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CAPITAL BUDGETING

CAPITAL BUDGETING. By CA. Pramod Prabhu. S.H., B.Sc, A.C.A, C.I.S.A (U.S.A). Working Capital. = (CA – CL) CA = Those which can be converted into cash within a short duration, generally < 1 year. CA = (Stock + Debtors + Cash and Bank + PP exp + Loans & Advances + Marketable Investments)

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CAPITAL BUDGETING

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  1. CAPITAL BUDGETING By CA. Pramod Prabhu. S.H., B.Sc, A.C.A, C.I.S.A (U.S.A)

  2. Working Capital • = (CA – CL) • CA = Those which can be converted into cash within a short duration, generally < 1 year. • CA = (Stock + Debtors + Cash and Bank + PP exp + Loans & Advances + Marketable Investments) • CL = Those which fall due for pay/settlement within a short duration, generally < 1 year. • CL = ( Creditors + O/s Exp + Tax provision + Proposed & unclaimed dividend + ST loans + Bank OD + CC)

  3. Working Capital - Classification • Based on Concept: • 1. Gross WC = CA only • 2. Net WC = CA – CL • Based on Time factor: • 1. Permanent WC – Min level of investment required in business at all points of time. Also called Fixed/Hard core WC. • 2. Temporary WC – WC requirements over & above permanent WC & is dependent on factors like peak season, trade cycle boom etc. Also called fluctuating/variable W Capital

  4. Importance - Working Capital • 1. Required to use FA properly; (If no RM, machinery is unused) • 2. Funds are required for day-to-day operations • 3. Adequate WC ensures ST solvency of firm. Inadequate WC would render the firm incapable to meet its immediate commitments • 4. Increase in activity levels & sales should be backed up by suitable investment in WC • 5. Liquidity & profitability aspects should be suitably analysed by the FM. Too much emphasis on profitability may adversely affect liquidity. • Adequate WC levels as per general conventions: When, • 1. CA > CL • 2. CR = 2:1 • 3. QR = not < 1:1 • Note: CR & QR conventions vary from industry to industry

  5. Determinants of Working Capital • 1. Nature/character of business • 2. Size/scale of operations • 3. Production policy • 4. Manufacturing process/length of prod cycle • 5. Seasonal variations • 6. Working Capital cycle • 7. Rate of stock turnover • 8. Credit Policy • 9. Business Cycles • 10. Rate of growth of business • 11. Earning capacity & dividend policy • 12. Price level changes

  6. Working Capital Management • Managing CA & CL of a firm in such a way that a satisfactory level of WC is maintained, i.e. not inadequate/excessive. • Three dimensions of Working Capital management: • 1. Formulate policies regarding profitability, risk & liquidity • 2. Decision about composition & level of CA • 3. Decision about composition & level of CL • Principles of WCM: • 1. Principle of Risk Variation: • Risk refers to the inability of the firm to meet its obligations when they fall due. Larger investment in CA with less dependence on ST borrowings increases liquidity, reduces risk & also decreases the opportunity for gain/loss. At the same time, Lesser investment in CA with more dependence on ST borrowings increases risk, reduces liquidity & also increases profitability. Thus the management should establish a trade off between profitability & risk

  7. Working Capital Management • 2. Principle of Cost of Capital: • Various sources of raising WC have different cost of capital & degrees of risk. A sound WCM should try to achieve a proper balance between these two. • 3. Principle of Equity Position: • Concerned with planning the total investment in CA. Accordingly, WC invested in each component should adequately justify a firm’s equity position. Every Re invested in CA should contribute to the net worth of the firm • 4. Principle of Maturity of Payment: • Concerned with planning the sources of finance for WC. A firm should make every effort to relate the maturities of payment to the flow of its internally generated funds.

  8. Sources of Financing of Working Capital • Working capital requirements of a concern can be classified as Permanent & Temporary/Variable WC requirements • The fixed portion of WC should generally be financed from fixed capital sources while the temporary requirements may be met from ST capital sources • Sources of Permanent WC: • Shares, debentures, Public deposits, Ploughing back of Profits, Loans from financial institutions • Sources of Temporary/variable WC: • Commercial banks, indigenous bankers, Trade creditors, Installment credit, Advances, Accounts receivable – Credit/Factoring, Accrued Expenses, Commercial Paper

  9. WCM – Commercial Paper • Is a short-term promissory note issued by a company negotiable by endorsement & delivery, issued at a discount on face value, as may be determined by the issuing company. It is issued at a discount & redeemed at face value • Features: • 1. ST money market instrument. Min maturity period – 3 months & max 6 m from date of issue • 2. Essentially a promissory note with a fixed maturity value • 3. A certificate evidencing unsecured corporate debt of ST maturity • 4. Issued at a discount on face value; Can also be issued in interest bearing form • Eligibility for issue of CPs: • 1. Issuing company is listed in any RSE; Relaxation to PSU & closely held Co

  10. WCM – Commercial Paper • 2. Necessary credit rating obtained from approved agencies like ICRA, CRISIL etc. • 3. Issuing Co considered “standard asset” by all its bankers • 4. Minimum tangible NW of Rs. 5 Cr as per latest audited BS • 5. Fund based WC limit is not < 5 crores • 6. Min CR = 1.33:1 • 7. All issue expenses like dealer’s fee etc. are borne by the issuer company • Issue Procedure: • 1. Apply to RBI through financing bank • 2. RBI will approve if found satisfactory, considering the conditions above • 3. Issuing Co shall make arrangements for private placement of the issue, which should be completed within 2 weeks from date of approval by RBI • 4. Within 3 weeks of approval, Co shall intimate RBI on completion of issue & compliance with conditions

  11. WCM – Commercial Paper • Advantages of CP: • 1. Simplicity: Minimum documentation only • 2. Cash flow management: CPs with maturities tailored to match the CF of the company can be issued • 3. Diversification from Bank Finance: to relatively cheaper cost funds • 4. Incentive for financial strength: • Cos raising CPs become better known in the financial world, thus becoming in a more favorable position • 5. Returns to Investors: • CPs provide investors with higher returns than the banking system

  12. Working Capital Cycle • Also called Cash cycle/Operating cycle • Is the time duration for conversion of cash into cash equivalents like RM, WIP, FG, sundry debtors & thereafter back into cash • Operating Cycle represented: • Cash RM WIP • S Dr FG • Segments/Phases of Operating Cycle: • 1. Conversion of Cash into RM – Lead Time • 2. Conversion of RM into WIP & then to FG – Production/process cycle • 3. Conversion of FG into debtors through sales – Stockholding Period • 4. Conversion of receivables into cash – Ave Collection period

  13. Working Capital Cycle • Computation: • In terms of No. of days/months. • Operating Cycle = [( RM storage period + WIP holding period + FG storage period + Debtors collection period) – Creditors Payment period]

  14. Working Capital Cycle • Operating cycle indicates the total time required for rotation of funds. The faster the funds rotate the better for the company • Hence WC cycle should be at par with the industry average. A long cycle indicates overstocking of inventories/delayed receivables collection • Using the operating cycle, WC turnover ratio is computed as 365/WC cycle • A high TO ratio indicates a better position

  15. Estimation of Working Capital • 1. Total approach – All expenses & profit margin included • 2. Cash cost approach – Only cash expenses (Excl depreciation) are incl. • Steps: • 1. determine the various items of CA & CL to be estimated • 2. Determine the period of holding of each item • 3. determine the rate at which each items are to be valued • 4. Ascertain amount of each item as Period * Rate • 5. Find out net WC as (CA – CL)

  16. Estimation of Working Capital • W Note: Rate at which each items are to be valued:

  17. Working Capital Management – Major Considerations • Liquidity, Profitability & Structural Health • If amount of WC is high, the liquidity is high. But, due to low capital TO ratio, the ROI/profitability will also be low • If WC amount is low, profitability as indicated by a high TO will be higher. But, liquidity may be seriously affected causing loss of reputation for the firm in the short run • Also the structural health of the firm on LT & ST basis depends upon optimum amount of W capital • Hence the FM has to strike a balance between liquidity & profitability without affecting the structural health of the firm

  18. Important Theory Questions • 1. What is Working Capital? What are the major considerations in Estimation of Working Capital? • 2. What are the advantages of adequate working capital? • 3. What do you understand by working capital management? Discuss the principles of working capital management. • 4. Discuss the various approaches to determine an appropriate finance mix of working capital. • 5. Discuss the various sources of working capital funds. • 6. State & explain i) Commercial Paper ii) Factoring

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