Q.N.1. Discuss the Various Methods adopted for a Capital Budgeting Decision.
Ans: CAPITAL expenditure decisions are concerned with decisions regarding investment of funds in fixed and current assets for getting returns for a number of years. Such decisions are extremely important because of following reasons:
(i) Substantial sums of money are involved.
(ii) It may be difficult to reverse the decision.
(iii) Such decisions have considerable impact on the future of a firm. Sometimes, the success or failure of the firm may depend upon a single investment decision.
Before discussing capital expenditure decision methods, we may understand following three points:
(i) Cost of capital.
(ii) Time Value of Money.
(iii) Cash inflow from operation:
There are two criteria for capital expenditure decisions:
(a) Accounting profit,
(b) Cash flow. Under Cash flow criterion, we require cash inflow, i.e., post-tax profit before non-cash items. Important non-cash items are depreciation and apportioned fixed costs. By apportioned fixed costs we mean, such fixed costs which are not being incurred because of the proposal but which are just being charged for determining accounting profit.
CRITERIA FOR CAPITAL EXPENDITURE DECISION EXPENDITURE DECISIONSS
As stated above, there are two criteria for capital expenditure decisions:
(i) Accounting profit,
(ii) Cash flow.
Under Accounting profit criterion, only one method is there. It is known accounting rate of return or unadjusted rate of return. (It is known as unadjusted rate of return because for its calculations, we do not make any adjustment on account of time value of money).
In case of cash flow criterion, cash inflows and cash outflows because of the proposal are considered for the decision. Cash inflow includes cash coming in as well as reduced outflows. Cash outflows include cash going out as well as reduced inflows. Cash flow criterion is preferred as compared to accounting profit criterion for following reasons:
(i) Use of cash flows avoids accounting ambiguities;
(ii) It is possible to consider time value of money.
Under cash flow criterion, two categories of methods are there:
(i) Payback period method,
(ii) Methods based on discounted cash flows.
There are three important methods based on the discounted cash flows: 3
(a) Net present value,
(b) Profitability index,
(c) Internal rate of return.
a) METHOD BASED ON ACCOUTING PROFIT
(1)UNADJUSTED RATE OF RETURN OR ACCOUNTING RATE OF RETURN:
(a) On the basis of own funds invested:
Profit after depreciation and after interest on borrowed funds
Own funds invested
This approach assumes that borrowed funds are not key factors. We can raise any amount of borrowed funds that we need. Hence, the return should be maximized on the basis of own funds invested. Return is available to own funds (owners or shareholders of the business) only after paying interest. Hence, we take the profit after interest. If tax is considered, the profit (considered in the above formula) should be taken as post- tax.
There is an alternative approach under which, instead of own funds, we take Average own funds invested.
(b) On the basis of total funds invested:
Profit after depreciation but before interest
Total funds invested
This approach assumes that borrowed funds are key factors. We can raise only limited amount of borrowed funds. Hence, the return should be maximized on the basis of own as well borrowed funds invested i.e. on the basis of total funds.
Total return available on total funds (“owners or shareholders” as well as 4 “suppliers of borrowed funds”) means EBIT i.e. before paying interest. Hence, we take the profit before interest. If tax is considered, the profit (considered in the above formula) should be taken as “before interest post- tax.” This is calculated as follows: [EBIT – Interest] – Tax rate [EBIT – Interest] + interest. There is an alternative approach under which, instead of total funds, we take Average total funds invested.
Generally we calculate rates of return for capital expenditure decisions on the basis of own funds assuming that borrowed funds are available as per requirements. If borrowed funds are available in limited amount only, we calculate rate of return on the basis of total funds invested.
METHODS BASED ON CASHFLOWS
(A) PAY BACK PERIOD (PBP) METHOD / APPROACH
i. Pay back period is the period within which the project will pay back its cost.
ii. Smaller the pay back period, better the project.
iii. The main advantage of the method is its simplicity.
iv. The main disadvantage is that it does not consider post pay back period profitability.
v. Pay back period can be calculated on the basis of simple cash flow or discounted cash flow.
vi. PBP method is quite suitable when rate of becoming obsolete is quite high.
(a) NPV METHOD:-
NPV = PV of inflow – PV of outflow.
If NPV is positive the project may be taken up. If NPV is zero, project may be taken up only if non-financial benefits are there. If NPV is negative project may not be taken up.
(b) PROFITABLITY METHOD:-
Present value of inflow
Profitability index (PI) = —————————-----
PV of outflow
If PI is more than one the project may be taken. If PI is one project may be taken up only on the basis of non-financial considerations. If PI is less than one the project may not be taken up. It is also called benefit cost ratio or desirability Factor.
(c) INTERNAL RATE OF RETURN: IRR is the rate of return on funds employed; it is calculated on the basis of discounted cash flow approach. It is inclusive of cost of capital. For example, cost of capital is 10% and IRR is 15%, it means the total return on the funds employed is 15%; out of which 10% is to meet the cost of capital and the balance it is extra profit over and above cost of capital. IRR is that discounting rate at which NPV of a project is Zero. Hence,
i. If NPV = 0 or PI = 1, than IRR is equal to discounting.
ii. If NPV is greater than zero or if PI is greater than one, IRR is greater than discounting rate.
iii. If NPV is less than zero or PI is less than one, than IRR is less than discounting rate.
Q.N.2. Explain the Mechanism of Determining a Cost Plus Price Decision.
Ans: Price Decision: - Price fixation is an important managerial function in all business enterprises. If the price set is quite high, the seller may not find enough number of consumers to buy his product. If the price fixed is too low, the seller may not be able to cover his cost. Thus, fixing appropriate price is a major decision-taking function of any enterprise. Price- decisions, no doubt, need to be reviewed from time to time.
As per the traditional Economic Theory price is determined by the interaction of demand and supply. Thus, the buyers and sellers determine the price. However, in practice some other parties and several other factors are involved in fixation of the price. The two main parties are the Competitors and the Government. Competitors are in the form of potential rivals who manufacture and sell related products; these may be in the form of close substitutes. In such cases the price fixed by one producer may influence the price fixation policy of the other. The Government influences prices through the imposition of taxes or providing subsidies and also through measures of direct controls.
Determinants of price of a commodity:
1. Cost of production
2. The demand for the product
3. Its elasticity of demand
4. The objective or the goal of the producer
5. The nature of competition in market (market structure) and
6. Government policy pertaining to the product.
Pricing under different objectives:-Pursuit of different objectives will lead to different pricing decisions. Traditional Economic Theory assumes that a firm sets the price and quantity of its product so as to maximize its current profit. Baumol argued that the objective of the firm is to maximize sales in money terms subject to a profit constraint. The objective of some other firms is to provide useful service to the customers by charging reasonable price. Some firms would like to take care of the goodwill of the company and hence will charge fair price etc.
Pricing under different market structures: - A firm operates in a market and not in isolation. We have earlier elaborately discussed the Theory of Price Mechanism and Price Determination under different market categories. Under Perfect Competition price is determined by the forces of demand and supply. The point of intersection between demand and supply curves is the point of equilibrium which determines the equilibrium price. Each firm under perfect competition is a price taker and not a price maker. The Average Revenue Curve of a firm under perfect competition is horizontal and that AR = MR. Further there is always a tendency towards the prevalence of only one price under Perfect Competition; the respective changes in the forces of demand and supply alone influence the price.
In case of Monopoly the situation is slightly different. A monopolist can be a price maker. He can fix the price of his product, initially through a process of trial and error, by balancing losses and gains. He is in equilibrium at a point where MR = MC and corresponding point on the Average Revenue Curve determines the price that he would charge so as to earn maximum profit. As there are barriers to entry and no close substitutes, the monopolist will charge a high price and subsequently enjoy monopoly profits.
The monopolist may also practice price-discrimination i.e. he may charge different prices to different buyers and in different regions for the same product depending upon the elasticity of demand for the product. In case of dumping also different prices will be charged for the same product. In fact selling his product in foreign market at a price lower than his own market is itself referred to as Dumping.
In case of, Monopolistic Competition each producer is a monopolist of his product and a group of producers producing same, though not identical product compete with each other in the market. They differentiate their product and instead of having a price war with each other they practice product-differentiation. However, the prices charged are quite competitive in nature.
Under Oligopoly there are few sellers competing in the market. They may be rivals or may form collusion. The price policy of one producer is affected by the price policy of the others. Each producer before he fixes the prices of his product tries to understand the price behavior of other producers in the market. For instance producer A thinks that if he lowers the price of his product and others don’t then he will be able to capture wider market but it may so happen that if he lowers the price of his product and others also lower their prices then he will not be able to get more buyers and therefore all the producers may subsequently suffer. On the other hand, he may feel that if he raises the price of his product and others also raise their prices he may not loose out on many customers but it may so happen that when he raises his price and others don’t raise their prices, then demand for his product will go down. Therefore under Oligopoly there prevails the phenomenon of price rigidity. They may prefer to resort to non-price competition leaving each other to follow their own policies.
Full Cost Pricing or Cost Plus Pricing:-This method is also known as Cost plus Pricing. In this method the producer calculates per unit cost of production and adds a margin of profit to it, which he considers fair and thereby arrives at a price which is acceptable to the consumer. In fixing the price, the firm calculates the average variable cost, adds to it the average fixed cost and to that adds the amount of fair profit. Fair profit is normally taken as 10% to 15% of the cost.
. . Price = Average Variable Cost + Net Profit Margin + Average Fixed Cost
The rationale of Full Cost Pricing lies in its simplicity and apparent fairness. It appears reasonable that price based on cost is a just price.
The advantages of using cost plus pricing are:-
The main disadvantages of cost plus pricing are often considered to be:
a) This method ignores the concept of price elasticity of demand - it may be possible for the business to charge a higher (or lower) price to maximize profits depending on the responsiveness of customers to a change in price.
b) The business has less incentive to cut or control costs - if costs increase, then selling prices increase. However, this might be making an "inefficient" business uncompetitive relative to competitor pricing; it requires an estimate and apportionment of business overheads. For example, total factory overheads need to be calculated and then allocated in some way against individual products. This allocation is always arbitrary.
c) If applied strictly, a full cost plus pricing method may leave a business in a vicious circle. For example, if budgeted costs are over-estimated, selling prices may be set too high. This in turn may lead to lower demand (if the price is set above the level that customers will accept), higher costs (e.g. surplus stock) and lower profits. When the pricing decision is made for the next year, the problem may be exacerbated and repeated. Amongst the factors that influence the choice of the mark-up percentage are as follows:
i. Nature of the market - a mark-up should reflect the degree of competition in the market
ii. Bulk discounts - should volume orders attract a lower mark-up than a single order?
iii. Pricing strategy - e.g. skimming, penetration
iv. Stage of the product in its life cycle; products at the earlier stages of the life cycle may need a lower mark-up percentage to help establish demand.
Limitations of the Full Cost Pricing or Cost plus Pricing are:-
1. The main criticism against Full Cost Pricing is that it disregards demand, as also the purchasing power of the buyers.
2. One of the weaknesses of the full cost pricing is that it tends to diminish the interest of the sellers in cost control i.e. the seller will not make any effort to minimize cost because the price fixed will automatically cover the cost.
3. In such pricing, historical cost is considered. This leads to over-pricing under decreasing cost and under-pricing under increasing cost conditions.
4. Such type of pricing is difficult in case of wide fluctuations in variable cost.
5. It does not take account of the forces of competition.
In a dynamic market situation characterized by change and uncertainty, full cost pricing is not a sound policy. It may be a useful starting point provided the sellers are willing to deviate over a period of time.