Capital budgeting (or investment appraisal) is the planning process used to determine whether an organisation's

long term investments such as new machinery, replacement machinery, new plants, new products, and research
development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1]

Many formal methods are used in capital budgeting, including the techniques such as

• Accounting rate of return

• Net present value
• Profitability index
• Internal rate of return
• Modified internal rate of return
• Equivalent annuity

These methods use the incremental cash flows from each potential investment, or project. Techniques based on
accounting earnings and accounting rules are sometimes used - though economists consider this to be improper -
such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as
well, such as payback period and discounted payback period.

Indian Institute of Technology Madras

MODULE 2
Capital Budgeting
• Capital Budgeting is a project selection exercise performed by the
business enterprise.
• Capital budgeting uses the concept of present value to select the
projects.
• Capital budgeting uses tools such as pay back period, net present
value, internal rate of return, profitability index to select projects.
Capital Budgeting Tools
• Payback Period
• Accounting Rate of Return
• Net Present Value
• Internal Rate of Return
• Profitability Index
Payback Period
Payback period is the time duration required to recoup the investment
committed to a project. Business enterprises following payback period use
"stipulated payback period", which acts as a standard for screening the

project. Capital Budgeting

What Does Capital Budgeting Mean?

The process in which a business determines whether projects such as building a new plant or investing in a long-
term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows
are assessed in order to determine whether the returns generated meet a sufficient target benchmark.
Key terms

Capital budgeting is vital in marketing decisions. Decisions on investment, which take time to mature, have to be
based on the returns which that investment will make. Unless the project is for social reasons only, if the
investment is unprofitable in the long run, it is unwise to invest in it now.

Often, it would be good to know what the present value of the future investment is, or how long it will take to
mature (give returns). e Capital budgeting is a required managerial tool.
One duty of a financial
manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a
financial manager must be able to decide whether an investment is worth undertaking and be able
to choose intelligently between two or more alternatives. To do this, a sound procedure to
evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

cision situation where large funds are committed (invested) in the

initial stages of the project and the returns are expected over a long
period of time. These decisions are related to allocation of
investible funds to differen onsideration of two or more assets that perform the same function.
If one is chosen for purchase, the others are automatically rejected.

Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC).
The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals
that have different costs.

As the picture above illustrates, the capital budgeting decision may be thought of as a cost-benefit analysis. We
are asking a very simple question: "If I purchase this fixed asset, will the benefits to the company be greater than
the cost of the asset?" In essence, we are placing the cash inflows and outflows on a scale (similar to the one
above) to see which is greater.

A complicating factor is that the inflows and outflows may not be comparable: cash outflows (costs) are typically
concentrated at the time of the purchase, while cash inflows (benefits) may be spread over many years. The time
value of money principle states that dollars today are not the same as dollars in the future (because we would all
prefer possessing dollars today to receiving the same amount of dollars in the future). Therefore, before we can
place the costs and benefits on the scale, we must make sure that they are comparable. We do this by taking the
present value of each, which restates all of the cash flows into "today's dollars." Once all of the cash flows are on
a comparable basis, they may be placed onto the scale to see if the benefits exceed the costs.

The Major Capital Budgeting Techniques

A variety of measures have evolved over time to analyze capital budgeting requests. The better methods use time
value of money concepts. Older methods, like the payback period, have the deficiency of not using time value
techniques and will eventually fall by the wayside and be replaced in companies by the newer, superior methods
of evaluation.
Very Important: A capital budgeting analysis conducts a test to see if the benefits (i.e., cash inflows) are large
enough to repay the company for three things: (1) the cost of the asset, (2) the cost of financing the asset (e.g.,
interest, etc.), and (3) a rate of return (called a risk premium) that compensates the company for potential errors
made when estimating cash flows that will occur in the distant future.

Let's take a look at the most popular techniques for analyzing a capital budgeting proposal.

1. Payback Period

Alright, let's get this out of the way up front: the Payback Period isn't a very good method. After all, it doesn't use
the time value of money principle, making it the weakest of the methods that we will discuss here. However, it is
still used by a large number of companies, so we'll include it in our list of popular methods.

What is the payback period? By definition, it is the length of time that it takes to recover your investment.

For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years. Companies that use this
method will set some arbitrary payback period for all capital budgeting projects, such as a rule that only projects
with a payback period of 2.5 years or less will be accepted. (At a payback period of 3 years in the example
above, that project would be rejected.)

The payback period method is decreasing in use every year and doesn't deserve extensive coverage here.

2. Net Present Value

Using a minimum rate of return known as the hurdle rate, the net present value of an investment is the present
value of the cash inflows minus the present value of the cash outflows. A more common way of expressing this is
to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the
costs (PVC)

NPV = PVB - PVC

By using the hurdle rate as the discount rate, we are conducting a test to see if the project is expected to earn our
minimum desired rate of return. Here are our decision rules:

Should we expect to earn at least Accept the

If the NPV is: Benefits vs. Costs
our minimum rate of return? investment?
Positive Benefits > Costs Yes, more than Accept
Zero Benefits = Costs Exactly equal to Indifferent
Negative Benefits < Costs No, less than Reject

Remember that we said above that the purpose of the capital budgeting analysis is to see if the project's benefits
are large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate
of return that adequately compensates the company for the risk found in the cash flow estimates.

Therefore, if the NPV is:

• positive, the benefits are more than large enough to repay the company for (1) the asset's cost, (2) the cost
of financing the project, and (3) a rate of return that adequately compensates the company for the risk
found in the cash flow estimates.
 • zero, the benefits are barely enough to cover all three but you are at breakeven - no profit and no loss, and
therefore you would be indifferent about accepting the project.
• negative, the benefits are not large enough to cover all three, and therefore the project should be rejected.

3. Internal Rate of Return

The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the investment.
Technically, it is the discount rate that causes the present value of the benefits to equal the present value of the
costs. According to surveys of businesses, the IRR method is actually the most commonly used method for
evaluating capital budgeting proposals. This is probably because the IRR is a very easy number to understand
because it can be compared easily to the expected return on other types of investments (savings accounts, bonds,
etc.). If the internal rate of return is greater than the project's minimum rate of return, we would tend to accept the
project.

The calculation of the IRR, however, cannot be determined using a formula; it must be determined using a trial-
and-error technique. This process is explained in the following link.

Calculation of the Internal Rate of Return

Which Method Is Better: the NPV or the IRR?

Ignoring the payback period, let's ask the question: Which method is better - the NPV or the IRR? Answer: The
NPV is better than the IRR. It is superior to the IRR method for at least two reasons:

1. Reinvestment of Cash Flows: The NPV method assumes that the project's cash inflows are reinvested to
earn the hurdle rate; the IRR assumes that the cash inflows are reinvested to earn the IRR. Of the two, the
NPV's assumption is more realistic in most situations since the IRR can be very high on some projects.

2. Multiple Solutions for the IRR: It is possible for the IRR to have more than one solution. If the cash
flows experience a sign change (e.g., positive cash flow in one year, negative in the next), the IRR method
will have more than one solution. In other words, there will be more than one percentage number that will
cause the PVB to equal the PVC.

When this occurs, we simply don't use the IRR method to evaluate the project, since no one value of the IRR is
theoretically superior to the others. The NPV method does not have this problem.

Is there any way that we can improve the performance of the IRR? Fortunately, yes. Let's take a look at how we
can do this, with another technique called the modified internal rate of return.

4. Modified Internal Rate of Return

The Modified Internal Rate of Return (MIRR) is an attempt to overcome the above two deficiencies in the IRR
method. The person conducting the analysis can choose whatever rate he or she wants for investing the cash
inflows for the remainder of the project's life.

For example, if the analyst chooses to use the hurdle rate for reinvestment purposes, the MIRR technique
calculates the present value of the cash outflows (i.e., the PVC), the future value of the cash inflows (to the end of
the project's life), and then solves for the discount rate that will equate the PVC and the future value of the
benefits. In this way, the two problems mentioned previously are overcome:

1. the cash inflows are assumed to be reinvested at a reasonable rate chosen by the analyst, and
2. there is only one solution to the technique.

To see how the MIRR is calculated, click on the link below:

t long-term assets.
• Capital budgeting is a continuous process and it is carried out
by different functional areas of management such as
production, marketing, engineering, finan Profitability index
• Net present value
• Modified Internal Rate of Return
• Equivalent annuity
• Internal rate of return

Profitability Index

The profitability index is a technique of capital budgeting. This holds the relationship between the investment and
a proposed project's payoff. Mathematically the profitability index is given by the following formula:

Profitability Index = (Present Value of future cash flows) / (Present Value of Initial investment)

The profitability index is also sometimes called as value investment ratio or profit investment ratio. Profitability
index is used to rank various projects.

Net Present value

Net present value (NPV) is a widely used tool for capital budgeting. NPV mainly calculates whether the cash
flow is in excess or deficit and also gives the amount of excess or shortfall in terms of the present value. The
NPV can also be defined as the present value of the net cash flow.

Mathematically,

NPV = ?(Ct / (1+r)t) - C0 , where the summation takes the value of t ranging from 1 to n
Here,

n stands for the total project time

t stands for the cash flow time

r stands for the rate of discount

Ct stands for net cash flow at time t

C0 stands for capital outlay when t = 0

Modified Internal Rate of Return

The Modified Internal Rate of Return (MIRR) gives the measure of an investment's attractiveness in a business.
The prime use of the modified internal rate of return in the capital budgeting process is to rank various choices of
projects.

Equivalent Annuity

Equivalent Annual Cost is widely used in capital budgeting as a decision making tool. This is mainly used to
compare different projects having unequal project lifetime.

Internal Rate of Return

The internal rate of return (IRR) is a metric used by the capital budgeting in order to determine whether the firm
should make investments or not. The IRR indicates the efficiency of a particular investment. cial
management etc.
 Y

Institute of Management Studies

DEVI AHILYA VISHWAVIDYALAYA

Name: MEENAKSHI AMBEDKAR

PH : 9098655260
Meenakshi.ambedkar@gmail.co
m

OBJECTIVE: Acquire good knowledge about the working at hospital.

 EDUCATIONAL QUALIFICATIONS:

QUALIFICATION INSTITUTE UNIVERSITY/ YEAR/SEM %

BOARD age
B.B.A ( Hospital Institute Of Devi Ahilya 2008-2011 78.6

Admin ) Management University Perusing last

Studies , Indore sem.
AISSCE Jawahar CBSE 2007 77
Navodaya
Vidyalaya,
sanawad
AISSE Jawahar CBSE 2005 73
Navodaya
Vidyalaya,
sanawad
 SUMMER TRAININGS AND PROJECTS:

HOSPITAL DURATION PROJECT TITLE

Mayur Hospital And Research 30 days General Administartion
Centre, Indore
Chl Apollo hospital , Indore 30 days Third Party Administration

 CO-CURRICULAR ACTIVITIES
• Participated and achieved third position in Throw Ball at intra-college competition.
• Attended conference by HIMT on Recent Trends And infrastructure in Hospital, At Delhi.

 PERSONAL PROFILE
 Father’s name: Mr. Radheshyam Ambedkar

 Mother’s name: Mrs. Lakshmi Ambedkar

 Date of birth: 04-August-1989

 Hobbies: Sketching and Reading

 Languages known: English, Hindi

 Permanent address : Hospital Colony, Bhikangaon, Khargone (M.P.)

I hereby declare that all the above-mentioned information is true to the best of my knowledge
and belief.

Date:
Place: INDORE MEENAKSHI AMBEDKAR