Page 129 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes

Notes Kinds of Proposals

One can identify five types of proposals:
1. Replacement: As fixed assets are used they wear out or become outdated by new
technology. Money may be budgeted to replace worn out or obsolete equipment.

2. Expansion: A firm has to grow, and therefore production facilities are to be added
by way of single machinery or group of machines either for the same products or
new products in the same area.
3. Diversification: A business can reduce the risk by operating in several markets
rather than a single market. Firms seeking the facilities to enter new markets will
consider proposals for the purchase of new machinery and facilities to handle the
new products.

4. Research and development: Firms in industries where technology is rapidly changing
will expend large sums of money for research and development of new products. If
large sums of money are needed for equipment these proposals will normally be
included in the capital budget.
5. Miscellaneous: A firm will frequently have proposals that do not directly help achieve
profit-oriented goals e.g., installation of pollution control equipment. Safety items,
such as automatic sprinkling systems to protect against fire, may involve considerable
expenditures.

Self Assessment

Fill in the blanks:
1. ……………….. describes the firm's formal planning process for the acquisition and
investment of capital.
2. Capital investment decisions once made, are not easily ……………….. without much
financial loss to the firm

6.2 Capital Budgeting Process

A capital budgeting decision is a two-sided process:
1. Calculation of likely or expected return from the proposal. Here the focus is cash outflow
at the beginning of the project and a stream of cash flow flowing into the firm over the life
of the project. The calculation of expected return from cash outflow and cash inflows may
be done by different methods discussed later.
2. To select a required return that a project must achieve before it is acceptable. The focus is
the relationship between risk and 'return. Two methods may be used weighted average
cost of capital (if project risk is identical to firms current risk) or capital asset pricing
model (if project risk differs from firm's current risk).

The concept of cash outflow vs cash inflows: The following general rules to be followed:
1. Only cash flow is relevant: Cash flow should be differentiated with accounting profits.
2. Estimate cash flows on an incremented basis that follow from project acceptance.

124 LOVELY PROFESSIONAL UNIVERSITY