CAPITAL BUDGETING

Prof. P.D.Phadke

In a firm , expenditure are of two types for which budgeting is required . Capital expenditure -- Capital Budgets Operating expenditure - Operational Budgets Objective of capital budgeting is maximize shareholders' wealth . Two considerations -1 a ) Strategic considerations - involves long term plans and objective of the company b) Intangible considerations -- Company's philosophy c) Financial and operational feasibility considerations 2 Economic considerations -- Detailed analysis to ensure that a capital investment is in fact to the firm's advantage . Analysis of various capital expenditure proposals are made by developing relevant cash flows for capital budgeting . Following kinds of proposals are mainly submitted for evaluation . 1 Cost saving 2 Replacement 3 Expansion 4 Diversification 5 Research and Development 6 Miscellaneous -- safety , welfare etc . which may not contribute to profits directly . These are evaluated by by using various investment evaluation methods and then implented . After project is completed post capital expenditure audit is made with a view assess to what extent project objectives are achieved . Capital Rationing -- In view of resource constraint each division / department is provided with certain amount for their capital expenditure projects and each division has to select projects with higher returns . These are selected on the basis of PI . Projects may be divisible or indivisible . Leverages sales -- VC MC 1 Oerating Leverage = --------------------- = ------Sales - VC - FC EBIT isolates fixed costs

Sales -- VC -- FC EBIT 2 Financial Leverage =-------------------------------- =---------- isolates interest Sales - VC - FC -- Interest EBT Sales -- VC MC 3 Combined Leverage =---------------------------------------- = -------- isolates Sales -- VC -- FC -- Interest EBT fixed costs and interest If OL = 3/1 . FL = 2/1 . CL = 6/1 Sales rises by 20 % , EBIT rises by 60 % and EBT rises by 60 %