1. Capital Budgeting
Decisions

2. Learning Objectives
1. Understand the basics of capital budgeting
analysis.
2. Understand and apply alternative methods to
analyze capital investments.
3. Understand and incorporate the effects of
inflation on cash flows in capital budgeting.
4. Understand and incorporate the effects of taxes
on cash flows in capital budgeting.

3. Introduction
 Working Capital refers to the portion of capital which is employed in
the business to carry on its day-to-day activities.
 It is used by the business to perform its operating activities.
 the capital invested into the business to carry on the continuous
operational activities of a concern is called the ‘Working Capital.’
Working Capital of a business is invested in its Current Assets and
Current Liabilities.
 Without adequate Working Capital, a concern cannot perform its day-
to-day operating activities smoothly.
 Lack of Working Capital in a business results in interruption or
discontinuation of its day-to-day operational activities.

4. IMPORTANCE OF WORKING
CAPITAL
It has immense importance to every business concern. It helps in the
following business activities of every concern:
i. Smooth running of operating activities.
ii. A continuous or uninterrupted flow of production.
iii. Ensures continuous supply of raw materials in time at a least price.
iv. Regularity in payment to suppliers of raw materials and in payment of
wages and overhead.
v. Efficient use of Fixed Assets.
vi. Easy availability of bank overdraft or short-term loans.
vii. Regularity in payment of interest on loan and of dividend to shareholders.

5. NEED FOR WORKING CAPITAL
The cash invested in raw materials, wages and overheads are brought back
into the business only after realization from the sale of goods. There is a
time lag between such cash engagement and its recovery through sales. To
carry on a continuous production process, Working Capital is essentially
required to every business concern till sales realization occurs. Working
Capital of a business provides a continuous finance for purchasing raw
materials and payment of wages and overheads till the cash is brought back
into the business by way of sales realization. Once the cash is realized from
the sales, it is reinvested into the business for purchasing raw materials and
payment of wages and overheads

6. DIFFERENT CONCEPTS AND
CLASSIFICATION OF WORKING CAPITAL
 Different classifications of Working Capital are discussed in Figure 6.1.

7. Classification of Working Capital
on the Basis of Concept
 Working Capital is classified into two parts.
They are: (i) Gross Working Capital; and (ii) Net Working Capital.
A. Gross Working Capital: wider concept of Working Capital. The capital
invested in the total Current Assets alone is considered as the Working
Capital. Therefore, Gross Working Capital refers to the capital invested in
the total Current Assets of a business. This concept of Working Capital is
called ‘Balance Sheet approach of Working Capital.’ As the Gross Working
Capital is represented by the sum of total Current Assets, it always
becomes a positive value. Gross Working Capital = Total Current Assets.
If the Gross Working Capital is defined from the viewpoint of a complete
Balance Sheet, it may be expressed as follows: Gross Working Capital =
Proprietors’ Fund + Total Debt − Fixed Assets.
Where, Proprietors’ Fund = Share Capital + Reserves & Surplus −
Miscellaneous Expenditure and Total Debt = Long-term Loan + Current
Liabilities.

8. B. Net Working Capital: This is a narrower concept of Working Capital.
Under this concept, the capital invested in the total Current Assets less
the total Current Liabilities is considered as the Working Capital.
Therefore, Net Working Capital refers to the difference between the total
Current Assets and the total Current Liabilities of a business. This is the
most popular concept of the Working Capital. This concept of Working
Capital is also called ‘Balance Sheet approach of Working Capital.’ Net
Working Capital = Total Current Assets − Total Current Liabilities. If the
Net Working Capital is defined from the viewpoint of a complete Balance
Sheet, it may be expressed as follows: Net Working Capital = Proprietors’
Fund + Long-term Loan − Fixed Assets.
Also Net Working Capital is sub-classified into two parts. These are:
(a) Positive Working Capital and
(b) Negative Working Capital.
(a) Positive Working Capital: If the total Current Assets of a concern are
more than its total Current Liabilities, the difference between them is
called the positive Net Working Capital. Therefore, it is nothing but the
excess of total Current Assets of a concern over its total Current
Liabilities. It indicates a favorable short term solvency position of a
concern.

9. (b) Negative Working Capital: If the total Current Liabilities of a concern is
more than its total Current Assets, then the difference between them is called
the negative Net Working Capital. Therefore, it is nothing but the excess of total
Current Liabilities of a concern over its total Current Assets. It indicates an
adverse short-term solvency position of a concern.
Classification of Working Capital on the Basis of Time
Working Capital is classified into two parts. They are:
(i) Permanent Working Capital; and (ii) Temporary Working Capital.
1. Permanent Working Capital is the portion of the Working Capital which
remains permanently invested into the business. It is the minimum amount of
Working Capital which is always kept ready in the form of Current Assets to
carry on operational activities of a concern uninterruptedly throughout the
year. It constitutes the minimum amount of Working Capital locked up in
Current Assets in the form of stock of raw materials, work-in-process (WIP),
finished goods, loose tools, spare parts, cash in hand and at bank and so on,
throughout the year, so that the normal operational activities of the concern
could never be discontinued. This type of Working Capital is also known as
Core Current Assets or Core Working Capital.

10. As this type of Working Capital is required to be invested permanently in the
Current Assets of a concern, it is generally financed out of long-term sources
of capital of the concern, such as issue of shares, dentures and so on.
2. Temporary Working Capital: Permanent Working Capital is the portion of
Working Capital which is required for a short period over and above the
permanent Working Capital. It is the additional Working Capital that a
concern needs in the form of inventories, receivable, cash and so on, during
different times of the year. This type of Working Capital always changes its
forms from cash to inventory, inventory to receivables and receivables to
cash again. This type of Working Capital is also called Variable Working
Capital or Seasonal Working Capital.
 SOURCES OF WORKING CAPITAL
Every one has finance its Working Capital out of various sources. Fixed
Working Capital of the business is financed out of the long-term capital
employed in the business, whereas temporary Working Capital of the
business is arranged out of short-term capital employed in the business.
Different sources of permanent and temporary Working Capital are written as
follows:

11. Sources of Permanent Working Capital
(i) External sources:
(a) Issue of shares; (b) Issue of debentures; and (c) Raising of long-term loans.
(ii) Internal sources:
(a) Ploughing back of profit or reinvestment of profit.
Sources of Temporary Working Capital
(i) External sources:
(a)Trade creditors; (b) Advance from customers; (c) Short-term borrowings;
(d) Bank overdraft ; (e) Outstanding wages and expenses; and (f) Short-term
public deposits.
(ii) Internal sources:
(a) Provision for Depreciation and (b) Provision for Taxation.

12. DETERMINANTS OF WORKING CAPITAL
Following are the factors that are to be considered in determining the Working
Capital Requirements:
i. Nature of the business. ii. Size of the business.
iii. Volume of production and sales. iv. Length of operating cycle.
v. Production policy. vi. Credit policy.
vii. Operational efficiency. viii. Inventory policy.
ix. Seasonal variation. x. Expansion and growth of the business.
xi. Depreciation policy. xii. Level of taxes.
xiii. Dividend policy. xiv. Cash Reserve requirement.
xv. Price-level changes.

13. COMPONENTS OF WORKING CAPITAL
As Working Capital is the difference between the Current Assets and Current
Liabilities, the components of Working Capital are Current Assets and Current
Liabilities.
Current assets are those assets which can be converted into cash within one
accounting year in the ordinary course of business. These assets are easily
convertible into cash. Examples of currents assets are: stock of Raw Materials,
WIP, Finished Goods, Sundry Debtors, Cash in hand, Cash at bank, Bills
Receivable, Prepaid Expenses, Accrued Incomes and so on.
On the other hand, Current Liabilities are those liabilities which are intended to
be repaid within one accounting year in the ordinary course of business. These
liabilities are readily payable in cash. Examples of Current Liabilities are: Sundry
Creditors, Bills Payable, Outstanding Expenses, Pre-received Incomes and so on.
Above all, Current Assets and Current Liabilities are related to the operational
activities of the concern and are termed as Operating Current Assets and
Operating Current Liabilities. Provision for taxation, proposed dividend and
outstanding interest on loan or debentures are also Current Liabilities, but these
are not directly related to the operational activities of the concern and are
termed as non-operating Current Liabilities.

14. POSITIVE AND NEGATIVE WORKING CAPITAL
Whenever the Working Capital is determined on the basis of Gross Working
Capital concept, it always becomes a positive Working Capital, as the Gross
Working Capital represents the sum of all Current Assets only. But, on the other
hand, whenever the Working Capital is determined on the basis of Net Working
Capital concept, it may be positive- or negative Working Capital, as Net Working
Capital represents the difference between the Current Assets and Current
Liabilities. Whenever the total Current Assets exceed the total Current
Liabilities, it results in a positive Working Capital. Whenever the total Current
Liabilities exceed the total Current Assets, it results in a negative Working
Capital.
WORKING CAPITAL OR OPERATING CYCLE
Working Capital Cycle or Operating Cycle refers to the period that an enterprise
takes in converting the cash back into the business from the cash initially
invested in various operating activities of the enterprise. The said cycle starts
from the cash blocked by the way of purchase of raw materials and ends with
the realization of cash out of sales. Therefore, the said cycle is the time lag
between the cash investment in purchase of raw materials and

15. the recovery of cash by the way of sale of goods. In the mean period, the cash
engaged in operation is being gradually converted into different forms of
Working Capital till its recovery from the sales. Cash, thus, engaged in the
operating activities is being blocked in the following forms of Working Capital:
i. Cash blocked in purchase of raw materials—thus the cash is being converted
into the stock of raw materials.
ii. From the production process, the further cash is blocked by way of payment
of wages and overheads along with the cash blocked in the raw materials—thus
the stock of raw materials and cash paid for wages and overheads are being
blocked into the stock of WIP.
iii. Amount incurred for raw materials, wages and overheads are further blocked
in the finished goods—thus the stock of WIP is being converted into the stock of
finished goods.
iv. If the finished goods are sold on credit, then the amount invested in raw
materials, wages and overheads, along with profit, are further blocked in
debtors—thus the stock of finished goods is being converted into debtors.
v. Cash is brought back into the business by way of realization of sales from
debtors—thus the amount blocked in debtors is being converted into cash.