4. Risk and uncertainty in Capital budgeting: Capital budgeting decision is surrounded


    by great number of uncertainties. Investment is present and investment is future. The
    future is uncertain and full of risks. Longer the period of project, greater may be the
    risk and uncertainty. The estimates about cost, revenues and profits may not come true.
    5. Difficult to make decision in Capital budgeting: Capital budgeting decision making
    is a difficult and complicated exercise for the management. These decisions require an
    over all assessment of future events which are uncertain. It is really a marathon job to
    estimate the future benefits and cost correctly in quantitative terms subject to the
    uncertainties caused by economic-political social and technological factors.

    6. Large and Heavy Investment: The proper planning of investments is necessary since
    all the proposals are requiring large and heavy investment. Most of the companies are
    taking decisions with great care because of finance as key factor.

    7. Permanent Commitments of Funds: The investment made in the project results in the
    permanent commitment of funds. The greater risk is also involved because of
    permanent commitment of funds.

    8. Long term Effect on Profitability: Capital expenditures have great impact on


    business profitability in the long run. If the expenditures are incurred only after
    preparing capital budget properly, there is a possibility of increasing profitability of the
    firm.

    9. Complicacies of Investment Decisions: Generally, the long term investment


    proposals have more complicated in nature. Moreover, purchase of fixed assets is a
    continuous process. Hence, the management should understand the complexities
    connected with each projects.

    10. Maximize the worth of Equity Shareholders: The value of equity shareholders is
    increased by the acquisition of fixed assets through capital budgeting. A proper capital
    budget results in the optimum investment instead of over investment and under
    investment in fixed assets. The management chooses only most profitable capital
    project which can have much value. In this way, the capital budgeting maximize the
    worth of equity shareholders.

    11. Difficulties of Investment Decisions: The long term investments are difficult to be
    taken because decision extends several years beyond the current account period,
    uncertainties of future and higher degree of risk.

    12. Irreversible Nature: Whenever a project is selected and made investments as in the
    form of fixed assets, such investments is irreversible in nature. If the management wants
    to dispose of these assets, there is a heavy monetary loss.
    13. National Importance: The selection of any project results in the employment
    opportunity, economic growth and increase per capita income. These are the ordinary
    positive impact of any project selection made by any company.

    Explain the merits and demerits of payback, NPV and IRR methods of capital
    expenditure evaluation.

    Pay-Back Method:

    The payback period is the length of time required to recover the cost of an investment. The
    payback period of a given investment or project is an important determinant of whether to
    undertake the position or project, as longer payback periods are typically not desirable for
    investment positions. The payback period ignores the time value of money (TVM)

    Merits of Pay-Back Method:

    (1) This method is Easy and Simple:


    Pay-back method is easy to calculate and simple to understand. Its quick computation makes
    it a favourable among executives who prefer snap answers.

    (2) Ranking of Projects:


    This method is preferred by executives who like snap answers for the selection of the
    proposal. The projects are ranked in terms of their economic merits without much
    complications.

    (3) It Stresses the Liquidity Objective:


    Because this method gives importance to the speedy recovery of investment in capital assets.

    (4) Useful in Case of Uncertainty:


    Pay-back method is useful in the industries which are subject to uncertainty, instability or
    rapid technological changes because the future uncertainty does not permit projection of
    annual cash inflows beyond a limited period. It reduces the possibility of loss through
    obsolescence.

    (5) Handy Device or Method:


    This method is handy device for evaluating investment proposals where procession in
    estimates of profitability is not important.
    Demerits or Limitations of Pay-Back Method:

    (a) It ignores annual cash flow:


    Pay-back method totally ignores the annual cash inflow after the pay-back period.

    (b) It considers only the period of pay-back:


    Pay-back method does not consider the pattern of cash inflows or the magnitude and timing
    of cash inflows.

    (c) It overlooks capital cost:


    Pay-back method overlook the costs of capital i.e., interest factor which is an important
    consideration in making sound investment decisions.

    (d) No rational basis of decision:


    There is no rational basis for determining the minimum acceptable pay-back period. It is
    generally subjective decision of the management which creates so many administrative
    difficulties.

    (e) It is delicate and rigid:


    A slight change in operation cost may affect the cash inflow and as such pay-back period
    shall not be affected.

    (f) This method over emphasises the importance of liquidity as a goal of capital
    expenditure decisions:
    However, in-spite of these drawbacks we cannot undermine the importance and popularity of
    this method. This is more popular in America and in England.

    Net Present Value Method:


    Net Present Value (NPV) is the difference between the present value of cash inflows and the
    present value of cash outflows over a period of time. NPV is used in capital budgeting to
    analyze the profitability of a projected investment or project.

    Merits of Net Present Value Method:

    1. It is based on the time value of money.

    2. It considers the earnings or savings over the entire life of the project. These earnings or
    savings are converted into the present value of money.
    3. It helps to make a comparative assessment of different projects.

    4. Under this method, the highest net present value project is recommended for implementation.
    It leads to maximization of profits to the organization.

    5. It can be applied to even and uneven cash inflows patterns.

    6. The NPV method is generally preferred by economists. Hawkins and Pearce state that this
    method is theoretically unassailable. If one wishes to maximize profits, the use of NPV always
    finds the correct decision.

    Demerits of the Net Present Value Method:

    1. This method does not indicate the rate of return which is expected to be earned.

    2. This method may fail to give satisfactory answer when the projects are requiring different
    levels of amount of investment and with different economic life of the projects.

    3. The application or usage of this method requires the knowledge of rate of cost of capital. If
    cost of capital is unknown, this method cannot be used.

    4.The NPV method leads to confusing and contradictory answers in ranking of complicated
    projects.

    5.Determining an appropriate discount rate is difficult in this method.

    6. This method cannot be used for finding the number of years required to recoup the capital
    expenditure i.e. project amount.

    Internal Rate of Return (IRR)


    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the
    profitability of potential investments. Internal rate of return is a discount rate that makes
    the net present value (NPV) of all cash flows from a particular project equal to zero.

    Advantages and Disadvantages of IRR


    Internal Rate of Return (IRR) is the discount rate that makes the net present value of all cash
    flows from an investment project equal to zero.
    Advantages of Internal Rate of Return:

    1) This technique gives equal importance to all the cash flows. We just need to identify the
    point at which the present value of cash inflow is equal to present value of cash outflow.

    2) It is a good method of capital budgeting. The IRR method is considered more popular and
    straightforward than the NPV approach.

    3) IRR can be used to rank different prospective projects and the project with the highest IRR
    would be considered the best.

    4) This method considers the time value of money and is therefore more realistic than the
    Accounting Rate of Return (ARR) method.

    Disadvantages of Internal Rate of Return:

    1) This technique can be difficult to understand.

    2) IRR does not take into account of the cost of capital, thus it should not be used to compare
    projects of different duration.

    3) The IRR could be difficult to find if we want to calculate it by using trial and
    improvement.

    4) It fails to recognize the varying size of different investment projects.

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