COST OF CAPITAL

MEANING OF COST OF CAPITAL• THE COST OF CAPITAL OF A FIRM IS THE MINIMUM RATE OF

RETURN EXPECTED BY ITS INVESTORS.

• IT IS OTHERWISE CALLED CUT-OFF RATE

• ACCORDING TO WEALTH MAXIMIZATION OBJECTIVE, A FIRM MUST EARN A RATE OF RETURN MORE THAN ITS COST OF CAPITAL SO THAT THE MARKET VALUE OF CO.’S SHARES DOES NOT FALL.

DEFINITION

1. “THE RATE OF RETURN THE FIRM REQUIRES FROM INVESTMENT INORDER TO INCREASE THE VALUE OF THE FIRM IN THE MARKET PLACE” - HAMPTON JOHN J

2. “COST OF CAPITAL IS THE MINIMUM REQUIRED RATE OF EARNINGS OR THE CUT-OFF RATE OF CAPITAL EXPENDITURES” – SOLOMN EZRA

FEATURES• COST OF CAPITAL IS NOT A COST AS SUCH. IT IS THE

RATE OF RETURN THAT A FIRM REQUIRES TO EARN FROM ITS PROJECTS.

• IT IS THE MINIMUM RATE OF RETURN

• IT COMPRISES OF THREE COMPONENETS –

A. THE EXPECTED NORMAL RATE OF RETURN AT ZERO RISK LEVEL IE THE RATE OF INTEREST BY BANK.

B. THE PREMIUM FOR BUSINESS RISK

C. THE PREMIUM FOR FINANCIAL RISK

• COST OF CAPITAL K = R + B + F

WHERE

K = COST OF CAPITAL

R = NORMAL RATE OF RETURN AT ZERO LEVEL

B = PREMIUM FOR BUSINESS RISK

F = PREMIUM FOR FINANCIAL RISK

SIGNIFICANCE OF COST OF CAPITAL

1. AS AN ACCEPTANCE CRITERION IN CAPITAL BUDGETING• CAPITAL BUDGETING DECISIONS CAN BE MADE BY

CONSIDERING THE COST OF CAPITAL.

• ACCORDING TO THE PRESENT VALUE METHOD OF CAPITAL BUDGETING, IF THE PRESENT VALUE OF EXPECTED RETURNS FROM INVESTMENT IS GREATER THAN OR EQUAL TO THE COST OF INVESTMENT, THE PROJECT MAY BE ACCEPTED; OTHERWISE REJECTED

2. AS A DETERMINANT OF CAPITAL MIX IN CAPITAL STRUCTURE DECISIONS• THERE SHOULD BE A PROPER MIX OF DEBT AND EQUITY

CAPITAL IN FINANCING A FIRM’S ASSETS.

• WHILE DESIGNING THE OPTIMAL CAPITAL STRUCTURE, THE MGT HAS TO KEEP IN MIND THE OBJECTIVE OF MAXIMISING THE VALUE OF THE FIRM AND MINIMISING THE COST OF CAPITAL.

3. AS A BASIS FOR EVALUATING THE FINANCIAL PERFORMANCE

• THE CONCEPT OF COST OF CAPITAL CAN BE USED TO EVALUATE THE FINANCIAL PERFORMANCE OF TOP MGT.

• IF THE ACTUAL PROFITABILITY IS MORE THAN THE PROJECTED AND ACTUAL COST OF CAPITAL, THE PERFORMANCE MAY BE SAID TO BE SATISFACTORY.

4. AS A BASIS FOR TAKING OTHER FINANCIAL DECISIONS

• IT IS ALSO USED IN MAKING OTHER FINANCIAL DECISIONS SUCH AS DIVIDEND POLICY, CAPITALIZATION OF PROFITS, RIGHT ISSUE, ETC

TYPES OF COST • HISTORICAL COST – BOOK COST RELATED TO PAST• FUTURE COST – ESTIMATED COST FOR FUTURE• SPECIFIC COST – COST OF A SPECIFIC SOURCE OF

CAPITAL• COMPOSIT COST – COMBINED COST OF VARIOUS

SOURCES OF CAPITAL. IT IS WEIGHTED AVERAGE COST OF CAPITAL

• EXPLICIT COST – IT IS THE INTERNAL RATE OF RETURN• IMPLICIT COST – OPPORTUNITY COST• AVERAGE COST – COMBINED COST OF VARIOUS

SOURCES OF CAPITAL• MARGINAL COST – AVERAGE COST OF ADDITIONAL

CAPITAL REQUIRED BY THE FIRM

PROBLEMS IN DETERMINATION OF COST OF CAPITAL1. HISTORICAL AND FUTURE COST – ARGUIMENTS

AGAINST FUTURE COST IN DECISION MAKING

2. PROBLEMS IN COMPUTATION OF COST OF EQUITY – WE CAN NOT FIND OUT THE EXPECTATION OF SHAREHOLDERS

3. PROBLEMS IN COMPUTATION OF COST OF RETAINED EARNINGS – IT IS OPPORTUNITY COST. DIFFERENT SHAREHOLDERS MAY HAVE DIFFERENT OPPORTUNITIES

4. PROBLEMS IN ASSIGNING WEIGHTS – FOR WEIGHTED AVERAGE COST OF CAPITAL

CAPITAL BUDGETING

• IT IS THE PROCESS OF MAKING INVESTMENT DECISIONS IN CAPITAL EXPENDITURE.

• A CAPITAL EXPENDITURE MAY BE DEFINED AS AN EXPENDITURE THE BENEFITS OF WHICH ARE EXPECTED TO BE RECEIVED OVER PERIOD OF TIME EXCEEDING ONE YEAR.

• EG: AQUISITION OF LAND, BUILDING, MACHINERY, ETC.

DEFINITION

1. “CAPITAL BUDGETING IS LONG TERM PLANNING FOR MAKING AND FINANCING PROPOSED CAPITAL OUTLAYS” – CHARLES T HORNGREEN

2. “CAPITAL BUDGETING CONSISTS IN PLANNING AND DEVELOPMENT OF AVAILABLE CAPITAL FOR THE PURPOSE OF MAXIMISING THE LONG TERM PROFITABILITY OF THE CONCERN.” - LYNCH

FEATURES1. CAPITAL BUDGETING DECISIONS INVOLVE THE EXCHANGE

OF CURRENT FUNDS FOR THE BENEFITS TO BE ACHIEVED IN FUTURE.

2. THE FUTURE BENEFITS ARE EXPECTED TO BE REALISED OVER SERIES OF YEARS.

3. THE FUNDS ARE INVESTED IN NON-FLEXIBLE AND LONG TERM ACTIVITIES.

4. IT INVOLVES GENERALLY HUGE FUNDS.5. THEY HAVE THE LONG TERM AND SIGNIFICANT EFFECT ON

THE PROFITABILITY OF THE CONCERN.

NEED AND IMPORTANCE 1. LARGE INVESTMENT2. LONG-TERM COMMITMENT OF FUNDS3. IRREVERSIBLE NATURE4. LONG TERM EFFECT ON PROFITABILITY5. DIFFICULTIES ON INVESTMENT DECISIONS DUE

TO HIGH RISK, LONG PERIOD AND UNCERTAINTY OF FUTURE.

6. NATIONAL IMPORTANCE BECAUSE IT WILL CREATE EMPLOYMENT OPPORTUNITIES, NATIONAL IMPORTANCE, ETC.

PROCESS OF CAPITAL BUDGETING

1. IDENTIFICATION OF INVESTMENT PROPOSAL

• BEGINS WITH THIS STEP.

• THE HEAD OF THE ORGANIZATION AS WELL AS DEPARTMENTAL HEAD IDENTIFY THE VARIOUS PROPOSALS.

2. SCREENING THE PROPOSAL

• THE CAPITAL EXPENDITURE PLANNING COMMITTEE SCREENS THE VARIOUS PROPOSALS FROM VARIOUS ANGLES.

3. EVALUATION OF VARIOUS PROPOSALS• EVALUATE THE PROFITABILITY OF VARIOUS

PROPOSALS.• SEVERAL METHODS LIKE RATE OF RETURN, PAY BACK,

ETC CAN BE USED FOR EVALUATION. • AFTER EVALUATION WE CAN CLASSIFY INTO THREE

GROUPS:-

1. INDEPENDENT PROPOSAL – DO NOT COMPET WITH ONE ANOTHER

2. DEPENDENT PROPOSAL – DEPENDS UPON THE ACCEPTANCE OF OTHER CONDITIONS

3. MUTUALLY EXCLUSIVE – COMPETE WITH EACH OTHER

4. FIXING PRIORITIES

• AFTER EVALUATION THE UNPROFITABLE OR UNECONOMICAL PROPOSALS MAY BE REJECTED STRAIGHT AWAY.

• RANKING THE PROPOSAL ON THE BASIS OF THEIR PRIORITY.

5. FINAL APPROVAL AND PREPERATION OF CAPITAL EXPENDITURE BUDGET

• THE PROPOSAL WHICH ARE MEETING OUR CRITERIA SHOULD BE FINALISED AND THE BUDGET IS PREPARED.

6. IMPLEMENTING PROPOSAL

• AFTER THE COMPLETION OF ALL PLANNING PROCEDURE SUCCESSFULLY THE PROPOSED CAPITAL ASSET WILL PURCHASE AND MAKE IT READY TO USE.

7. PERFORMANCE REVIEW

• THIS IS THE LAST STAGE.

• COMPARISON OF ACTUAL WITH BUDGET AND IF ANY VARIANCE, FIND OUT THE REASON OF VARIATION AND IMPLEMENT THE REMEDIAL MEASURE.

METHODS OF CAPITAL BUDGETING OR EVALUATION OF

INVESTMENT PROPOSALA. TRADITIONAL METHODS• PAY-BACK PERIOD OR PAY OUT OR PAY OFF

METHOD• IMPROVEMENT OF TRADITIONAL APPROACH TO

PAY-BACK PERIOD METHOD• RATE OF RETURN METHOD OR ACCOUNTING

METHODB. TIME ADJUSTED METHOD OR DISCOUNTED METHOD• NET PRESENT VALUE METHOD – NPV• INTERNAL RATE OF RETURN METHOD – IRR• PROFITABILITY INDEX METHOD

PAY-BACK PERIOD METHOD• IT REPRESENTS THE PERIOD IN WHICH THE TOTAL INVESTMENT IN

PERMANENT ASSETS PAYS BACK ITSELF.

• THIS METHOD IS BASED ON THE PRINCIPLE THAT EVERY CAPITAL EXPENDITURE PAYS ITSELF BACK WITHIN A CERTAIN PERIOD OUT OF THE ADDITIONAL EARNINGS GENERATED FROM THE CAPITAL ASSETS.

SELECTION CRITERIA

• VARIOUS INVESTMENTS ARE RANKED ACCORDING TO THE LENGTH OF THEIR PAY BACK PERIOD IN SUCH A MANNER THAT THE INVESTMENT WITH A SHORTER PAY BACK PERIOD IS PREFERRED.

• FOR A SINGLE PROJECT, IT IS ADOPTED IF IT PAYS BACK WITHIN A PERIOD SPECIFIED BY THE MANAGEMENT, OTHERWISE REJECTED.

ADVANTAGES OF PAY - BACK PERIOD• IT IS SIMPLE TO UNDERSTAND AND EASY TO CALCULATE

• IT REQUIRES LESSER TIME AND LABOUR AS COMPARED TO OTHER METHODS OF CAPITAL BUDGETING

• IT REDUCES THE LOSS DUE TO OBSOLESCENCE BECAUSE SHORTER PAY-BACK PERIOD IS PREFERRED

• THIS METHOD IS SUITABLE TO FIRMS WHOSE FINANCIAL POSITION IS NOT GOOD

DISADVANTAGES OF PAY-BACK PERIOD• IT DOES NOT TAKE INTO ACCOUNT THE CASH INFLOWS AFTER THE

PAY-BACK PERIOD AND HENCE TRUE PROFITABILITY OF THE PROJECTS CAN NOT BE CORRECTLY ASSESSED.

• THIS METHOD DOES NOT CONSIDER THE TIME VALUE OF MONEY

• IT DOES NOT TAKE INTO CONSIDER THE COST OF CAPITAL

• MINIMUM ACCEPTABLE PAY-BACK PERIOD IS SUBJECTIVE

• IT DOES NOT MEASURE THE TRUE PROFITABILITY

IMPROVEMENTS IN TRADITIONAL APPROACH TO PAY-BACK PERIOD

METHOD

1. POST PAY-BACK PROFITABILITY METHOD• ONE OF THE IMPORTANT DRAWBACK OF PAY-BACK

PERIOD METHOD IS THAT IT DOES NOT CONSIDER CASH INFLOWS EARNED AFTER PAY-BACK PERIOD.

• THIS METHOD OVERCOMES THAT SHORTCOMING AND HERE PROFITABILITY AFTER THE PAY-BACK PERIOD IS CONSIDERED.

2. PAY-BACK RECIPROCAL METHOD

• THIS METHOD IS USED ONLY WHEN THE FOLLOWING TWO CONDITIONS ARE STISFIED:

1. EQUAL CASH INFLOWS ARE GENERATED EVERY YEAR.

2. THE PROJECT UNDER CONSIDERATION HAS A LONG LIFE WHICH MUST BE ATLEAST TWICE THE PAY-BACK PERIOD.

3. POST PAY-BACK PERIOD METHOD

• TAKES INTO ACCOUNT THE PERIOD BEYOND PAY-BACK PERIOD.

• THIS METHOD IS ALSO KNOWN AS SURPLUS LIFE OVER PAY-BACK METHOD.

• THE PROJECT WHICH GIVES THE GREATEST POST PAY-BACK PERIOD MAY BE ACCEPTED.

4. DISCOUNTED PAY-BACK METHOD• ANOTHER DRAWBACK OF PAY-BACK METHOD IS

THAT IT IGNORES THE TIME VALUE OF MONEY.• THIS METHOD OVERCOMES THIS LIMITATION.• UNDER THIS METHOD THE PRESENT VALUE OF

ALL CASH INFLOWS AND OUTFLOWS ARE COMPUTED AT A DISCOUNTED RATE.

• THE TIME AT WHICH THE PRESENT VALUE OF CASH INFLOWS EQUALS THE PRESENT VALUE OF CASH OUTFLOWS IS KNOWN AS THE DISCOUNTED PAY-BACK PERIOD. THE PROJECT WHICH GIVES A SHORTER DISCOUNTED PAY-BACK PERIOD IS ACCEPTED.

RATE OF RETURN METHOD• THIS METHOD TAKES INTO ACCOUNT THE EARNINGS EXPECTED

FROM THE INVESTMENT OVER THEIR WHOLE LIFE.• IT IS ALSO KNOWN AS ACCOUNTING RATE OF RETURN METHOD

BECAUSE THE PROFIT IS CALCULATED AS FOR ACCOUNTING PURPOSE IE. NET PROFIT AFTER TAX AND DEPRECIATION.

• THE PROJECT WITH HIGHER RATE OF RETURN IS SELECTED.

ADVANTAGES

• IT IS VERY SIMPLE TO UNDERSTAND AND EASY TO CALCULATE

• IT USES THE ENTIRE EARNINGS OF A PROJECT IN CALCULATING RATE OF RETURN.

• AS THIS METHOD IS BASED UPON ACCOUNTING CONCEPT OF PROFIT IT CAN BE READILY CALCULATED FROM THE FINANCIAL DATA.

DISADVANTAGES

• IT IGNORES THE TIME VALUE OF MONEY.

• IT DOES NOT TAKE INTO CONSIDERATION THE CASH FLOWS WHICH ARE MORE IMPORTANT THAN THE ACCOUNTING PROFITS.

• THIS METHOD CAN NOT BE APPLIED TO A SITUATION WHERE INVESTMENT IN A PROJECT IS TO BE MADE IN PARTS.

NET PRESENT VALUE METHOD

• IT IS THE MODERN METHOD OF EVALUATING INVESTMENT PROPOSALS.

• IT TAKES INTO CONSIDERATION THE TIME VALUE OF MONEY.

• IT RECOGNISES THE FACT THAT A RUPEE RECEIVED TODAY IS WORTH MORE THAN THE SAME RUPEE EARNED TOMORROW.

STEPS OF NPV METHOD1. DETERMINE AN APPROPRIATE ‘CUT-OFF RATE OR

DISCOUNT RATE’. THIS IS THE MINIMUM RATE OF RETURN.

2. COMPUTE THE PRESENT VALUE OF TOTAL INVESTMENT OUTLAY.

3. COMPUTE THE PRESENT VALUE OF CASH INFLOWS AT THE ABOVE DISCOUNT RATE. CASH INFLOW - PROFIT BEFORE DEPRECIATION AND AFTER TAX.

4. IF THE NPV IS POSITIVE OR ZERO IE WHEN THE PRESENT VALUE OF CASH INFLOWS EITHER EXCEEDS OR IS EQUAL TO THE PRESENT VALUE OF CASH OUTFLOWS, THE PROPOSAL MAY BE ACCEPTED OTHERWISE SHOULD BE REJECTED.

5. FOR MUTUALLY EXCLUSIVE PROJECTS, PROJECT WHICH HAS MAXIMUM POSITIVE NPV SHOULD BE SELECTED.

ADVANTAGES OF NPV METHOD

• IT RECOGNISES THE TIME VALUE OF MONEY.• IT TAKES INTO ACCOUNT THE EARNINGS OVER ENTIRE

LIFE OF THE PROJECT AND THE TRUE PROFITABILITY OF THE PROJECT CAN BE EVALUATED.

• IT TAKES INTO CONSIDERATION THE OBJECTIVE OF MAXIMUM PROFITABILITY.

DISADVANTAGES OF NPV METHOD

• MORE DIFFICULT TO UNDERSTAND AND OPERATE AS COMPARED TO OTHER METHODS.

• IT MAY NOT GIVE GOOD RESULTS WHILE COMPARING PROJECTS WITH UNEQUAL LIFE.

• IT MAY NOT GIVE GOOD RESULTS WHILE COMPARING PROJECTS WITH UNEQUAL INVESTMENT OF FUNDS.

• IT IS NOT EASY TO DETERMINE AN APPROPRIATE DISCOUNT RATE.

INTERNAL RATE OF RETURN METHOD - IRR

• IT IS ALSO KNOWN AS MODERN TECHNIQUE OF CAPITAL BUDGETING THAT TAKES INTO ACCOUNT THE TIME VALUE OF MONEY.

• IT IS ALSO KNOWN AS ‘TIME ADJUSTED RATE OF RETURN’, ‘DISCOUNTED CASH FLOW’, ‘DISCOUNTED RATE OF RETURN’, ‘YIELD METHOD’, AND ‘TRIAL AND ERROR YIELD METHOD’.

• UNDER THIS METHOD, SINCE THE DISCOUNT RATE IS DETERMINED INTERNALLY, THIS METHOD IS CALLED AS THE ‘INTERNAL RATE OF RETURN METHOD’.

• IT IS THE MINIMUM RATE OF RETURN WHICH THE MANAGEMENT DESIRES TO HAVE FROM THE INVESTMENT WHICH WILL HELP TO AVOID FALL IN PRICE OF FIRM’S SHARE IN THE MARKET.

STEPS OF IRR METHOD1. DETERMINE THE FUTURE NET CASH FLOWS- BEFORE

DEPRECIATION BUT AFTER TAX DURING THE ENTIRE ECONOMIC LIFE OF THE PROJECT.

2. DETERMINE THE RATE OF DISCOUNT AT WHICH THE PRESENT VALUE OF CASH INFLOWS EQUAL TO THE PRESENT VALUE OF CASH OUTFLOWS.

3. ACCEPT THE PROPOSAL IF IRR IS HIGHER THAN OR EQUAL TO THE MINIMUM REQUIRED RATE OF RETURN.

4. IN CASE OF ALTERNATIVE PROPOSALS SELECT THE PROPOSAL WITH HIGHEST RATE OF RETURN.

ADVANTAGES OF IRR METHOD

• IT CONSIDERS THE TIME VALUE OF MONEY.

• THE EARNINGS OVER THE ENTIRE LIFE OF THE PROJECT IS CONSIDERED.

• EFFECTIVE FOR COMPARING PROJECTS OF DIFFERENT LIFE PERIODS AND DIFFERENT TIMINGS OF CASH INFLOWS.

DISADVANTAGES

• DIFFICULT TO CALCULATE

• THIS METHOD PRESUMES THAT THE EARNINGS ARE REINVESTED AT THE RATE EARNED BY THE INVESTMENT WHICH IS NOT ALWAYS TRUE.

PROFITABILITY INDEX METHOD• THIS IS CALLED BENEFIT-COST RATIO. THIS IS THE SLIGHT

MODIFICATION OF THE NPV METHOD.

• THE PROFITABILITY INDEX IS THE RATIO OF THE PRESENT VALUE OF FUTURE CASH INFLOW TO THE PRESENT VALUE OF THE CASH OUTFLOW.

PRESENT VALUE OF CASH INFLOW

PROFITABILITY INDEX= ---------------------------------------

PRESENT VALUE OF CASH OUTFLOW

ACCEPTANCE CRITERIA

• IF THE PROFITABILITY INDEX IS EQUAL TO OR MORE THAN 1(ONE) THE PROPOSAL IS ACCEPTED.

• IF THERE ARE MORE THAN ONE INVESTMENT PROPOSAL, THE ONE WITH THE HIGHEST PROFITABILITY INDEX WILL BE PREFERRED.

• IT IS GENERALLY CALLED AS SUPERIOR TO THE NPV METHOD.

FACTORS INFLUENCING CAPITAL EXPENDITURE DECISIONS

• THERE ARE MANY FACTORS, FINANCIAL AS WELL AS NON-FINANCIAL, WHICH INFLUENCE THE CAPITAL EXPENDITURE DECISIONS.

• THE MAJOR FACTOR IS THE PROFITABILITY OF THE PROJECT.

• THE OTHER FACTORS ARE:

1. URGENCY

• SOMETIMES AN INVESTMENT IS TO BE MADE TO AN URGENCY FOR THE SURVIVAL OF THE FIRM OR TO AVOID HEAVY LOSSES. IN SUCH CIRCUMSTANCES THE PROPER EVALUATION OF THE PROPOSAL CANNOT BE MADE THROUGH PROFITABILITY TEST.

• EG: BREAKDOWN OF SOME PLANT & MACHINERY

2. DEGREE OF CERTAINTY

• PROFITABILITY IS DIRECTLY RELATED TO RISK, HIGHER THE PROFITS, GREATER IS THE RISK OR UNCERTAINTY

• SOMETIMES A PROJECT WITH LOWER PROFITABILITY MAY BE SELECTED DUE TO CONSTANT FLOW OF INCOME.

3. INTANGIBLE FACTORS

• SOMETIMES A CAPITAL EXPENDITURE HAS TO BE MADE DUE TO CERTAIN EMOTIONAL AND INTANGIBLE FACTORS SUCH AS SAFETY AND WELFARE OF WORKERS, PRESTIGIOUS PROJECT, SOCIAL WELFARE, GOODWILL OF THE FIRM, ETC.

4. LEGAL FACTORS

• AN INVESTMENT WHICH IS REQUIRED BY THE PROVISIONS OF LAW IS SOLELY INFLUENCED BY THIS FACTOR.

5. AVAILABILITY OF FUNDS

• CAPITAL EXPENDITURE GENERALLY REQUIRES LARGE FUNDS, SO THE AVAILABILITY OF FUNDS IS ANOTHER FACTOR.

6. FUTURE EARNINGS

• A PROJECT MAY NOT BE PROFITABLE AS COMPARED TO ANOTHER TODAY, BUT IT MAY PROMISE BETTER EARNINGS. IN SUCH CASE IT MAY BE PREFERRED TO INCREASE EARNINGS.

7. OBSOLESCENCE

• THERE ARE CERTAIN PROJECTS WHICH HAVE GREATER RISK OF OBSOLESCENCE THAN OTHERS.

8. RESEARCH & DEVELOPMENT PROJECTS

• IT IS NECESSARY FOR THE LONG-TERM SURVIVAL OF THE BUSINESS TO INVEST IN RESEARCH AND DEVELOPMENT PROJECTS THOUGH IT MAY NOT LOOK TO BE PROFITABLE PROJECTS.

9. COST CONSIDERATION

• COST OF THE CAPITAL PROJECT, COST OF PRODUCTION, OPPORTUNITY COST OF CAPITAL, ETC ARE OTHER CONSIDERATIONS INVOLVED IN THE CAPITAL BUDGETING DECISIONS.

LIMITATIONS OF CAPITAL BUDGETING• THE TECHNIQUES OF CAPITAL BUDGETING REQUIRES

ESTIMATION OF FUTURE INFLOW AND OUTFLOW. BUT FUTURE IS UNCERTAIN.

• CERTAIN FACTORS LIKE MORALE OF EMPLOYEES, GOOD WILL OF THE FIRM, ETC. CANNOT BE CORRECTLY QUANTIFIED.

• URGENCY & RISK ARE ANOTHER LIMITATIONS• APPLICATION OF CAPITAL BUDGETING DECISIONS FOR

MUTUALLY EXCLUSIVE MAY NOT BE TRUE IN SOME PARTICULAR CASES.

CAPITAL EXPENDITURE CONTROLOBJECTIVES:1. TO MAKE TIMELY CASH INFLOWS FOR THE PROJECTS2. TO SEE THAT THE TOTAL OUTFLOW IS WITHIN THE FINANCIAL

RESOURCES3. TO ENSURE THAT ALL CAPITAL EXPENDITURE IS PROPERLY

SANCTIONED4. TO PROPERLY CO-ORDINATE THE PROJECTS5. TO FIX PRIORITIES AMONG VARIOUS PROJECTS6. TO MEASURE THE PERFORMANCE OF THE PROJECT7. TO ENSURE THAT THE CAPITAL EXPENDITURE IS WITH THE RAPID

TECHNOLOGICAL DEVELOPMENTS

STEPS IN CAPITAL EXPENDITURE CONTROL1. PREPARATION OF CAPITAL EXPENDITURE BUDGET

2. PROPER AUTHERISATION OF CAPITAL EXPENDITURE

3. RECORDING AND CONTROL OF EXPENDITURE

4. EVALUATION OF PERFORMANCE OF THE PROJECT

CAPITAL RATIONING• CAPITAL RATIONING REFERS TO A SITUATION WHERE A FIRM IS NOT

IN A POSITION TO INVEST IN ALL PROFITABLE PROJECTS DUE TO THE CONSTRAINTS ON AVAILABILITY OF FUNDS.

• SO THE FIRM HAS TO SELECT THE COMBINATION OF PROPOSALS THAT WILL YIELD THE GREATEST PROFITABILITY.

• EG: LET US ASSUME THAT A FIRM HAS ONLY RS.10 LAKHS TO INVEST AND MORE FUNDS CANNOT BE PROVIDED. THE VARIOUS PROPOSALS ALONGWITH THEIR COST AND PROFITABILITY INDEX ARE AS FOLLOWS:

PROPOSAL COST OF PROJECT PROFITABILITY INDEX A 3,00,000 1.46

B 1,00,000 0.098 C 5,00,000 2.31 D 2,00,000 1.32 E 1,50,000 1.25

• IN THIS EXAMPLE ALL PROPOSALS EXCEPT B GIVE PROFITABILITY INDEX EXCEEDING ONE AND ARE PROFITABLE INVESTMENTS. THE TOTAL OUTLAY REQUIRED TO BE INVESTED IN ALL OTHER PROJECTS IS RS.11,50,000. BUT TOTAL FUNDS AVAILABLE WITH THE FIRM ARE RS.10 LAKHS AND HENCE THE FIRM HAS TO DO CAPITAL RATIONING AND SELECT THE MOST PROFITABLE COMBINATION OF PROJECTS. PROJECT E WHICH HAS THE LOWEST PROFITABLE INDEX AMONG THE PROFITABLE PROPOSALS CANNOT BE TAKEN.