FUNDAMENTALS OF FINANCIAL MANAGEMENT BCOM 5th SEM NOTES
UNIT 2
INVESTMENT DECISIONS
The Capital Budgeting Process, Cash flow Estimation, Payback Period Method, Accounting Rate of Return, Net Present Value (NPV), Net Terminal Value, Internal Rate of Return (IRR), Profitability Index, Capital budgeting under Risk-Certainty Equivalent Approach and Adjusted Discount.
SHORT TYPE QUESTIONS & ANSWERS
1.What is Capital Budgeting?
Ans: Capital Budgeting is a process of making decision regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture. Budgeting is long term planning for making and financing proposed capital outlays. According to Robert N.Anthony. The capital budget is essentially a list of what management believes to be worth white projects for the acquisition of new capital assets gather with the estimated cost of each product.
2. Give four characteristics of Capital Budgeting.
Ans: Four characteristics of Capital budgeting are:
(i) Capital budgeting plans involve a huge investment in fixed assets.
(ii) Capital budgeting once approved represents long term investment that cannot be reserved or with drawn without subs tainting a loss.
(iii) Preparation of capital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects.
(iv) In view of the investment of large amount for a fairly long period of time, any error in the evaluation of investment projects, may lead to serious consequences, financially and otherwise and may adversely affect the other future plans of the organization.
3.Write five importance of Capital Budgeting.
Ans: Five importance of capital Budgeting are:
(i) Long term implications,
(ii) Irreversible decisions,
(iii) If affects company's future cost structure,
(iv) Bearing on competitive positions of the firm,
(v) Cash forecast.
4.Mention the various kind or technique of capital budgeting.
Ans: The various kind or technique of capital budgeting:
(i) Pay back period method,
(ii) Unadjusted Rate of Return Method,
(iii) Present value Method,
(iv) Time adjusted Rate of Return method,
(v) Net present value method.
5. Mention five merits of pay back method.
Ans: Five merits of pay back method are:
(i) It is easy to calculate and simple to understand,
(ii) It is preferred by executive who like answers for the selection of the proposal.
(iii) It is useful where the firm is suffering from each deficiency,
(iv) It reduces the possibility of loss through obsolescence.
(v) It is a handy device for evaluating investment proposals, whose precision in estimates of profitability is not important.
6. Define Capital Budgeting.
Ans: The planning and control of capital expenditure is termed as Capital Budgeting. In the words of Charles T. Homgreen: "Capital Budgeting is long term planning for making and financing proposed capital outlays" According to R.M. Lynch, "Capital Budgeting consists in planning the development of available capital for the purpose of maximising the long term profitability (return on investment) of the firm".
7. Write five factors influencing the size of receivables.
Ans: The size of receivables are:
(i) Size of credit sales,
(ii) Credit policies,
(iii) Terms of trade,
(iv) Expansion plans,
(v) Relation with Profits.
8. Mention four problems associated with the cash management.
Ans: The cash management are:
(i) Controlling of level of cash,
(ii)Controlling inflow of cash, (iii)Controlling outflow of cash,
(iv) Optimal Investment of surplus cash.
9.Mention five functions or advantages of cash budget.
Ans: The functions or advantages of cash budget are:
(ii) Helpful in planning, 60 Forecasting the future needs of funds,
(iii) Maintenance of ample each balance,"
(iv) Controlling cash Expenditure,
(v) Evaluation of performance.
10. Mention the merits of pay back period.
Ans: Merits of pay back period method: The pay back period method is quite an easy method for evaluation of capital expenditure projects. The merits of this method are as follows:
(i) Simple: This method is quite simple to understand as well as easy to calculate.
(ii) Saves time, cost and labour: It saves in cost, it requires lesser time and labour as compared to other methods of capital budgeting.
(iii) More accurate estimates: In this method we do not consider entire life of the project but only the period of pay back it taken into consideration. Therefore estimates are more accurate and real.
(iv) Risk of obsolescence: In this method, as a project with a shorter payback period is preferred to the one having a longer pay back period, it reduces the loss through obsolescence. This method is more suited to the developing countries, like India, which are in the process of development and have quick obsolescence.
11.Write the demerits of pay back period?
Ans: Demerits of pay-back period method:
(i) More importance to pay back of invested funds: There is more importance to liquidity rather than to the profitability which is not right too much emphasis is given on payback of original investment.
(ii) Does not consider the income received after pay back pering : In this method only the pay back of original investment is consider and the income after that period is not considered. The objective of business firm to invest money in capital projects is not only to get th investment back but to earn profit, therefore earnings in the entire life the project should be considered.
(iii) Does not measure risks: This method does not measure risk in the project. If a project has shorter pay back period but more risk can also be accepted which is not good.
(iv) Ignores cost of capital: The cost of capital is the strong basi for investment decisions but this method ignores cost of capital.
12. Write the merit of average rate of return method?
Ans: Merits of average rate of return method: Simple: This method is quite simple.
(ii) Considers whole life of the project: This method considers the income of whole life of the project. (iii) Test of profitability: In this method profitability of differen projects is evaluated; so comparison of different projects is possible.
(iv) More useful for analysis of long term projects: This method is quite useful for the analysis of long term projects because it consider the whole life of the project.
13. What do you mean by capital rationing?
Ans: Capital rationing is a situation where a firm is not in a situation to invest in all profitable projects due to the constraints on availability of funds. The resources are always limited and the demand for them far exceeds their availability. So the firm cannot take up all the projects though profitable, and has to select the combination of proposal that will yield the greatest profitability. The capital rationing is proper allocation of capital between various projects, those projects are left in which the expected profitability rate is lower than the cost of capital.
14. Write the demerits of rate of return method?
Ans: Demerits of average rate of return method:
(i) Does not consider time value of money: It does not consider time value of money. The comparative study is essential for the evaluation of different projects and for this purpose the calculation of present value of ash inflow of different projects is necessary. But this is not done in method.
(ii) Profits affected by micro factors are not tested : In this method the profits affected by micro factors are not measured and only average annual profits are considered.
(iii) Concepts of investment and income are vague: In this method, the income and investment words are used which have got many meanings so there is uncertainty.
15. Mention the net present value method?
Ans: Merits of the net present value method:
(i) Recognises the time value of money and is suitable to be applied in a situation with uniform cash outflow and uneven cash inflows or cash flows at different periods of time. Considers the whole life of the project: It takes into account the earnings over the entire life of the project and the true profitability of the investment proposal can be evaluated.
(ii) Considers the objective of profitability: It takes into consideration the objective of maximum profitability.
16. Write the demerits of the net present value method?
Ans: Demerits of the net present value method:
(i) Difficult to understand and operate: As compared to traditional methods, the net present value method is more difficult to understand and operate.
(ii) Does not give good results : It may not give good results while comparing projects with unequal investment of funds.
(iii) Difficult to determine discount rates: It is not easy to determine an appropriate discount rate.
(iv) Internal rate of return: The internal rate of return method is also a technique of capital budgeting that takes into account the time value of money. It is also known as time adjusted rate of return, discounted.
17. Write the merits of internal rate of return method?
Ans: Merits of internal rate of return method:
(i) Uses the concept of time value of money: It takes into account the time value of money and can be usefully applied in situations with even as well as uneven cash flow at different periods of time.
(ii) Easier: The determination of cost of capital is not a prerequisite for the use of this method and hence it is better than net present value method where the cost of capital cannot be determined easily.
(iii) Considers entire economic life: It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability.
(iv) Uniform ranking: It provides for uniform ranking of various proposals due to the percentage rate of return.
18. Write the demerits of rate of return method?
Ans: Demerits of internal rate of return method:
(i) Difficult to understand as well as evaluate: It is difficult to understand and is the most difficult method of evaluation of investment proposals.
(ii) Unjustified assumption: This method is based upon the assumption that the earnings are reinvested at the internal rate of return for the remaining life of the project, which is not a justified assumption particularly when the average rate of return earned by the firm is not close to the internal rate of return.
(iii) Profitability index or benefit cost ratio It is also a time-adjusted method of evaluating the investment proposals. The proposal is accepted if the profitability index is more than one and is rejected in case the profitability index is less than one. Profitability index also called as 'Benefit Cost Ratio' or desirability factor is the relationship between present value of cash inflows and the present value of cash outflows. Thus,
Profitability index= Present value of cash inflows/Present value of cash outflows
The method is a slight modification of the net present value method. The net present value method has one major drawback that it is not easy to rank projects on the basis of this method particularly when the costs of the projects differ significantly. To evaluate such projects the profitability index method is most suitable. The other merits and demerits of this method are the same as those of net present value method.
19. How Are Cash Flows Different Than Revenues?
Ans: Revenues refer to the income earned from selling goods and services. If an item is sold on credit or via a subscription payment plan, money may not yet be received from those sales and are booked as accounts receivable. But these do not represent actual cash flows into the company at the time. Cash flows also track outflows as well as inflows and categorise them with regard to the source or use.
20. What Are the Three Categories of Cash Flows?
Ans: Operating cash flows are generated from the normal operations of a business, including money taken in from sales and money spent on cost of goods sold (COGS), along with other operational expenses such as overhead and salaries.
Cash flows from investments include money spent on purchasing securities to be held as investments such as stocks or bonds in other companies or in Treasuries. Inflows are generated by interest and dividends paid on these holdings. Cash flows from financing are the costs of raising capital, such as shares or bonds that a company issues or any loans it takes out.
21. What is free cash flow and why is it important?
Ans: Free cash flow is the cash left over after a company pays for its operating expenses and CapEx. It is the money that remains after paying for items like payroll, rent, and taxes. Companies are free to use FCF as they please.
Knowing how to calculate FCF and analyze it helps a company with its cash management and will provide investors with insight into a company's financials, helping them make better investment decisions. FCF is an important measurement since it shows how efficient a company is at generating cash.
22. Do companies need to report a cash flow statement?
Ans: The cash flow statement complements the balance sheet and income statement and is a mandatory part of a public company's financial reporting requirements since 1987.
23. Why is the Price-to-Cash Flows ratio used?
Ans. The price-to-cash flow (P/CF) ratio is a stock multiple that measures the value of a stock's price relative to its operating cash flow per share. This ratio uses operating cash flow, which adds back non-cash expenses such as depreciation and amortization to net income.
P/CF is especially useful for valuing stocks that have positive cash flow but are not profitable because of large non-cash charges.
24. What is Operating Cash Flow (OCF)?
Ans: Operating cash flow (OCF) is a measure of the amount of cash generated by a company's normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion.
25. What is Terminal Value (TV)?
Ans: Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.
26. How is Terminal Value Estimated?
Ans: There are several terminal value formulas. Like discounted cash flow (DCF) analysis, most terminal value formulas project future cash flows to return the present value of a future asset. The liquidation value model (or exit method) requires figuring the asset's earning power with an appropriate discount rate, then adjusting for the estimated value of outstanding debt. The stable (perpetuity) growth model does not assume the company will be liquidated after the terminal year. Instead, it assumes that cash flows are reinvested and that the firm can grow at a constant rate into perpetuity. The multiples approach uses the approximate sales revenues of a company during the last year of a discounted cash flow model, then uses a multiple of that figure to arrive at the terminal value without further discounting applied.
27. What does a negative terminal value mean?
Ans: A negative terminal value would be estimated if the cost of future capital exceeded the assumed growth rate. In practice, however, negative terminal valuations cannot exist for very long. A company's equity value can only realistically fall to zero at a minimum, and any remaining liabilities would be sorted out in a bankruptcy proceeding. Whenever an investor comes across a firm with negative net earnings relative to its cost of capital, it's probably best to rely on other fundamental tools outside of terminal valuation.
28. What are the limitations of Terminal Value(TV)?
Ans: Limitations of Terminal Value: (i) The growth rate and the discount rate are assumptions in the perpetuity growth model. Any inaccuracy in these rates can lead to improper results. Also, these rates may change with every passing year. This model does not take care of these aspects.
(ii) The growth rate can be higher than the discount rate or the WACC for some time. In such a case, the terminal value calculation will give negative result and go wrong. Also, a company can show negative fre cash flow, and hence, the calculation will again go wrong with the perpetuity growth model.
(iii) In the case of exit multiples method, the multiples change with time and even between companies. Hence, choosing the correct multiple becomes a challenge and may lead to incorrect results.
29. Name all the statistical/mathematical techniques of risk evaluation used in capital budgeting.
Ans: Following statistical/mathematical techniques of risk evaluation are used in capital budgeting:
(a) Certainty Equivalent Approach, (b) Probability Assignment,
(c) Expected Net Present Value,
(d) Standard Deviation,
(e) Coefficient of Variation,
(f) Sensitivity Analysis,
(g) Simulation,
(h) Probability Distribution Approach,
(i) Normal Probability Distribution,
(j) Linear Programming.
30. Write a short note on:
Risk adjusted discount rate.
Ans: Risk-adjusted discount rate is the rate used in the calculation of the present value of a risky investment. It is calculated as follows:
Formula: Rf+à (Rm-Rf) The risk-adjusted discount rate is the total of the risk-free rate, i.e. the required return on risk-free investments, and the market premium, ie the required return of the market. Financial analysts use the risk-adjusted discount rate to discount a firm's cash flows to their present value and determine the risk that investor should accept for a particular investment.
31. What is the Risk-Adjusted Discount Rate?
Ans: A risk-adjusted discount rate is the rate obtained by combining an expected risk premium with the risk-free rate during the calculation of the present value of a risky investment. A risky investment is an investment such as real estate or a business venture that entails higher levels of risk. Although it is the usual convention to use the market rate as the discount rate in most applications, under certain circumstances, the application of a risk-adjusted discount rate becomes crucial.
32. How Does a Risk-Adjusted Return Work?
Ans: The risk-adjusted discount rate signifies the requisite return on investment, while correlating risk with return. This essentially means that an investment that is exposed to higher levels of risk also tends to bring in potentially higher returns, especially since the magnitude of potential losses is also greater. A risk-adjusted discount rate reflects such a correlation since discount rates are adjusted based on the magnitude of the risk involved.
33. Name the three factors affecting Investment decisions.
Ans: The three factors affecting Investment decisions are:
(i) Cash flows of the project: The series of cash receipts and payments over the life of an investment proposal should be considered and analyzed for selecting the best proposal.
(ii) Rate of return: The expected returns from each proposal and risk involved in them should be taken into account to select the best proposal
(iii) Investment criteria involved: The various investment proposals are evaluated on the basis of capital budgeting techniques. Which involve calculation regarding investment amount, interest rate, cash flows, rate of return etc. It is to be considered which technique to use for evaluation of projects.
34. What Is Cash Flow?
Ans: The term cash flow refers to the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows. A company's ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow (FCF). FCF is the cash generated by a company from its normal business operation after subtracting any money spent on capital expenditures (CapEx)
35. Write some important points of cash flow.
Ans: Some important points of cash flow are:
(i) Cash flow is the movement of money in and out of a company.
(ii) Cash received represents inflows, while money spent represents outflows.
(iii) The cash flow statement is a financial statement that reports on a company's sources and usage of cash over a specified time period.
(iv) A company's cash flow is typically categorized as cash flows from operations, investing, and financing.
(v) There are several methods used to analyse a company's cash flow, including the debt service coverage ratio, free cash flow, and unlevered cash flow.
36. What do you mean by Investment decision?
Ans: A financial decision which is concerned with how the firm's funds are invested in different assets is known as investment decision Investment decision can be long-term or short-term.
A long term investment decision is called capital budgeting decisions which involve huge amounts of long term investments and are irreversible excep at a huge cost. Short-term investment decisions are called working capital decisions, which affect day to day working of a business. It includes the decisions about the levels of cash, inventory and receiyables.
A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business. A bad working capital decision affects the liquidity and profitability of business.
Fundamental of Financial Management : Unit-2 Investment Decisions | B.com 5th Sem | Gauhati University Notes
LONG TYPE QUESTIONS & ANSWERS
1. Discuss the various importance's of capital budgeting.
Ans: Following are the importance of capital budgeting:
(i)Long term Complications: Capital budgeting decisions have long term implications for the firm because they affect the future profitability of the firm and the cost structure. It influences the rate and function of firm's growth. A wrong decision may bead the firm to a disastrous future and may endanger the very survival of the firm. Unwanted investment is fixed assets will result in unnecessary heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to complete successfully and to stop the loss of its potion of the market share. Long term commitment of funds may also change the risk elements of the firm. If adoption of an investment proposal increases firms' average carryings but simultaneously causes frequent functions in its earnings, the firm will become more risky. Thus, Capital budgeting decisions have long term implications and therefore need serious considerations.
(ii) Irreversible Decisions: The capital investment decisions a heavy amount of funds. In most of the cases, the capital budgeting decisions are in reversible and the amount invested cannot be taken back without sensing a substantial loss because it is very difficult to find market for the second hand capital goods and their conversion into other uses may not be financially feasible.
(iii) It affects company's future cost-structure: By taking a capital structure expenditure decision, a firm commits itself of a seeable amount of fixed costs in terms of labour, supervisor's salary insurance, rent of the building and so on. If the investment in future terms out to be unsuccessful or yield less than the burden of fixed cost unless the assets is completely written off. In short firms future costs, break-even points, sales and profits will all be determined by the firms selection of assets.
(iv) Bearing on Competitive Position of the Firm: The Capital investment in fixed assets decisions also have a bearing on the competitive position of the firm because the fixed assets, represent in a souse, true earning assets of the firm. They enable the firm to generate finished good that can ultimately be sold for profit. As we have discussed in the earlier point that it also determines the cost structure of the company's product. In other words capital investment decisions determine the future profits and cost for the firm that ultimately affects the competitive positions of the firm.
(v) Cash Forecast: Capital Investment requires substantially large amount of funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus, it facilitates cash forecasts to plan the investment programmers carefully, So that the firm can meet its long term obligations without any difficulty.
(vi) Worth Maximization of Shareholders: The impact of long term capital investment decision is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over investment and under investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity shareholders.
2.Describe the characteristics and Procedure of capital Budgeting.
Ans: Following are the characteristics of capital budgeting:
- Capital expenditure plans involve a huge investment in fixed assets.
- Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn with out sustaining a loss.
- Preparation of capital budget plans involve forecasting of several years profits in advance in order judge the profitability of projects.
- In view of the investment of large amount for a family long period of time, any error in the evaluation of investment project may lead do serious consequences, financially and otherwise may adversely affect the other future plans of the organization.
- Capital budgeting decisions involve the exchange of current for the benefits to be achieved in future.
- The future benefits are expected to be real used over a series of years.
- The funds are invested in non flexible and long term activities.
- They have a long term and term and significance effect on the profitability of the business.
The following procedure may bad opted in preparing capital budget:
(i) Origination investment Proposals: The first step in capital budgeting process is the conception of profit idea. The proposals may come from rank and file worker of any department or from any line. The department head collects collects all the investment proposals and reviews than in the light of financial and risk polices of the organization in order to send then to the capital expenditure planning committee for consideration. The idea may originate from the top management level taking a longer view in the interest of the company. It may be the result of periodic assessment of facilities, surveys of comparative position in the industries, research on the development of new product and new markets and similar investigations.
(ii) Screening the Proposals: In large organisations a capital expenditure planning committee is established for the heads of various departments and the line offices of the company or by the top executives. The committee sources the various proposals within the long range policy framework of the organization. It is to be ascertained by the committee whether the proposals are within the selection criterion of the firm, or they do not lead to department ambulates or they are profitable. The committee consolidates the proposals and sends then to the Board of Directors for its final approval.
(iii) Evaluation of projects: The next step in capital budgeting process is to evaluate the different proposals in terms of the cost of capital the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation techniques.
(a) Degree of urgency method.
(b) Pay back method.
(c) Return on Investment Method.
(d) Discounted cash flow method.
v)Establishing Priorities: After proper sieving of the proposals uneconomic or unprofitable proposals are dropped out rightly. The profitable projects or in other words acceptable projects are then put in priority. It facilitates their acquisition or construction according to the somas available and avoid unnecessary and costly delays and serious cost-over runs. Generally, priority is fixed in the following order:
(a) Current and incomplete projects are given first priority.
(b) Safety projects and projects necessary to carry on the legislative requirements.
(c) Projects or maintaining the percent efficiency of the firm.
(d) Projects for supplementing the income and
(e) Projects for the expansion of new product.
(iv) Final Approval: Proposals finally recommended by the committee are sent to the top management along with the deleted report both the capital expenditure and of somas of funds to meet then. The management affirms its final real proposals taking in view the urgency, profitability of the projects and the availability of financial resources. Projects are the sent to the budget committee for incorporating then in the capital budge
(v)Evaluation: Last but not the least important step in the capital budgeting process is an evaluation of the programme after it has bee fully implemented. Budget proposals and the Net investment in the project are compared periodically and on the basis of such evaluation the budge figures may be seemed and presented in a more realistic way.
3.Discuss the various kinds of capital budgeting proposal decisions.
Ans: The main objective of capital budgeting is to maximize the profitability of a firm or the return on investment. This objective can be achieve either by increasing the revenues or by reducing costs. Thus, cap budgeting decisions can be broadly classified into two categories.
(a) Those which increase revenue and
(b) Those which reduce costs.The first category of capital budgeting decisions are expected to increase revenue of the firm through expansion of the production line. The second category increases the earnings of the firm by reducing costs and includes decisions relating to replacement of obsolete, out molded or work out assets. In such cases, a firm has to decide whether to continue with the same assets or replace it. Such a decision is taken by the firm by evaluating the benefits from replacement of the asset in the form of reduction in operating costs and the cost cash outlay needed for replacement of the assets. Both categories of above decisions involve investment in fixed assets decisions involve difference between the two decisions this in the fact that in creasing revenue. Investment decisions are subject to more uncertainty as compared to cost reducing investment decisions.
Moreover, capital budgeting decisions or proposal can be classified as follows:
(a) Accept Reject Decisions: Accept Reject Decisions relate to independent projects which do not compete with one another. Such decisions are generally taken on the basis of minimum return on investment. All those proposals which yield a rate of return higher than the minimum required rate of return or the cost of capital are accepted and the rest are rejected. If the proposal is accepted the firm makes investment in it and if it is rejected the firm does not invest in the same.
(b) Mutually Exclusive project Decisions: such decisions relate to proposals which compete with one another in such way that acceptance of one automatically exclusive the acceptance of the other. Thus, one of the proposals is selected at the cost of the option of a new machine, or second hand machine as taking an old machine on tire or selecting a machine out of more than one brands available in the market. In such a case, the company may select one best alternative out of the various options by adopting some suitable technique or method of capital budgeting One alternative is selected the other are automatically rejected.
(c) Capital Rationing Decisions: A firm may have several profitable investment proposals but only limited funds to invest. In such a case, these various investments proposals comate, for limited funds, and thus the firm has to ration then. The firm selects the combination of proposals that will yield the greatest profitability by ranking them in descending order of their profitability.
Fundamental of Financial Management : Unit-2 Investment Decisions | B.com 5th Sem | Gauhati University Notes
4. What is Cash Budget? Mention the various functions importance of cash Budget.
Ans: Cash budget is an analytical device to estimate the flow of cash any business over a future period of time. It presents an estimate of ca inflows and receipts and cash of the firm over various intervals of time It reveals to the financial manager the timing and amount of expecte cash inflows and outflows over the period studied.
According to games C. von Horne. A cash budget is a forecast of future cash receipts and cash disbursements over various intervals of time. In the words of bushman and Doug all, Cash budget is an estimate of cash receipts and disbursements for a future period of time.
Functions or Importance of cash Budget
The importance's of cash budget are discussed fellow:
(i) Helpful in planning: Cash budget help planning for the most efficient for the most efficient use of cash. It points out cash surplus or deficiency at selected point of time and enables the management to arrange for the deficiency before time or to plan for investing the surplus money as profitably as possible without and throat to the liquidity.
(ii) Fore casting the future needs of funds: Cash budget forecasts the future needs of funds, its time and the amount well in advance. It thus, helps planning for raising the funds through the most profitable source at reasonable terms and costs.
(iii) Maintenance of Ample cash Balance: Cash is the basis of liquidity of the enterprise. Cash budget helps maintaining the liquidity. It suggests adequate cash balance for retiring the obligations and a fair margin for the predictable and unpredictable contingencies.
(iv) Controlling Cash Expenditure: Cash budget acts as a controlling device. The expense of various departments in the firm can best be controlled so as not to exceed the budgeted limit.
(v) Evaluation of Performance: Cash Budget acts as a standard for evaluating the financial performance by comparing the actual performance with the budgeted figures. If deviations are positive, the performance may be regarded as good.
(vi) Testing the Influence of Proposed Expansion programmed: Cash budget forecasts the inflows from a proposed expansion as investment programme and testify its impact an cash position.
(vii) Sound Dividend Policy: Cash Budget plans for cash dividend to shareholders consistent with the liquid position of the firm. It helps in
following a consistent dividend policy.
Basis of Long term Planning and Coordination: Cash budget helps in coordinating the various finance functions, such as sales credit, investment, working capital etc. It is an important basis of long term financial planning and helpful in the study of long term financing with respect to probable amount, timing forms of security and methods of repayment.
5. Discuss various methods of capital budgeting.
Ans: The various methods used for the evaluation of investment or capital expenditure decisions may be grouped into the following two categories, which are discussed below:
(i) Pay back period method: The period in which we get the invested amount back is called pay-back period. The annual income received from the invested capital or whatever savings are there, they are called 'cash earning' or 'net cash inflows'.
A project is accepted if its pay back period is less than the maximum pay back period set up by the top management. A ranking of various projects is done keeping the project of least pay back period on the top. If the management has to choose one project between two mutually exclusive projects, the project with shortest pay back period will be chosen.
Pay-back period= Initial investment / Annual Cash inflow
(ii) Average 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. According to this method various projects are ranked in order of the rate of earnings or return. The project with the higher rate of return is selected as compared to the one with lower rate of return. This method can also be used to make decision as to accepting or rejecting a proposal.
(iii) Accounting rate of return on initial investment: The accounting rate of return on initial investment is the ratio between initial investment and estimated net average annual income.
The calculation is done by the following formula:
Accounting rate of return Estimated average net annual
after depreciation & tax / Initial investment x100
(iv) Rate of return on average investment: In this method also the average net income is calculated. The average net income is divided not by the initial investment but by average investment. Average investment is calculated by dividing initial investment + scrap value by two. This can be explained with the following formula:
ARR= Average annual income after tax and depreciation / Average investment x 100
(v) Net present value method: It is quite important for the analysis of capital expenditure and it is based on time adjusted rate of return. This is also known as excess present value method or net gain method. The present value of the project can be known quite easily.
(vi) Internal rate of return: The internal rate of return method is also a technique of capital budgeting that takes into account the time value of money. It is also known as time adjusted rate of return, discounted rate of return, yield method and trial and error yield method. It is the rate at which the sum total of cash inflow after discounting equals to the discounted cash outflow. The IRR of a project is the discount rate which makes NPV of the project equal to zero.
6. Discuss the types of cash flow.
Ans: Types of Cash Flow:
Cash Flows from Operations (CFO): Cash flow from operations (CFO) or operating cash flow, describes money flows involved directly with the production and sale of goods from ordinary operations. CFO . indicates whether or not a company has enough funds coming in to pay its bills or operating expenses. In other words, there must be more operating cash inflows than cash outflows for a company to be financially viable in the long term. Operating cash flow is calculated by taking cash received from sales and subtracting operating expenses that were paid in cash for the period. Operating cash flow is recorded on a company's cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion.
Note that CFO is useful in segregating sales from cash received. If, for example, a company generated a large sale from a client it would boost revenue and earnings. However, the additional revenue doesn't necessarily improve cash flow if there is difficulty collecting the payment from the customer.
Cash Flows from Investing (CFT): Cash flow from investing (CFI) or investing cash flow reports how much cash has been generated or spent from various investment-related activities in a specific period. Investing activities include purchases of speculative assets, investments in securities, or the sale of securities or assets. Negative cash flow from investing activities might be due to significant amounts of cash being invested in the long-term health of the company, such as research and development (R&D), and is not always a warning sign.
Cash Flows from Financing (CFF): Cash flows from financing (CFF) or financing cash flow, shows the net flows of cash that are used to fund the company and its capital. Financing activities include transactions involving issuing debt, equity, and paying dividends. Cash flow from financing activities provides investors with insight into a company's financial strength and how well a company's capital structure is managed.
7. Why operating cash flow is important?
Ans: Importance of Operating Cash Flow: Financial analysis sometimes prefer to look at cash flow metrics because they stri away certain accounting anomalies. Operating cash flow, specifically provides a clearer picture of the current reality of the busines operations.
For example, booking a large sale provides a big boost to revenue, b if the company is having a hard time collecting the cash, then it is no a true economic benefit for the company. On the other hand, a compan may generate high amounts of operating cash flow but report a ver low net income if it has a lot of fixed assets and uses accelerate depreciation calculations.
If a company is not bringing in enough money from its core busines operations, it will need to find temporary sources of external funding through financing or investing. However, this is unsustainable in th long run. Therefore, operating cash flow is an important figure assess the financial stability of a company's operations.
8. Describe the two types of Terminal Value.
Ans: Types of Terminal Value:
(i) Perpetuity Method: Discounting is necessary because th time value of money creates a discrepancy between the current an future values of a given sum of money. In business valuation, fre cash flow or dividends can be forecast for a discrete period of time but the performance of ongoing concerns becomes more challengin to estimate as the projections stretch further into the future. Moreover it is difficult to determine the precise time when a company may cease operations.
To overcome these limitations, investors can assume that cash flow will grow at a stable rate forever, starting at some point in the future This represents the terminal value. Terminal value is calculated by dividing the last cash flow forecast b the difference between the discount rate and terminal growth rate.
Fundamental of Financial Management : Unit-2 Investment Decisions | B.com 5th Sem | Gauhati University Notes
9.Risk and uncertainty is quite inherent in capital budgeting. comment.
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What are the risk and uncertainty in capital budgeting decisions ?
Ans: Risk analysis gives management better information about th possible outcomes that may occur so that management can use the judgment and experience to accept an investment or reject it. Since risk analysis is costly, it should be used relatively in costly and importa projects. Risk and uncertainty are quite inherent in capital budgeting decisions. This is so because investment decisions and capital budgeting are actions of today which bear fruits in future which is unforeseen Future is uncertain and involves risk. The projection of probability of cash inflows made today is not certain to be achieved in the course of future. Seasonal fluctuations and business cycles both deliver heavy impact upon the cash inflows and outflows projected for different projec proposals. The cost of capital which offers cut-off rates may also be inflated or deflated under business cycle conditions. Inflation and deflation are bound to effect the investment decision in future period rendering the degree of uncertainty more severe and enhancing the scope of risk Technological developments are other factors that enhance the degree of risk and uncertainty by rendering the plants or equipments obsolete and the product out of date. Tie up in the procurement in quantity and/or the marketing of products may at times fail and frustrate a business unless possible alternative strategies are kept in view. All these circumstances combined together affect capital budgeting decisions. It is therefore necessary to allow discounting factor to cover risk. One way to compare risk in alternative proposals is the use of Standard Deviation. Lowe standard deviation indicates lower risk. However, wherever returns are expressed in revenue terms the co-efficient of variation gives better measurement for risk evaluation.
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Also Read: Fundamentals of financial management complete notes