This document discusses various aspects of capital budgeting and working capital management. It defines capital budgeting as the process of determining the viability of long-term investments and outlines techniques used such as payback period, net present value, internal rate of return. It also discusses sources of long-term and short-term financing, the operating cycle of working capital, and the significance of the cost of capital in investment evaluation and designing an optimal debt policy.

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Topic No. 3 CAPITAL BUDGETING
Que. 1Nature and Significance of Capital Budgeting?
Nature of capital budgeting can be explained in brief as under
(a) Capital expenditure plans involve a huge investment in fixed assets.
(b) Capital expenditure once approved represents long-term investment that cannot be reserved or
withdrawn without sustaining a loss.
(c) Preparation of coital budget plans involve forecasting of severalyears profits in advance in order
to judge the profitability of projects.
It may be asserted here that decision regarding capital investment should be taken very carefully so
that the future plans of the company are not affected adversely.
The key function of the financial management is the selection of the most profitable assortment of
capital investment and it is the most important area of decision-making of the financial manger
because any action taken by the manger in this area affects the working and the profitability of the
firm for many years to come.
The need of capital budgeting can be emphasized taking into consideration the very nature of the
capital expenditure such as heavy investment in capital projects, long-term implications for the firm,
irreversible decisions and complicates of the decision making. Its importance can be illustrated well
on the following other grounds
(1) Indirect Forecast ofSales.
The investment in fixed assets is related to future sales of the firm during the life time of the assets
purchased. It shows the possibility of expanding the production facilities to cover additional sales
shown in the sales budget. Any failure to make the sales forecast accurately would result in over
investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the
firm to serious economic results.
(2) Comparative Study of Alternative Projects
Capital budgeting makes a comparative study of the alternative projects for the replacement
of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible
investment in the replacement of assets. For this purpose, the profitability of each projects is
estimated.
(3) Timing of Assets-Acquisition.
Proper capital budgeting leads to proper timing of assets-acquisition and improvement in
quality of assets purchased. It is due to ht nature of demand and supply of capital goods. The demand
of capital goods does not arise until sales impinge on productive capacity and such situation occur
only intermittently. On the other hand, supply of capital goods with their availability is one of the
functions of capital budgeting.
(4) Cash Forecast.
Capital investment requires substantial funds which can only be arranged by making
determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast.
(5) Worth-Maximization of Shareholders.
The impact of long-term capital investment decisions 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 share-holders.
(6) Other Factors. The following other factors can also be considered for its significance:-
(a) It assist in formulating a sound depreciation and assets replacement policy.
(b) It may be useful n considering methods of coast reduction. A reduction campaign may necessitate
the consideration of purchasing most up-to—date and modern equipment.

2. FINANCIALMANAGEMENT
(c) The feasibility of replacing manual work by machinery may be seen from the capital forecast be
comparing the manual cost an the capital cost.
(d) The capital cost of improving working conditions or safety can be obtained through capital
expenditure forecasting.
(e) It facilitates the management in making of the long-term plans an assists in the formulation of
general policy.
(f) It studies the impact of capital investment on the revenue expenditure of the firm such as
depreciation, insure and there fixed assets.
Que:. 2 Techniques in Capital Budgeting Decisions
Capital Budgeting
Capital budgeting (or investment appraisal) is the process of determining the viability to
long-term investments on purchase or replacement of property plant and equipment, new
product line or other projects.
Capital budgeting consists of various techniques used by managers such as:
1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index
All of the above techniques are based on the comparison of cash inflows and outflow of a
project however they are substantially different in their approach.
A brief introduction to the above methods is given below:
 Payback Period measures the time in which the initial cash flow is returned by the
project. Cash flows are not discounted. Lower payback period is preferred.
 Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash
inflows. Higher NPV is preferred and an investment is only viable if its NPV is
positive.
 Accounting Rate of Return (ARR) is the profitability of the project calculated as
projected total net income divided by initial or average investment. Net income is not
discounted.
 Internal Rate of Return (IRR) is the discount rate at which net present value of the
project becomes zero. Higher IRR should be preferred.
 Profitability Index (PI) is the ratio of present value of future cash flows of a project
to initial investment required for the project.

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Topic No. 3 Sources of Finance
Que:. 3 Sources of Long Term Finance
As the name suggests, Long term financing is a form of financing that is provided for a period of
more than a year. Long term financing services are provided to those business entities that face a
shortage of capital.
It is different from short term financing whichis normally used to provide money that has to be paid
back within a year. The period may be shorter than one year as well.
Examples of long-term financing include - a 30 year mortgage or a 10-year Treasury note.
Equity is another form of long-term financing, such as when a company issues stock to raise capital
for a newproject
Sources of Long Term Financing:
The various sources are as follows -
1. Shares: These are issued to the general public. The holders of shares are the owners
of the business. These may be of two types:
o Equity shares and
o Preference shares.
2. Debentures: These are also issued to the general public. The holders of debentures
are the creditors of the company.
3. Public Deposits: General public also likes to deposit their savings with a popular and
well established company which can pay interest periodically and pay-back the
deposit when due.
4. Retained Earnings: The Company may not distribute the whole of its profits among
its shareholders. It may retain a part of the profits and utilize it as capital.
5. Term Loans from Banks: Many industrial development banks, cooperative banks
and commercial banks grant medium term loans for a period of 3-5 years.
6. Loan from Financial Institutions: There are many specialized financial institutions
established by the Central and State governments which give long term loans at
reasonable rates of inters
Que. 4 Sources ofShort Term Finance
Sources of Short-term Finance
There are a number of sources of short-term finance which are listed below:
1. Trade credit
2. Bank credit
– Loans and advances
– Cash credit
– Overdraft
–Discounting of bills
3. Customers’ advances
4. Installment credit
5. Loans from co-operatives
1. Trade Credit
Trade credit refers to credit granted to manufactures and traders by the suppliers of
raw material, finished goods, components, etc. Usually business enterprises buy supplies on a
30 to 90 days credit. This means that the goods are delivered but payments are not made until
the expiry of period of credit. This type of credit does not make the funds available in cash
but it facilitates purchases without making immediate payment. This is quite a popular source
of finance
2. Bank Credit

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Commercial banks grant short-term finance to business firms which are known as bank
credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at
one time or in installments as and when needed. Bank credit may be granted by way of loans,
cash credit, overdraft and discounted bills
i) Loans
When a certain amount is advanced by a bank repayable after a specified period, it is known
as bank loan. Such advance is credited to a separate loan account and the borrower has to pay
interest on the whole amount of loan irrespective of the amount of loan actually drawn.
Usually loans are granted against security of assets.
(ii) Cash Credit
It is an arrangement whereby banks allow the borrower to withdraw money up to a specified
limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This
limit can be extended after review for another year. However, if the borrower still desires to
continue the limit, it must be renewed after three years. Rate of interest varies depending
upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this
arrangement, the borrower can draw, repay and again draw the amount within the sanctioned
limit. Interest is charged only on the amount actually withdrawn and not on the amount of
entire limit.
(iii) Overdraft
When a bank allows its depositors or account holders to withdraw money in excess of the
balance in his account up to a specified limit, it is known as overdraft facility. This limit is
granted purely on the basis of credit-worthiness of the borrower. Banks generally give the
limit up to Rs.20,000. In this system, the borrower has to show a positive balance in his
account on the last Friday of every month. Interest is char geed only on the overdrawn
money. Rate of interest in case of overdraft is less than the rate charged under cash credit.
(iv) Discounting of Bill
Banks also advance money by discounting bills of exchange, promissory notes and handiest.
When these documents are presented before the bank for discounting, banks credit the
amount to
customer’s account after deducting discount. The amount of discount is equal to the amount
of interest for the period of bill. This part has been discussed in detail later on in this chapter
3. Customers’ Advances
Sometimes businessmen insist on their customers to make some advance payment. It is
generally asked when the value of order is quite large or things ordered are very costly.
Customers’ advance represents a part of the payment towards price on the product (s) which
will be delivered at a later date. Customers generally agree to make advances when such
goods are not easily available in the market or there is an urgent need of goods. A firm can
meet its short-term requirements with the help of customers’ advances.
4. Installment credit
Installment credit is now-a-days a popular source of finance for consumer goods like
television, refrigerators as well as for industrial goods. You might be aware of this system.
Only a small
amount of money is paid at the time of delivery of such articles. The balance is paid in a
number of installments. The supplier charges interest for extending credit. The amount of
interest is included while deciding on the amount of installment. Another comparable system
is the hire purchase system under which the purchaser becomes owner of the goods after the
payment of last installment. Sometimes commercial banks also grant installment credit if they
have suitable arrangements with the suppliers.
5. Loans from Co-operative Banks

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Co-operative banks are a good source to procure short-term finance. Such banks have been
established at local, district and state levels. District Cooperative Banks are the federation of
primary credit societies. The State Cooperative Bank finances and controls the District
Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations.
Some of these banks like the Vani Co-operative Bank was initially established as a co-
operative society and later converted into a bank. These banks grant loans for personal as
well as business purposes. Membership is the primary condition for securing loan. The
functions of these banks are largely comparable to the functions of commercial banks
Topic No. 5 Working Capital
Que. 5 Explain the Working Capital and Nature of working capital.
In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-
day operations of a concern. This is related to short-term assets and short-term sources of
financing. Hence it deals with both, assets and liabilities—in the sense of managing working
capital it is the excess of current assets over current liabilities. In this article we will discuss
about the various aspects of working capital.
There are two concepts in respect of working capital:
(i) Gross working capital and
(ii) Networking capital.
Gross Working Capital:
The sum total of all current assets of a business concern is termed as gross working capital.
So,
Gross working capital = Stock + Debtors + Receivables + Cash.
Net Working Capital:
The difference between current assets and current liabilities of a business concern is termed
as the Net working capital. Hence, Net Working Capital = Stock + Debtors + Receivables +
Cash – Creditors – Payables
Que. 6 Nature and Needof Working Capital
The nature of working capital is as discussed below:
i. It is used for purchase of raw materials, payment of wages and expenses.
ii. It changes form constantly to keep the wheels of business moving.
iii. Working capital enhances liquidity, solvency, creditworthiness and reputation of the
enterprise.
iv. It generates the elements of cost namely: Materials, wages and expenses.
v. It enables the enterprise to avail the cash discount facilities offered by its suppliers.
vi. It helps improve the morale of business executives and their efficiency reaches at the
highest climax.
vii. It facilitates expansion programmers of the enterprise and helps in maintaining
operational efficiency of fixed assets.
Need for Working Capital:
Working capital plays a vital role in business. This capital remains blocked in raw materials,
work in progress, finished products and with customers.
The needs for working capital are as given below:

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i. Adequate working capital is needed to maintain a regular supply of raw materials, which in
turn facilitates smoother running of production process.
ii. Working capital ensures the regular and timely payment of wages and salaries, thereby
improving the morale and efficiency of employees.
iii. Working capital is needed for the efficient use of fixed assets.
iv. In order to enhance goodwill a healthy level of working capital is needed. It is necessary
to build a good reputation and to make payments to creditors in time.
v. Working capital helps avoid the possibility of under-capitalization.
vi. It is needed to pick up stock of raw materials even during economic depression.
vii. Working capital is needed in order to pay fair rate of dividend and interest in time, which
increases the confidence of the investors in the firm.
Que. 7 Operating Cycle of Working Capital
Definition:
Working capital is that amount of funds which is required to carry out the day-to-day
operations of an enterprise-whether big or small. It may also be regarded as that portion of an
enterprise’s total capital which is employed in its short-term operations.
Operating Cycle:
Working capital is also called a circulating capital or revolving capital. That is the
money/capital which circulates in various forms of current assets in a continued manner. For
example, at a point of time, funds may be tied up in raw materials, then later converted into
semi-finished products, then into finished/ final products and when these finished products
are sold, it is converted either into account receivables or cash. This cash is reinvested in
current assets. Thus, the amount always keeps on circulating or revolving from cash to
current assets and back again to cash. That is why some people prefer to use the term
liquidity management instead of working capital management. Although this circulation takes
place at short intervals, the money is required again and again.
The American Institute of Certified Public Accountants defined the operating cycle
as: “the average time intervening between the acquisition of material or services entering the
process and the final cash realization.”According to I. M. Pandey, “Operating cycle is the
time duration involved in the acquisition of resources, conversion of raw materials into work-
in-process into finished goods, conversion of finished goods into sales and collection of
sales.”

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Topic No. 6 Working Capital
Que. 8 Significance ofCostof Capital
A firm raises funds from various sources, which are called the components of capital.
Different sources of fund or the components of capital have different costs. For example, the
cost of raising funds through issuing equity shares is different from that of raising funds
through issuing preference shares. The cost of each source is the specific cost of that source,
the average of which gives the overall cost for acquiring capital.
The firm invests the funds in various assets. So it should earn returns that are higher
than the cost of raising the funds. In this sense the minimum return a firm earns must be equal
to the cost of raising the fund. So the cost of capital may be viewed from two viewpoints—
acquisition of funds and application of funds. From the viewpoint of acquisition of funds, it is
the borrowing rate that a firm will try to minimize.
Definition of Cost of Capital:
We have seen that cost of capital is the average rate of return required by the investors.
The significance and relevance of cost of capital has been discussed below:
Investment Evaluation:
The primary objective of determining the cost of capital is to evaluate a project. Various
methods used in investment decisions require the cost of capital as the cut-off rate. Under net
present value method, profitability index and benefit-cost ratio method the cost of capital is
used as the discounting rate to determine present value of cash flows. Similarly a project is
accepted if its internal rate of return is higher than its cost of capital. Hence cost of capital
provides a rational mechanism for making the optimum investment decision.
Designing Debt Policy:
The cost of capital influences the financing policy decision, i.e. the proportion of debt and
equity in the capital structure. Optimal capital structure of a firm can maximize the share-
holders’ wealth because an optimal capital structure logically follows the objective of
minimization of overall cost of capital of the firm. Thus while designing the appropriate
capital structure of a firm cost of capital is used as the yardstick to determine its optimality.
Project Appraisal:
The cost of capital is also used to evaluate the acceptability of a project. If the internal rate of
return of a project is more than its cost of capital, the project is considered profitable. The
composition of assets, i.e. fixed and current, is also determined by the cost of capital. The
composition of assets, which earns return higher than cost of capital, is accepted.