Objective type questions

PART X : INDIAN CAPITAL MARKET

31 INDIAN CAPITAL MARKET : STRUCTURE

Capital Market Efficiency Indian Capital Market : An Overview Over The Counter Exchange of India (OTCEI) National Stock Exchange Inter-Connected Stock Exchange Limited (ICSE) Capital Market Reforms and SEBI

STUDENTS ACTIVITIES

Points to remember Objective type questions Assignments

32 INDIAN CAPITAL MARKET : EMERGING TRENDS

Securities and Exchange Board of India Investors’ Protection, Grievances and Education Unfair Trade Practices Insider Trading Delisting of Equity Shares Mutual Funds Hedge Funds Depositories and Scripless Trading Derivatives Book Building Stock Lending Scheme Buy-back of Shares Rolling Settlement Green Shoe Option Indian Depository Receipts Algorithmic Trading (also known as ‘algo’) Demutualization of Stock Exchanges - Terms Commonly used in Capital Market

STUDENTS ACTIVITIES

Points to remember Graded illustrations in NAV Objective type questions Multiple choice questions Assignments

CASE STUDIES

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“Many important business decisions require the selection of projects (investments) whose outlays or benefits are spread out over several periods of time. The decision to acquire a factory building, for example, may require a large immediate outlay of funds, and also commits the company to the maintenance and operation of the building for a long period of years. In evaluating investments proposals, it is important to weigh the expected benefits of the investments against the expenses associated with it. For capital budgeting decisions, the costs and benefits are measured more appropriately by the cash flows attributable to the investment.”1

Introduction, Features and Significance of Capital Budgeting. Types of Capital Budgeting Decisions. Capital Budgeting Decision. Costs and Benefits. Assumptions. Procedure. Estimation of Costs and Benefits of a Proposal. Accounting Profit Versus Cash Flows. Types of Cash Flows. - Initial Cash Flows. - Subsequent Cash Flows. - Terminal Cash Flows. Incremental Approach to Cash Flows. Taxation and Cash Flows. Treatment of Depreciation and Cash Flows. Financial Cash Flows. Basic Principles for Calculation of Cash Flows. Cash Flows from the Point of View of Different

Perspectives. Graded Illustrations in Cash Flows. Capital budgeting decisions are related to the allocation of funds to different long term assets. Broadly speaking, the capital budgeting decision denotes a decision situation where the lump sum funds are invested in the initial stages of a projects and the returns are expected over a long period. Though there is no hard and fast rule to define the long term, yet period involving more than a year may be taken as a long period for investments decisions. The capital budgeting decision involve the entire process of decision making relating to acquisition of long term assets whose returns are expected to arise over a period beyond one year. Some of the capital budgeting decisions may be to buy land, building or plants; or to undertake a program on research and development of a product, to diversify into a new product line; a promotional campaign, etc. Some of these decisions may directly affect the profit of the firm e.g., launching a new product, whereas some other decision may affect the profit by reducing the costs e.g. replacing an existing machine by a more efficient one. But in both the cases, the decision once taken set the profit line of the firm for several years. All the relevant a functional departments play a crucial role in the capital budgeting decision process of any organization, yet for the time being, only the financial aspects of capital budgeting decisions are considered. The role of a finance manager in the capital budgeting basically lies in the process of critical and in-depth analysis and evaluation of various alternative proposals and then to select one out of these. The objective of capital budgeting is to select those long-term investment projects that are expected to make maximum contribution to the wealth of the shareholders.

1. Bierman H. and Drebin A.R., Management Accounting : An Introduction, The Macmillan Company, London, III Printing P. 197.

Capital budgeting decisions are those decisions that involve current outlay in return for a series of benefits in coming years. The capital budgeting decisions are often said to be the most important part of corporate financial management. Any decision that requires the use of resources is a capital budgeting decision; thus the capital budgeting decisions cover everything from broad strategic decisions at one extreme to say computerization of the office, at the other. The capital budgeting decisions affect the profitability of a firm for a long period, therefore the importance of these decisions is obvious. Even a single wrong decision by a firm may endanger the existence of the firm as a profitable firm. There are several factors and considerations which make the capital budgeting decisions as the most important decisions of a finance manager. The relevance and significance of capital budgeting may be stated as follows : (a) Long-Term Effects : Perhaps, the most important features of a capital budgeting decision and which makes the capital budgeting so significant is that these decisions have long term effects on the risk and return composition of the firm. These decision affect the future position of the firm to a considerable extent as the capital budgeting decisions have long term implications and consequences. By taking a capital budgeting decision, a finance manager in fact makes a commitment into the future, both by committing to the future needs of funds of the projects and by committing to its future implications. (b) Substantial Commitments : The capital budgeting decisions generally involve large commitment of funds and as a result substantial portion of capital funds are blocked in the capital budgeting decisions.

In relative terms therefore, more attention is required for capital budgeting decisions, otherwise the firm may suffer from the heavy capital losses in time to come. It is also possible that the return from a projects may not be sufficient enough to justify the capital budgeting decision. (c) Irreversible Decisions : Most of the capital budgeting decisions are irreversible decisions. Once taken, the firm may not be in a position to revert back unless it is ready to absorb heavy losses which may result due to abandoning a project in midway. Therefore, the capital budgeting decisions should be taken only after considering and evaluating each and every minute detail of the project, otherwise the financial consequences may be far reaching. (d) Affect the Capacity and Strength to Compete : The capital budgeting decisions affect the capacity and strength of a firm to face the competition. A firm may loose competitiveness if the decision to modernize is delayed or not rightly taken. Similarly, a timely deci-

sion to take over a minor competitor may ultimately result even in the monopolistic position of the firm. Thus, the capital budgeting decisions involve a largely irreversible commitment of resources i.e., subject to a significant degree of risk. These decisions may have far reaching effects on the profitability of the firm. These decisions therefore, require a carefully developed decision making process and strategy based on a reliable forecasting system.

The capital budgeting decisions are not only critical and analytical in nature, but also involve various difficulties which a finance manager may come across. The problems in capital budgeting decisions may be as follows : (a) Future Uncertainty : All capital budgeting decisions involve long term which is uncertain. Even if every care is taken and the project is evaluated to every minute detail, still 100% correct and certain forecast is not possible. The finance manager dealing with the capital budgeting decisions, therefore, should try to be as analytical as possible. The uncertainty of the capital budgeting decisions may be with reference to cost of the project, future expected returns from the project, future competition, expected demand in future, legal provisions, political situation etc. (b) Time Element : The implications of a capital budgeting decision are scattered over a long period. The cost and benefit of a decision may occur at different point of time. As a result, the cost and benefits of a capital budgeting decision are generally not comparable unless adjusted for time value of money. The cost of a project is incurred immediately, however, it is recovered in number of years. These total returns may be more than the cost incurred (in absolute terms), still the net benefit cannot be ascertained unless the future benefits are adjusted to make them comparable with the cost. Moreover, the longer the time period involved, the greater would be the uncertainty. (c) Measurement Problem : Some times a finance manager may also face difficulties in measuring the cost and benefits of a projects in quantitative terms. For example, the new product proposed to be launched by a firm may result in increase or decrease in sales of other products already being sold by the same firm. But how much ? This is very difficult to ascertain because the sales of other products may increase or decrease due to other factors also.

Every capital budgeting decision is a specific decision in the given situation, for a given firm and with given