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Concept of capital expenditure

In the industrial and business world, all the business organisations and industries cannot have surplus money at all the times. And at the same time, they retain a certain sum of money to meet out the day to day operations. It is known as working capital. During the business period, at any time, the company has to face the problem of either replacement of fixed assets or purchase of fixed assets. In this respect, the company needs heavy capital outlay for the purpose of meeting out the capital investment in the fixed assets or development of new project. So, the capital budgeting plays a significant role in the management.

 

Concept of capital expenditure

 

Capital expenditure is one which is intended for future periods and generally includes investment in fixed assets and other developmental projects. In other words, capital expenditure is that which has to be incurred for the purpose of obtaining benefit not only for the current year but also for the specific future periods.

 

CAPITAL BUDGET ING-MEANING

 

Capital budgeting refers to long term planning for the proposed capital outlay and their financing. In other words, it is the process of making investment decisions regarding the capital expenditures. Capital budgeting is also known as investment decision making, capital expenditure decision, planning capital expenditure, etc.

 

Charles T Horngreen has defined capital budgeting as “Capital budgeting is long term planning for making and financing proposed capital outlays”.

 

According to Lynch “Capital budgeting consists in planning development of available capital for the purpose of maximising the long term profitability of the concern.”

 

Need and Importance of Capital Budgeting

 

(i)                 Capital budgeting decision normally involves huge capital. If wrong decision is taken by the firm, it may affect the survival of the firm. So, it is very important for the firm to plan and control capital expenditure.

 

(ii)               Funds involved in capital expenditure are not only huge but more or less permanently blocked in the organisation. In this respect, it involves longer time and greater risk. So careful planning is essential.

original investment of the project. Normally, shorter pay back period of the project should

be recommended.

 

Procedure for the calculation of pay  back period :

 

(a) In the case of even cash inflows

Pay back period = Original Cost / Annual Cash inflow

Annual cash inflow = Net savings or net profit + Depreciations

 

NOTE : Suppose cash inflow is given in the problem, then there is no need to find out cash

inflow. If cash inflows are not given in the problem, we have to find out cash inflow.

 

(b) In the case of uneven cash inflows

If cash inflows are not uniform, the calculation of pay back period takes a cumulative way   i.e., arriving at net cash inflow until the total is equal to original cost of the project.

 

(ii) Post Pay Back Profitability Method

Calculation :

Total cash inflow from the Proposal

during its economic life                                  xx

Less : original cost                                          xx

Post pay back profitability                              xx

 

(iii) Accounting Rate of Return Method [Accounting Method]

 

This method is otherwise known as accounting rate return method or return on investment or average rate of return method. It can be expressed in the following ways.

 

(i) Average rate of return = Average annual profit  /  Original investment

 

(ii) Return Per unit of investment method

 

Return per unit of investment =  Total Profit / net Investment x 100

 

(iii) Rate of Return on average investment method

 

Return on average investment = Profit after depreciation tax / Average investment

Average investment = Original Investment / 2

 

(iv) Average return on average investment method

 

Average return on average investment= Average annual profit / average investment x100

 

(v) Rate of return on original investment method

 

Return on original investment = Profit/ Original investment

(b) Time Adjusted Method or Accounting Methods

(i) Net Present Value Method

 

This method is otherwise known as excess present value or net gain method or time

adjusted method

Sum of Discounted cash inflows        xx

Less : original cost                              xx

Net present value                                xx

 

If the present value of cash inflows is more than (or equal to) the present value of cash outflows, the project would be accepted. If it is less, the project will be rejected.

 

(ii) Internal Rate of Return Method

 

The internal rate of return for an investment proposal is the discount rate that equates the present value of initial cost of the investment with the present value of the expected net cash flows. In other words, it is the rate which discounts the cash flows to zero. Normally, the internal rate of return is found by trial and error method. It can be stated in the following way.

 

Cash inflows  /  Cash outflows= 1