?




 

No decision places a company in more jeopardy than those decisions involving capital
improvements. Often these investments can cost billions of dollars, and without a suitable return
the very existence of the company can be compromised{In the course of their business, firms
have to make capital investment decisions. This involves critical evaluation of long-term
investments and their impact on the value of the company. The corporations make large
investments in buildings and land, and in plant and equipment. There is a constant need for
modernization of equipment due to changes in technology. As the firm grows, they need larger
facilities. A firm may embark on new projects, which may entail large investment of time and
capital. The firm considers all these decisions in light of the long-term benefit of the corporation.
From the financial point of view, only those projects will be acceptable that add to the value of
the firm, and increase the wealth of the owners of the firm.

A company has to evaluate many projects. Some of these projects may be mutually exclusive in
the sense that you have to pick only one and exclude others. A company may want to install gas
heat, or oil heat, in a factory, but not both. The company may have to evaluate several alternative
projects and rank them according to their profitability. Finally, they may have to pick only one or
two projects that they can finance with the available capital. Thus, capital budgeting becomes an
important issue.

{ 


The paper has been prepared with considering the following scopes:
6 The main focus of the paper is to understand the concept of capital budgeting.
6 The paper identifies the factors influencing the need of capital budgeting.
6 The paper evaluates factors affecting changes in capital budgeting decision.
6 It identifies different capital budgeting techniques, their advantages and disadvantages.

c


{   


The paper has been undertaken with the following objectives:

6 To identify scopes of improvement in the capital budgeting process.

6 To evaluate the strengths and weaknesses of each capital budgeting method and conduct
a comparison
6 To identify those capital budgeting practices that are used in the private sector
6 To learn about the risks involved in capital budgeting decision.

{
  
  


The paper is subjected to the following limitations:

6 The paper has been prepared under the time constraints.

6 All the rationales are based on secondary data.

c


 ?


?
 

 


?apital budgeting is the process of planning significant outlays on projects that have long-term
implications such as the purchase of new equipment or the introduction of a new product
?apital budgeting can be defined as the process of analyzing, evaluating, and deciding whether
resources should be allocated to a project or not. It is the process by which the financial manager
decides whether to invest in specific capital projects or assets. ?apital budgeting addresses the
issue of strategic long-term investment decisions. In some situations, the process may entail in
acquiring assets that are completely new to the firm. In other situations, it may mean replacing an
existing obsolete asset to maintain efficiency. Process of capital budgeting ensure optimal
allocation of resources and helps management work towards the goal of shareholder wealth
maximization

?apital investment involves a cash outflow in the immediate future in anticipation of returns at a
future date. A capital investment decision involves a largely irreversible commitment of
resources that is generally subject to significant degree of risk. Such decisions have for reading
efforts on an enterprise¶s profitability and flexibility over the long-term. Acceptance of non-
viable proposals acts as a drag on the resources of an enterprise and may eventually lead to
bankruptcy. For making rational decisions regarding the capital investment proposals, the
decision maker needs some techniques to convert the cash outflows and cash inflows of a project
into meaningful yardsticks which can measure the economic worthiness of projects.

During the capital budgeting process answers to the following questions are sought:
6 £hat projects are good investment opportunities to the firm?
6 From this group which assets are the most desirable to acquire?
6 Ñow much should the firm invest in each of these assets?

c


 ?
 

  ?
 


 
 

^udgeting for capital expenditure has evolved over the decades and its importance has increased
over time. Overall, six discernible stages of changes in capital budgeting practices and systems
can be identified.

The ©
 is the Great Depression years during which efforts were mainly focused on
designing ways to ensure economic recovery. At the time, public borrowing for financing capital
outlays, except for emergencies, was not favored. In a cautious approach, Sweden introduced a
capital budget that was to be funded by public borrowing and used to finance the creation of
durable and self-financing assets that would contribute to an expansion of net worth equivalent to
the amount of borrowing. This so-called investment budget found extended application in other
Nordic countries in following years.

The 
 took place during the late 1930s when the colonial government in India
introduced a capital budget to reduce the budget deficit by shifting some items of expenditures
from the current budget. It was believed that the introduction of this dual budget system would
provide a convenient way to reduce deficits while justifying a rationale for borrowing.

The 
 refers to the growing importance attached to capital budgets as a ³vehicle´ for
development plans. Partly influenced by the Soviet-style planning, many low-income countries
formulated comprehensive five-year plans and considered capital budgets the main impetus for
economic development. £here capital budgets did not exist, a variant known as the 
 

 was introduced.

The ©
 reflects the importance of economic policy choices on the allocation of
resources in government. Quantitative appraisal techniques were applied on a wider scale during
the 1960s leading to more rigorous application of investment appraisal and financial planning. In
the 1960s and 1970s, it was widely believed that government budget allocation, including

c


investment expenditures, could be largely reduced to a ³scientific´ process by systems such as
PP^S (planning, programming and budgeting system) or even Z^^ (zero-based budgeting).

A © © saw a revival of the debate about the need for a capital budget in government,
particularly in the United States. Along with the growing application of quantitative techniques
during the 1960s came the view that the introduction of a capital budget could be advantageous.
^ut this view did not gain much support. A president¶s commission in 1999 investigating budget
concepts in the United States concluded that a capital budget could lead to greater outlays on
bricks and mortar, and as a result, current outlays could suffer. Ñaving rejected the use of
separate capital budgets, the commission advocated the introduction of accrual accounting in
government accounts. The introduction of accrual accounting which did not make any progress
in the United States until the early 1990s would have meant the division of expenditures into
current and investment outlays. Meanwhile, however, a development cast more serious doubts on
the need for capital budgets. Sweden (and other Nordic countries), which had made pioneering
efforts in the 1930s, undertook a review of its budget system in the early 1970s. They found that
excessive focus on capital budgets would need to be tempered by a recognition that the overall
credibility and creditworthiness of a government depend more on its macroeconomic policy
stance and less on a government¶s net worth. This shift in emphasis contributed to a decline in
the popularity of the use of the capital budget until the late 1980s, when it came to be revived in
a different form.

During the  , partly because of the experiences of Australia and New Zealand, there
was a renewed push by the professional bodies and, from the late 1990s, the international
financial institutions for the introduction of accrual budgeting and accounting. These ideas found
a foothold in the United States, where advocates held the view that the absence of a distinction
between investment outlays and ordinary or current outlays led to unintended neglect of
infrastructure or accumulated assets. Ensuring proper asset maintenance (as important as asset
creation) required a division of outlays into current and capital outlays, as a part of day-to-day
budget management.




c
 

 ?
 

?!""#?$ $!%& #&"$? ?

Dual budgeting originated in European countries, but in those countries it lasted only for a short
period. It was introduced in the late 1930s in order to help governments ensure that the resources
they borrowed were used only for capital expenditures. After the Second £orld £ar, as
governments relaxed their use of borrowed funds, budgets were integrated. The change in
approach reflected several factors: massive postwar reconstruction work and increased recurrent
expenditures, along with the acceptance of the Keynesian model of linking government spending
and the size of the budget deficit and borrowing requirements to both fiscal and monetary
determinants and the business cycle. Moreover, it soon became clear that the need to reap a
return²whether financial, social, or economic²applied to the entire spectrum of government
spending. Ñence, it came to be accepted that regardless of their financing sources, government¶s
recurrent spending and capital investment are complements in any logical combination that may
be required, and that the two types of expenditures together produce results, provided the context
is one of overall macro-fiscal balance.

The U.K. government, in an effort to keep its budget deficit in a fiscally sound range, has in
recent years reintroduced the golden rule of limiting capital expenditures to the size of
borrowing, but this should be regarded as a self-imposed fiscal discipline measure only, and has
not created any type of dual budgeting.

In the United States, periodic recommendations were made for the introduction of a separate
capital budget. ^ut this never materialized, primarily because it might tilt the resource allocation
in favor of ³bricks and mortar.´ Ñowever, the budget documents presented a special analysis of
investment expenditures, which was for information only and had no accounting or other
implementation impact for the budget structure

Most OE?D countries have also achieved a high degree of integration of their current and capital
budgets. This has usually occurred through a process of development in their public
administration and budgetary systems that has taken place over many decades. It is the result of a

c



growing realization by these governments that: (i) the distinction between recurrent and capital
spending is often quite arbitrary or uncertain; and (ii) better resource allocation and management
decisions can often be made within a single, unified (and medium term) framework for revenues
and expenditures.

£hile there are now few developed countries which maintain totally separate budgets, the extent
and form of budgetary integration²particularly the management of capital spending²still
differs significantly in some instances. For this reason, effective integration of current and capital
budgets is perhaps best measured qualitatively by the extent to which the current and investment
spending decisions of the government are ³well-balanced,´ in the sense of being logically
consistent with, and mutually supportive of, a given policy framework or set of policy objectives.
In practice, this means that the services for which government departments and spending
agencies are responsible are delivered as effectively and efficiently as possible, given the budget
resources available. The budget systems of countries with a high degree of integration between
current and capital expenditures exhibit several key features:

6 a single (combined) annual budget law and appropriation process;

6 clear, and unified, responsibilities for budgetary preparation and implementation within
the relevant public sector institutions;
6 the existence of effective and widely employed investment appraisal techniques;
6 a unified budget presentation, with supporting classification and accounting systems; and
6 budget planning and management techniques within individual spending agencies that
encourage and enable good use of financial resources.

Most developed countries¶ budgetary systems incorporate some of these features. Ñowever, the
full benefits of a unified budget can only be achieved where each of these conditions is present.
And although each of these features is important, it is often in the last area the budget planning
and management within spending agencies where the most challenging reform measures, and
greatest gains, are to be found.

c


Above-mentioned characteristics of a sound budgetary system are often strengthened by the use
of a medium-term approach to public investment. Public investments are primarily meaningful in
a medium- to long-term perspective. If the sole focus is only on preparing and executing the
annual budget, the main reasons for pursuing investment projects will be related to short-term
macro-economic effects, for instance on employment, and short-term political considerations. In
such a setting, the potential long-term effects of the investments may be accorded little
importance. As a result, the capital budget will tend to be underfunded. In addition, project
selection will tend to prioritize high-visibility, fast-track projects, not the projects that give the
highest net benefits. Allocation of resources to different sectors and investment projects should
ideally be based on efficiency. £hat are the benefits compared to the costs of the projects? In the
short term, the main focus will tend to be on static efficiency: what are the expected results of
allocating resources to certain sectors based on their current capacity to deliver specific public
goods and services? In a longer-term perspective, dynamic efficiency becomes more important:
resource allocation should also be governed by the possibilities for improving the capacity of the
sectors over time, and investment projects will play a critical role in this regard.

It is also important to pursue cost-effective delivery of individual public goods and services. In
the short term, efforts to improve cost-effectiveness will tend to focus on cost minimization,
without any fundamental changes in production processes and methods. In an longer-term
perspective, it will be possible to pursue more ambitious modernization and re- engineering of
the way in which government agencies operate, while still producing the same type of public
service. Such restructuring will often require investments.
Many of the efforts to extend the time horizon for investment planning also include the
introduction of medium-term budget frameworks (MT^Fs). There are many differences between
countries in the exact nature of these MT^Fs, and in their focus and level of detail.
Ñowever, in general, effective MT^Fs tend to share certain characteristics:
6 The ministry of finance develops a medium-term macroeconomic forecast, which forms
the basis for multi-year spending ceilings by organizations or programs.
6 The line ministries develop policy-based, three-year budget estimates for their activities.
These estimates should reflect ministries¶ strategies and policies.

c


 6 The ministries¶ budget estimates distinguish clearly between the costs of existing policies
and programs, and the costs of new proposals, including investments.
6 The budget preparation process gives a formal status to the out-year estimates. On a
rolling basis, the first out-year estimates of expenditures should become the basis of
preparation of the following year¶s budget.

?urrently, the majority of OE?D countries prepare comprehensive MT^Fs. Few low-income
countries have been able to introduce full-fledged MT^Fs so far. Experience shows that this type
of reform is conceptually and practically very demanding. In particular, it has turned out to be
difficult for line ministries to develop credible, multi-year budget estimates.

A viable alternative is to begin by preparing multi-year budget estimates only for public
investments and for major expenditures driven by demographics and entitlements. These
estimates should be based on common methodologies, and the estimates should be agreed upon
by the line ministries and the ministry of finance. £hile this approach does not provide the
stringency of a full MT^F, it does give a much better basis for effective budget deliberations
than the traditional, annual approach. Another factor that has been mostly successful only in
developed countries is the development of a well-designed process


c
 

 ?
 


?
 


 

?apital expenditures can be very large and have a significant impact on the firm¶s financial
performance. ^esides, the investments take time to mature and capital assets are long-term,
therefore, if a mistake were done in the capital budgeting process, it will affect the firm for a
long period of time. ^asically, the importance of capital budgeting are as follow:

{

'



?apital budgeting decisions involves the investment of substantial amount of funds. It is

therefore necessary for a firm to make such decisions after a thoughtful consideration so as to
result in the profitable use of its scarce resources. The hasty and incorrect decisions would not
only result into huge losses but may also account for the failure of the firm.

{  

The capital budgeting decision has its effect over a long period of time. These decisions not only
affect the future benefits and costs of the firm but also influence the rate and direction of growth
of the firm.

{    (

Most of the investment decisions are irreversible. Once they are taken, the firm may not be in a
position to reverse them back. This is because, as it is difficult to find a buyer for the second-
hand capital items.

){?'
  
The capital investment decisions involve an assessment of future events, which in fact is difficult
to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the costs
relating to a particular investment decision


c


ü{$


The future success of a business largely depends on the investment decisions that corporate
managers make today. Investment decisions may result in a major departure from what the
company

*{&


Through making capital investments, firm acquires the long-lived fixed assets that generate the
firm¶s future cash flows and determine its level of profitability. Thus, this decision greatly
influences a firm¶s ability to achieve its financial objectives.
For example, if the firm invests too much it will cause higher depreciation and expenses. On the
other hand, if the firm does not invest enough, the firm will face a problem of inadequate
capacity and thus, lose its market share to its competitors.


+{, 
  
 
Proper capital budgeting analysis is critical to a firm¶s successful performance because capital
investment decisions can improve cash flows and lead to higher stock prices. Yet, poor decisions
can lead to financial distress and even to bankruptcy. Although a tactical investment decision
generally involves a relatively small amount of funds, strategic investment decisions may require
larger amount of funds.

c


 ?
 

^ 
  - 

 

 

( 

^usiness decisions that require capital budgeting analysis are decisions that involve in outlay
now in order to obtain some return in the future.

This return may be in the form of increased revenue or reduced costs. Typical capital budgeting
decisions include:

1. ?
 
  { Should new equipment be purchased to reduce costs?

2. '
 
  { Should a new plan, warehouse, or other facility be acquired to
increase capacity and sales?

3. -  
  { £hich of several available machines should be the most
cost effective to purchase?

4. 
(
  { Should new equipment be leased or purchased?

5. - 

  { Should old equipment be replaced now or later?

c


 ?
 

?
 

 

Financial planners recommend developing a capital budgeting process for small and large
businesses to ensure long-term success. In today's economy, it takes money to make money and
it takes making wise choices to stay on top. £hether large or small, no business can operate
efficiently without implementing a long-term plan to invest monetarily in equipment and
facilities to expedite the corporate mission and increase profitability. Improper planning results
in failed enterprises and a loss of resources; but proprietorships and corporations which make
prudent decisions about what, where, when, and how much money to allocate to new facilities or
improve on existing ones will have a fighting chance at staying in the black.

 ?
 


 

Finance Manager is not initiating the project he just evaluating the proposals and arranges funds
for approved projects.

1. Strategic planning
2. Identification of investment opportunities
3. Preliminary screening of projects
4. Financial appraisal of projects
5. Qualitative factors in project evaluation
6. The accept/reject decision
7. Project implementation and monitoring
8. Post-implementation audit

c


 
?
 

 

 
 

 

?apital budgeting is a multi-faceted activity. There are several sequential stages in the process.
For typical investment proposals of a large corporation, the distinctive stages in the capital
budgeting process are depicted, in the form of a highly simplified flow chart, in Figure 1


 



A strategic plan is the grand design of the firm and clearly identifies the business the firm is in
and where it intends to position itself in the future. Strategic planning translates the firm¶s

c


corporate goal into specific policies and directions, sets priorities, specifies the structural
strategic and tactical areas of business development, and guides the planning process in the
pursuit of solid objectives. A firm¶s vision and mission is encapsulated in its strategic planning
framework. There are feedback loops at different stages, and the feedback to µstrategic planning¶
at the project evaluation and decision stages ± indicated by upward arrows in Figure 1 is
critically important. This feedback may suggest changes to the future direction of the firm which
may cause changes to the firm¶s strategic plan.


 © 
 ©

 

 

The identification of investment opportunities and generation of investment project proposals is

an important step in the capital budgeting process. Project proposals cannot be generated in
isolation. They have to fit in with a firm¶s corporate goals, its vision, mission and long-term
strategic plan. Of course, if an excellent investment opportunity presents itself the corporate
vision and strategy may be changed to accommodate it. Thus, there is a two-way traffic between
strategic planning and investment opportunities. Some investments are mandatory ± for instance,
those investments required to satisfy particular regulatory, health and safety requirements ± and
they are essential for the firm to remain in business. Other investments are discretionary and are
generated by growth opportunities, competition, cost reduction opportunities and so on. These
investments normally represent the strategic plan of the business firm and, in turn, these
investments can set new directions for the firm¶s strategic plan. These discretionary investments
form the basis of the business of the corporation and, therefore, the capital budgeting process is
viewed in this book mainly with these discretionary investments in mind. A profitable
investment proposal is not just born; someone has to suggest it. The firm should ensure that it has
searched and identified potentially lucrative investment opportunities and proposals, because the
remainder of the capital budgeting process can only assure that the best of the proposed
investments are evaluated, selected and implemented. There should be a mechanism such that
investment suggestions coming from inside the firm, such as from its employees, or from outside
the firm, such as from advisors to the firm, are µlistened to¶ by management. Some firms have
research and development (R&D) divisions constantly searching for and researching into new
products, services and processes and identifying attractive investment opportunities. Sometimes,

c
 

excellent investment suggestions come through informal processes such as employee chats in a
staff room or corridor.


 




 ©


Generally, in any organization, there will be many potential investment proposals generated.
Obviously, they cannot all go through the rigorous project analysis process. Therefore, the
identified investment opportunities have to be subjected to a preliminary screening process by
management to isolate the marginal and unsound proposals, because it is not worth spending
resources to thoroughly evaluate such proposals. The preliminary screening may involve some
preliminary quantitative analysis and judgments based on intuitive feelings and experience.



 
  ©


Projects which pass through the preliminary screening phase become candidates for rigorous
financial appraisal to ascertain if they would add value to the firm. This stage is also called
quantitative analysis, economic and financial appraisal, project evaluation, or simply project
analysis. This project analysis may predict the expected future cash flows of the project, analyse
the risk associated with those cash flows, develop alternative cash flow forecasts, examine the
sensitivity of the results to possible changes in the predicted cash flows, subject the cash flows to
simulation and prepare alternative estimates of the project¶s net present value. Thus, the project
analysis can involve the application of forecasting techniques, project evaluation techniques, risk
analysis and mathematical programming techniques such as linear programming. £hile the basic
concepts, principles and techniques of project evaluation are the same for different projects, their
application to particular types of projects requires special knowledge and expertise. For example,
asset expansion projects, asset replacement projects, forestry investments, property investments
and international investments have their own special features and peculiarities.





c



ü   ©


 


£hen a project passes through the quantitative analysis test, it has to be further evaluated taking
into consideration qualitative factors. Qualitative factors are those which will have an impact on
the project, but which are virtually impossible to evaluate accurately in monetary terms. They are
factors such as:
6 the societal impact of an increase or decrease in employee numbers
6 the environmental impact of the project
6 possible positive or negative governmental political attitudes towards the project
6 the strategic consequences of consumption of scarce raw materials
6 positive or negative relationships with labor unions about the project
6 possible legal difficulties with respect to the use of patents, copyrights and trade or brand
names
6 impact on the firm¶s image if the project is socially questionable.
Some of the items in the above list affect the value of the firm, and some not. The firm can
address these issues during project analysis, by means of discussion and consultation with the
various parties, but these processes will be lengthy, and their outcomes often unpredictable. It
will require considerable management experience and judgmental skill to incorporate the
outcomes of these processes into the project analysis. Management may be able to obtain a feel
for the impact of some of these issues, by estimating notional monetary costs or benefits to the
project, and incorporating those values into the appropriate cash flows. Only some of the items
will affect the project benefits; most are externalities. In some cases, however, those qualitative
factors which affect the project benefits may have such a negative bearing on the project that an
otherwise viable project will have to be abandoned.

 !
 


NPV results from the quantitative analysis combined with qualitative factors form the basis of
the decision support information. The analyst relays this information to management with
appropriate recommendations. Management considers this information and other relevant prior
knowledge using their routine information sources, experience, expertise, µgut feeling¶ and, of

c


course, judgement to make a major decision ± to accept or reject the proposed investment
project.

"
 







Once investment projects have passed through the decision stage they then must be implemented
by management. During this implementation phase various divisions of the firm are likely to be
involved. An integral part of project implementation is the constant monitoring of project
progress with a view to identifying potential bottlenecks thus allowing early intervention.
Deviations from the estimated cash flows need to be monitored on a regular basis with a view to
taking corrective actions when needed.

# $ 


  

Post-implementation audit does not relate to the current decision support process of the project; it
deals with a post-mortem of the performance of already implemented projects. An evaluation of
the performance of past decisions, however, can contribute greatly to the improvement of current
investment decision-making by analysing the past µrights¶ and µwrongs¶.
The post implementation audit can provide useful feedback to project appraisal or strategy
formulation. For example,  assessment of the strengths (or accuracies) and weaknesses (or
inaccuracies) of cash flow forecasting of past projects can indicate the level of confidence (or
otherwise) that can be attached to cash flow forecasting of current investment projects. If
projects undertaken in the past within the framework of the firm¶s current strategic plan do not
prove to be as lucrative as predicted, such information can prompt management to consider a
thorough review of the firm¶s current strategic plan.

c


 ?
 '

?$ $!%& #&?,# .!

Firms operating in a dynamic environment must continuously make changes in different areas of
its operations in order to meet the needs of a challenging environment for growth and survival.
?ontinuous change assists in improving the operational process, thereby putting the organization
at an advantage over their competitors. Most changes involve capital expenditure decisions,
which can invariably involve large sums of money. The expenditure might involve expansion in
the current line of business, diversification or takeovers. Prior to the decision of appraising an
investment opportunity, the organization must identify a strategic need for investment in the
project. The need will determine aspects like, which of the many investment opportunities before
the entity will best help to meet their strategic objectives, how much to commit to the project in
terms of funds, human resource and the time towards the investment. Most of the strategic
decisions which necessitate large investments require managers to undertake detailed project
analysis before a final decision is made on whether or not to invest money in such a project.

A number of capital budgeting techniques are available to financial managers of either small
businesses or large businesses. The generally accepted techniques are

6 c
c 
6 Π
 
 
6 
   

6 Ú c  

6 a     

6 c 
a 

The most popular primary and secondary capital budgeting techniques used by large businesses
are payback period and internal rate of return. A recent study showed that most firms using a
discounted cash flow model utilize the weighted average cost of capital of their firm for the
discount rate.

c
 

 *{
(
/ 

Payback period is the time duration required to recoup the investment committed to a project.
^usiness enterprises following payback period use "stipulated payback period", which acts as a
standard for screening the project.

The basic element of this method is to calculate the recovery time, by year wise accumulation of
cash inflows (inclusive of depreciation) until the cash inflows equal the amount of the original
investment. The time taken to recover such original investment is the ³payback period´ for the
project.

The payback period is the most frequently used capital budgeting technique for large businesses,
although in large businesses it is very rarely used alone, but generally with some other technique
as well. Unfortunately, this is not true for small businesses, where frequently the payback period
is the only technique used.

Small business owners rely on payback period for their capital budgeting decisions because the
principles underlying it are easily understood. The payback period shows the small business
owner how long it will take him to payback his/her investment in the project. This concept is
more meaningful to a small business owner than the other methods, particularly because of the
interest in the liquidity of the firm, rather than the return on investment. ^ecause cash flows in
the distant future are inherently risky, a shorter payback period implies that a project is less risky.

*{{?
 

3
 

  
     
 

c
 
      



*{{ %  "
${?
 
"
   
 
O Select the projects which have payback periods lower than or equivalent to the stipulated
payback period.
O Arrange these selected projects in increasing order of their respective payback periods.

c


 O Select that project from the top of the list till the capital ^udget is exhausted.

{0
(' 

In the case of two mutually exclusive projects, the one with a lower payback period is accepted,
when the respective payback periods are less than or equivalent to the stipulated payback period.

*{{
$



(
/ 

6 It is easy to understand and apply. The concept of recovery is familiar to every decision-
maker.
6 ^usiness enterprises facing uncertainty - both of product and technology - will benefit by
the use of payback period method since the stress in this technique is on early recovery of
investment. So enterprises facing technological obsolescence and product obsolescence -
as in electronics/computer industry - prefer payback period method.
6 Giquidity requirement requires earlier cash flows. Ñence, enterprises having high
liquidity requirement prefer this tool since it involves minimal waiting time for recovery
of cash outflows as the emphasis is on early recoupment of investment.
6 No assumptions about future interest rates.
6 In case of uncertainty in future, this method is most appropriate.
6 A company is compelled to invest in projects with shortest payback period, if capital is a
constraint.
6 Ranking projects as per their payback period may be useful to firms undergoing liquidity
constraints.







c


*{{)% 




(
/ 

6 The time value of money is ignored. For example, in the case of project
6 A Tk.500 received at the end of 2nd and 3rd years are given same weight age. ^roadly a
rupee received in the first year and during any other year within the payback period is
given same weight. ^ut it is common knowledge that a Taka received today has higher
value than a rupee to be received in future.
6 ^ut this drawback can be set right by using the discounted payback period method. The
discounted payback period method looks at recovery of initial investment after
considering the time value of inflows.
6 ?ash generation beyond payback period is ignored.
6 Percentage Return on the capital invested is not measured.
6 Projects with long payback periods are characteristically those involved in long-term
planning, which are ignored in this approach.
6 The payback rules do not properly consider the riskiness of cash flows.
6 Investment decision is essentially concerned with a comparison of rate of return
promised by a project with the cost of acquiring funds required by that project. Payback
period is essentially a time concept; it does not consider the rate of return.

Academics have not succeeded much in understanding the preference for the use of payback
period by managers. Ñowever in a study by Narayanan (1985), who investigates for an economic
rationale for the use of P^ ascertains that under separate ownership and control, the management
has an incentive to make decisions that yield cash flows earlier in time when there is
informational asymmetry. It can be ascertained that many companies still use the P^ as a
measure of the capital attractiveness however its use as a single criterion seems to have
decreased over time and it may be probably best regarded as an initial screening tool. It is
inappropriate as a basis for sophisticated investment decisions.

c


*{ % 

(
/ 


The discounted payback period can be defined as the period required for the initial cash
investment in a project to equal the discounted value of the expected cash inflows . The
discounted payback method is similar to the payback period in that it looks at the length of time
it takes a project to "payback." The difference lies in the discounting of the cash flows with the
discounted payback period, while the cash flows are not discounted in the traditional payback
period. The discounted payback period is a better gauge of break-even than the payback period
because it is a period beyond which a project generates economic profit rather than accounting
profit. The discounted payback period is also a more conservative approach to capital budgeting
than the traditional payback period. The weighted average cost of capital of the firm should be
used as the discount rate in calculating the cash flows of the project. Another limitation of the
discounted payback period is that it is much harder to calculate than the traditional payback
period. It does, however, make a suitable substitute for the traditional payback period for a small
business owner because it is almost as easy to understand as the traditional payback period.

*{ {?
 

Same as the payback period, only discounted cash flow is used instead of normal cash flow.

*{ { %  "

A÷÷ ÷
  ÷   ÷÷

 !


*{ {
$


% 

(
/ 

6 ?÷ ÷
6 ?÷÷"# $%
  &

*{ {)% 



% 

(
/ 

6 ' ÷   ÷    
6 Ignores cash flows beyond the discounted payback period

c


*{
$ "
"

Accounting rate of return is the rate arrived at by expressing the average annual net profit (after
tax) as given in the income statement as a percentage of the total investment or average
investment. The accounting rate of return is based on accounting profits. Accounting profits are
different from the cash flows from a project and hence, in many instances, accounting rate of
return might not be used as a project evaluation decision. Accounting rate of return does find a
place in business decision making when the returns expected are accounting profits and not
merely the cash flows.

The accounting rate of return (ARR), computed from the financial statements, is a periodic and
an ex post indicator. Vatter (1966) ascertains that ARR is a figure based only on the data related
to a given year, and is not referenced to other parts of the project except the year to which it
applies. It is commonly defined as the ratio of accounting profit earned in a particular period to
the book value of the capital employed in the period. According to the different numerators and
denominators applied to calculate ARR, there are several kinds of definitions used in analysis.
For the numerator of ARR, it is usually financial annual accounting profit or income, while the
denominator is often determined by book value of assets or book value of equity. Employing the
µclean surplus¶ concept, Peasnell (1982) defines ARR as the ratio of the accounting profit to the
book value of assets at the beginning of the period.

*{
{?
 $ "
"

3  
   

 
 
Or

Sometimes average rate of return is calculated by using the following

Formula: (Net profit after tax /Average Investment)*100

£here average investment = (Initial Investment + Salvage Value)/2

c



*{
{ %  "

${?
 
"
   
 
O Select the projects whose rates of return are higher than the cut-off rate
O Arrange them in the declining order of their rate of return and
O Select projects starting from the top of the list till the capital available is exhausted.

{#?
 
"
   
 
Select all projects whose rate of return are higher than the cut-off rate.

?{0
(' 
Select the one that offers highest rate of return.

*{
{
$


$ "
"

6 It Is Easy To ?alculate.
6 The Percentage Return Is More Familiar To The Executives.
6 This method considers all the years in the life of the project.
6 It is based upon profits and not concerned with cash flows.
6 Quick decision can be taken when a number of capital investment proposals are being
considered.
6 The advantage in ARR is the easy availability of information for the computation of
results. The accounting data can be readily obtained from annual reports.








c
 

*{
{)% 



$ "
"1
6 The definition of cash inflows is erroneous; it takes into account profit after tax only. It,
therefore, fails to present the true return.
6 Definition of investment is ambiguous and fluctuating. The decision could be biased
towards a specific project, could use average investment to double the rate of return and
thereby multiply the chances of its acceptances.
6 Time value of money is not considered here.
6 It is biased against short-term projects.
6 The ARR is not an indicator of acceptance or rejection, unless the rates are compared
with the arbitrary management target.
6 It fails to measure the rate of return on a project even if there are uniform cash flows.

£hen analyzing investment / projects the managers are interested in the cash flows earning over
the life of the project and since ARR is based on numbers that include non-cash items, it doesn¶t
give a true picture of project quality. The ARR method does not take into account the time value
of money. Unlike the other modern techniques which account for the timing of the cash flows,
ARR values £1 today as similar to £1 at the end of the year. Although the ARR is simple to
calculate the other methods of capital investment valuation are not very difficult to calculate
given the availability of computing power. The data may also be unreliable due to problems of
creative accounting

£e can conclude on the basis of previous literature and criticism that since ARR does not take
into account the time value of money, and is wholly unadjusted for non-cash items, any
investment decision based on it is necessarily seriously flawed. Its only advantage is that it is
very easy to calculate.

c



*{)#2


The net present value method provides a framework to consider alternative capital investments,
utilizing a discount rate for the time value of money. The present value of the cash inflows are
compared against the present value of the cash harder to calculate than net present outflows. As
long as the present value of the cash inflows is greater than the present value of the cash
outflows, the project is acceptable. £ith limited capital, those investments with the highest net
present value are accepted, until the available capital is exhausted. The discount rate that is
generally used is the weighted average cost of capital for the firm (12).

The net present value method is very useful, and considers the time value of money. Although it
is more difficult to calculate than payback period, the recent advances in hand-held calculators
have made the determination of net present value much easier. The main obstacle to its greater
acceptance by the small business community is a lack of understanding of the process by small
business owners. Many of the owners are unaware the process exists, how it can be used, and the
principles underlying it.

Another problem with the net present value method is that it assumes that positive net present
value projects do exist and can be identified. Shapiro outlined a general set of situations in which
positive net present value projects generally occur. Ñe pointed out the service is the key to
extraordinary profit ability for many firms, and for small businesses this alternative is probably
the best.

NPV is a standard method in finance for capital budgeting purposes. Managers use NPV as a
cutoff / criterion for project selection, by undertaking a project if the present value of all future
cash inflows minus the present value of all cash outflows (which equals the net present value) is
greater than zero. The key inputs of the calculation of NPV are the interest rate or ³discount rate´
which is used to compute present values of future cash flows. If the discount rate exceeds the
shareholder¶s required rate of return, and the project has a positive NPV at this rate, then
shareholders will expect an additional profit that has a present value equal to the NPV. Thus if
the goal of the corporation is to maximize shareholder wealth, managers would undertake all
projects that have a positive NPV, or choose the higher NPV project if faced with two or more

c


mutually exclusive positive NPV projects. NPV analysis is sensitive to the reliability of future
cash inflows that an investment or project will yield.

Net present value of an investment/project is the difference between present value of cash
inflows and cash outflows. The present values of cash flows are obtained at a discount rate
equivalent to the cost of capital.

*{){?
 #2
3#24
O G     
   
O    

 
 
O     
O    

  
O      
Then,

Present value of cash inflows, ? = ™ ct / (1+k) t

Present value of cash outflows, ^ = ™ bt / (1+k) t

Net Present Value, NPV = (?-^) or

NPV= ™ (ct-bt) / (1+k) t

  
  !
 
 
   
  Ú 
 

  
    

NPV = ™ ct / (1+k) t ± I

6 "a
   
 " 

# !
 
 $ 




c


*{){ %  "

${5?
 
"
  5 
 
Select projects whose NPV is positive or equivalent to zero.
Arrange in the descending order of NPVs.
Select Projects starting from the list till the capital budget allows.

{5#
 
"
  5 
 
Select every project whose NPV >= 0

?{0
(' 
Select the one with a higher NPV.


*{){
$


#2

6 It recognises the Time Value of Money.
6 It considers total benefits during the entire life of the Project.
6 This is applicable in case of mutually exclusive Projects.
6 Since it is based on the assumptions of cash flows, it helps in determining
Shareholders £ealth.
6 The NPV is based on the forecasted cash flows from the investment. Ñence the
accounting practice like depreciation and non-cash expenditures, managements
taste and profits from existing business don¶t affect the decision.
6 Since the present values are a measure of future returns, they can be easily added
up. Ñence incase of two projects even with different time horizon, the present
value of the combines investment is the sum of the parts. The additive property
assists in recognizing suboptimal opportunities which are packaged with good
projects

c
 


*{){)% 



#2

6 This is not an absolute measure.
6 Desired rate of return may vary from time to time due to changes in cost of capital.
6 This Method is not effective when there is disparity in economic life of the projects.
6 More emphasis on net present values. Initial investment is not given due importance
6 If a project NPV exhibits inconsistent behavior of annual net benefits or net cash flow
from a project due to change in sign more than once over the planning horizon, the
method becomes unsuitable for certain types of investment decisions. (^oehme, 2000)
This makes NPV technique less useful in valuing highly technical and risky projects.
6 NPV systematically undervalues all investment projects. This is due to the strong implicit
assumptions made that no decisions would be taken in the future after the investment
decision. The technique ignores the managerial flexibility has been made. Managers are
known to undertake negative NPV projects in many cases because they are armed with
the options of expansion, delay, abandonment and contracting (shrink) the project which
has value.
6 NPV technique treats some options as mutually exclusive from others. ?onsider a
deferral option where a project can be deferred forgone or two years. NPV would value
the two cases separately to seek the option with higher value. It forces to conceive of
false mutually exclusive alternatives when confronted with decisions that could be made
in the future.

The NPV method has been successfully accepted and widely used by all mid-size and large size
companies as a primary capital budgeting technique. Survey by Graham and Ñarvey (2001)
reveals that 75% of the ?FO¶s taken from a large random sample always or almost always use
NPV as the preferred capital budgeting technique. They mainly attribute this to the ?EO
characteristics, the size of the firm and leverage. Another factor can be the availability of huge
computing power and sophistication.

c


6.5 
"
"

The internal rate of return is similar to the net present value, in that it considers the time value of
money. An internal rate of return is the true or effective interest yield generated by an investment
over its life, and can be defined as the discount rate that equates the present values of the cash
outflows to equal the present values of the cash inflows. The internal rate of return is used by
businesses more often than net present value. The internal rate of return is also more easily
understood by users who do not have formal training in accounting or finance.

Internal rate of return has some drawbacks, one of which is that it is harder to calculate than net
present value, particularly if it has uneven cash flows. This problem has been partially alleviated
by the increase in the capabilities of handheld calculators, but still can be tough for the small
business owners to grasp. Another problem with internal rate of return is that, when projects are
ranked by this criterion, it assumes the firm has the opportunity to reinvest the cash generated at
the internal rate of return. The net present value method assumes the cash flows generated by a
project can be reinvested at the firm's cost of capital. ^righam also noted that the net present
value method is preferable over the internal rate of return in the ranking of investment
alternatives.

The internal rate of Return (IRR) is the discount rate that equals the present value of a future
steam of cash flows to the initial investment. In simple terms, discount rate is the rate at which
the Net present value of a project equals zero. It can be thought of as the annualized rate of return
(in percent) of an investment using compound interest rate calculations.

*{ü{%  "

${5?
 
"
  5 
 Select those projects whose IRR (r) = k, where k is the cost
of capital. Arrange all the projects in the descending order of their Internal Rate of Return. Select
projects from the top till the capital budget allows.

c


 {5#?
 
"
  5 
 Accept every project whose IRR (r) = k, where k is the
cost of capital. ?{0
(' 

*{ü{ $


 ""

6 The Time Value of Money is considered.
6 All cash flows in the project are considered
6 The IRR technique computes the present value of investment opportunities cash flows
and hence takes into account the time value of money. This value states that a pound
today is more valuable than a pound tomorrow. This is a primary condition in the choice
of investment of investment appraisal techniques.
6 The IRR is based on the expected net cash flows from the project. These cash flows are
computed as total cash inflow less total cash outflow. Ñence the accounting practice like
depreciation and profits from existing business don¶t affect the decision making process.
6 Returns expressed in terms of percentage are easier to understand and communicate for
managers and shareholders compared to NPV, due to unfamiliarity with the details of the
appraisal techniques

*{ü{
% 



 ""

6 Possibility of multiple IRR, interpretation may be difficult.
6 If two projects with different inflow/outflow patterns are compared, IRR will lead to
peculiar situations.
6 If mutually exclusive projects with different investments, a project with higher
investment but lower IRR contributes more in terms of absolute NPV and increases the
shareholders¶ wealth
6 The IRR assumes that the time value of money is the project specific IRR, as it doesn¶t
discount the cash flows at the opportunity cost of capital. The method assumes that the
intermediate cash flows can earn the same rate of returns as the original project, and this
c


 creates unrealistic returns to the management and shareholders. (Kelleher and
Mc?ormack, Aug 2004) It can be very unreasonable to expect the returns to remain
stable over the life of the projected hence can give a misleading view of a proposed
investment.
6 The IRR method is unsuccessful in measuring returns in terms of absolute amounts of
wealth changes. It only gives a percentage measure of returns and this may cause
difficulties in ranking projects where there are conditions of mutual exclusivity.
6 The IRR technique fails to supports the additive principle when evaluating multiple
projects as the returns are expressed in percentage terms. The additive principle is
particularly necessary when evaluating project of different time horizons.

Although academics have been always certified NPV as the most appropriate theoretical method
for project evaluation, IRR has always been the favored technique in practice by the managers
around the globe. Surveys conducted (Arnold and Ñatzpoulos, July 2000;
Graham and Ñarvey, 2001) confirm that IRR has been the most accepted primary technique of
capital budgeting by ?FO¶s is most developed and developing nations.

c


 ?

?$ $"$ # #&

In capital budgeting ?apital rationing is a situation where a constraint or budget ceiling is placed
on the total size of capital expenditures during a particular period. Often firms draw up their
capital budget under the assumption that the availability of financial resources is limited. Under
this situation, a decision maker is compelled to reject some of the viable projects having positive
net present value because of shortage of funds. It is known as a situation involving capital
rationing. Financial Management & international finance 125


+{


?
 
"
  

Two different types of capital rationing situation can be identified, distinguished by the source of
the capital expenditure constraint.

{'

- ?apital rationing may arise due to external factors like imperfections of
capital market or deficiencies in market information which might have for the availability of
capital. Generally, either the capital market itself or the Government will not supply unlimited
amounts of investment capital to a company, even though the company has identified investment
opportunities which would be able to produce the required return. ^ecause of these imperfections
the firm may not get necessary amount of capital funds to carry out all the profitable projects.

{ 

- ?apital rationing is also caused by internal factors which are as follows:
6 Reluctance to take resort to financing by external equities in order to avoid assumption of
further risk
6 Reluctance to broaden the equity share base for fear of losing control.
6 Reluctance to accept some viable projects because of its inability to manage the firm in
the scale of operation resulting from inclusion of all the viable projects.



c



+{  
 ?
 
"
  

 
  6

  


 
  
:
The following are the steps to be adopted for solving the problem under this situation:
a. ?alculate the profitability index of each project
b. Rank the projects on the basis of the profitability index calculated in (a) above.
c. ?hoose the optimal combination of the projects.

 
  - 
 
  


 
  

The following steps to be followed for solving the problem under this situation:
a. ?onstruct a table showing the feasible combinations of the project (whose aggregate of initial
outlay does not exceed the fund available for investment.
b. ?hoose the combination whose aggregate NPV is maximum and consider it as the optimal
project mix.

c
 

 ?
  
" /$
(  ?
 

 
?apital budgeting appraisal techniques were applied on the assumption that the project will
generate a given set of cash flows. It is quite obvious that one of the limitations of D?F
techniques is the difficulty in estimating cash flows with certain degree of certainty. ?ertain
projects when taken up by the firm will change the business risk complexion of the firm.
This business risk complexion of the firm influences the required rate of return of the investors.
Suppliers of capital to the firm tend to be risk averse and the acceptance of a project that changes
the risk profile of the firm may change their perception of required rates of return for investing in
firm¶s project.

Generally the projects that generate high returns are risky. This will naturally alter the business
risk of the firm. ^ecause of this high risk perception associated with the new project a firm is
forced to assess the impact of the risk on the firm¶s cash flows and the discount factor to be
employed in the process of evaluation.

†{" /:
Risk may be defined as the variation of actual cash flows from the expected cash flows. The term
risk in capital budgeting decisions may be defined as the variability that is likely to occur in
future between the estimated and the actual returns. Risk exists on account of the inability of the
firm to make perfect forecasts of cash flows.

Risk arises in project evaluation because the firm cannot predict the occurrence of possible future
events with certainty and hence, cannot make any correct forecast about the cash flows. The
uncertain economic conditions are the sources of uncertainty in the cash flows. For example, a
company wants to produce and market a new product to their prospective customers. The
demand is affected by the general economic conditions. Demand may be very high if the country
experiences higher economic growth. On the other hand economic events like weakening of US
dollar, subprime crises may trigger economic slowdown. This may create a pessimistic demand
drastically bringing down the estimate of cash flows. Risk is associated with the variability of

c



future returns of a project. The greater the variability of the expected returns, the riskier the
project is. Every business decision involves risk. Risk arises out of the uncertain conditions
under which a firm has to operate its activities. ^ecause of the inability of firms to forecast
accurately cash flows of future operations the firms face the risks of operations. The capital
budgeting proposals are not based on perfect forecast of costs and revenues because the
assumptions about the future behavior of costs and revenue may change. Decisions have to be
made in advance assuming certain future economic conditions.

There are many factors that affect forecasts of investment, cost and revenue.
6 The business is affected by changes in political situations, monetary policies, taxation,
interest rates, policies of the central bank of the country on lending by banks etc.
6 Industry specific factors influence the demand for the products of the industry to which
the firm belongs.
6 ?ompany specific factors like change in management, wage negotiations with the
workers, strikes or lockouts affect company¶s cost and revenue positions.

Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management.
The best business decisions may not yield the desired results because the uncertain conditions
likely to emerge in future can materially alter the fortunes of the company.
Every change gives birth to new challenges. New challenges are the source of new opportunities.
A proactive firm will convert every problem into successful enterprise opportunities. A firm
which avoids new opportunities for the inherent risk associated with it, will stagnate and
degenerate. Successful firms have empirical history of successful management of risks.
Therefore, analysing the risks of the project to reduce the element of uncertainty in execution has
become an essential aspect of today¶s corporate project management.

c


†{ % ( /

Risks in a project are many. It is possible to identify three separate and distinct types of risk in
any project.
%
&

'( it is measured by the variability of expected returns of the project.
%
©  
'( A firm can be viewed as portfolio of projects having as certain degree of risk.
£hen new project added to the existing portfolio of project the risk profile the firm will alter.
The degree of the change in the risk depends on the covariance of return from the new project
and the return from the existing portfolio of the projects. If the return from the new project is
negatively correlated with the return from portfolio, the risk of the firm will be further diversified
away.
%)
'
*
': It is measured by the effect of the project on the beta of the firm. The
market risk for a project is difficult to estimate.
Stand alone risk is the risk of a project when the project is considered in isolation. ?orporate risk
is the projects risks to the risk of the firm. Market risk is systematic risk. The market risk is the
most important risk because of the direct influence it has on stock prices.

†{
 /:
The sources of risks are
1. Project ± specific risk
2. ?ompetitive or ?ompetition risk
3. Industry ± specific risk
4. International risk
5. Market risk

1.1   /: The sources of this risk could be traced to something quite specific to
the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead
to a situation of actual cash flows realised being less than that projected.

2. ?   /?   /unanticipated actions of a firm¶s competitors will

materially affect the cash flows expected from a project. ^ecause of this the actual cash flows
from a project will be less than that of the forecast.

c


3. 
(1  : industry ± specific risks are those that affect all the firms in the industry.
It could be again grouped into technological risk, commodity risk and legal risk. All these risks
will affect the earnings and cash flows of the project. The changes in technology affect all the
firms not capable of adapting themselves to emerging new technology.
The best example is the case of firms manufacturing motor cycles with two strokes engines.
£hen technological innovations replaced the two stroke engines by the four stroke engines those
firms which could not adapt to new technology had to shut down their operations.
?ommodity risk is the risk arising from the effect of price ± changes on goods produced and
marketed.
Gegal risk arises from changes in laws and regulations applicable to the industry to which the
firm belongs. The best example is the imposition of service tax on apartments by the
Government of India when the total number of apartments built by a firm engaged in that
industry exceeds a prescribed limit. Similarly changes in Import ± Export policy of the
Government of India have led to the closure of some firms or sickness of some firms.

4. 
 
" /these types of risks are faced by firms whose business consists mainly of
exports or those who procure their main raw material from international markets. For example,
rupee ± dollar crisis affected the software and ^POs because it drastically reduced their
profitability. £eakening reduced their competitiveness in the global markets. The surging ?rude
oil prices coupled with the governments delay in taking decision on pricing of petro products
eroded the profitability of oil marketing ?ompanies in public sector like Ñindustan Petroleum
?orporation Gimited. Another example is the impact of US subprime crisis on certain segments
of Indian economy.
The changes in international political scenario also affect the operations of certain firms.

5. 0
/" /Factors like inflation, changes in interest rates, and changing general economic
conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course
of business. Techniques used for incorporation of risk factor in capital budgeting decisions There
are many techniques of incorporation of risk perceived in the evaluation of capital budgeting
proposals. They differ in their approach and methodology so far as incorporation of risk in the
evaluation process is concerned.

c
 

 ?
# 
?
 

 ?


Geveraging your cost data into strategic planning requires sound processes and sharp tools.
Many of the requirements, workflows, and data management methods for capital planning,
procurement, and construction make it hard to streamline visibility of your past efforts. Teams
do the best they can with Excel models, but disconnected forms and processes are cumbersome;
too often people are comparing apples to oranges when critical questions arise.

Store costs must be in line with the financial plan and sales projections; an isolated real estate
and construction department has the potential to undermine an entire company.

To summarize the challenges:

1. Different sources pulling from varying ³all-in´ numbers to create a single budget.
2. Accounting, Procurement and most ^udgeting systems are not estimating solutions;
3. System limitations dictate the current depth and level of line items in the budget.
4. Gimited ability to quickly analyze budgets in more than two simple dimensions.

These limitations make it hard to:

1. ?ontrol project costs and develop performance metrics.

2. Quickly and effectively leverage existing data to make clear decisions.
3. Identify sources of variance between the proforma, funding budgets, and actuals.
4. Identify certain budget owners¶ costs within cost categories and cost targets.
5. Determine the impact of a departments¶ category spend on the total cost.

Opening a store is a complex process. It¶s essential that a company¶s real estate and construction
department support Operations and Finance by aligning its costs with the overall business plan.
The integrated processes and tools offered by site folio will provide the visibility and
consistency required.

c


 ?

?#?! #

Many small businesses continue to use payback period for their capital budgeting decisions.
Unfortunately, this is not a good criterion to rank these decisions, and the discounted payback
method is vastly superior. In addition, small businesses should also be using the net present value
method for ranking projects. The net present value method is more easily understood and
computed by small business owners than the internal rate of return, and is generally felt to be
superior. If small businesses utilize these two methods in their capital budgeting decisions, they
should become more profitable, more long-term oriented, and have a higher level of profitability.

?orporate manager have obligation to owners i.e. stockholders to increase company¶s

profitability i.e. long-term profitability. Successful capital projects are fundament of efficient
company. Main problem that emerges from capital budgeting is risk and insecurity. Regard to
characteristic of capital projects; long period of time implementing and long period of project
life, risk and insecurity is very high. Using just traditional methods and techniques managers
can¶t determine with certainly risk. ?ombining traditional methods and techniques for
determination risk process of selecting optimal projects manager can get much better and
stronger projects calculations. Using scenario, sensitivity, Monte ?arlo and decision tree analysis
manager can get better decisions. Enumerate techniques provide miscellaneous information that
manager can use in decision process. In paper trough example of widget factory its argument that
using techniques for risk determination manager can perform better because from stand-alone
risk techniques they get information¶s necessary for risk analysis. Trough risk analysis manager
could predict cash flow values, and could predict how different decisions affect on project
values. In addition to traditional techniques methods like scenario, sensitivity, decision tree and
Monte ?arlo provide additional view on possible variables that have impact on profitability of
project. Using these methods corporate managers can decide with better about acceptance or
rejection of the project, because all methods are observing and using in the account risk and
probability. For conclusion we determine that successful selection of optimal project can¶t be
conducted without implementation of at least two or more of techniques for risk managing in
capital budgeting.

c


$ "

6 Jeryl G. Nelson, £ayne State ?ollege Roy A. ?ook, Fort Gewis ?ollege. ³?APITAG
^UDGETING TE?ÑNIQUES FOR SMAGG FIRMS´

6 Prof. R.Madumathi ,Indian Institute of Technology ,Madras, ³?APITAG ^UDGETING´

6 Sean Donohue and Gina M Downing ³?APITAG ^UDGETING: DO PRIVATE
SE?TOR METÑODS OF ^UDGETING FOR ?APITAG ASSETS ÑAVE
APPGI?A^IGITY TO TÑE DEPARTMENT OF DEFENSE.´
6 Shelton £eeks,TÑE DEVAGUATION OF ?APITAG ^UDGETING IN REAG ESTATE
DEVEGOPMENT FIRMS´ Journal of Real Estate Portfolio Management Vol. 9, No. 3,
2003
6 Mohd Amy Azhar ^. Ñj. Mohd Ñarif, Ph.D, ?.A.(M) & Ñarizal ^. Osman
³FINAN?IAG MANAGEMENT PRA?TI?ES: AN INDEPTÑ STUDY AMONG TÑE

?EO OF SMAGG AND MEDIUM ENTERPRISE (SMEs)´

6 Gyorgy Andor , Sunil K. Mohanty & Tamas Toth ?APITAG ^UDGETING

PRA?TI?ES: A SURVEY OF ?ENTRAG AND EASTERN EUROPEAN FIRMS.´

6 Don Dayananda, Richard Irons, Steve Ñarrison, John Ñerbohn and Patrick Rowland
³?APITAG ^UDGETING: AN OVERVIE£.´
6 ?^O paper ,may 2008
6 Kashyap Soni, Nottingham University ^usiness School ,´?APITAG ^UDGETING
PRA?TI?ES IN INDIA.´
6 Peter A. ^rous, ³INTEGRATING TÑEORY AND PRA?TI?E: TÑE ?APITAG
^UDGETING PRO?ESS REPORT´

6 Morris G. Danielson Jonathan A. Scott ³TÑE ?APITAG ^UDGETING DE?ISIONS OF

SMAGG ^USINESSES´
6 Ñoward Gawrence, ³TÑE USE OF MODERN ?APITAG ^UDGETING
TE?ÑNIQUES´
6 The institute of cost & works accountants of India

c


£"

6 http://en.wikipedia.org
6 http://www.mbaknol.com
6 http://www.answers.com
6 http://www.brainmass.com
6 http://www.accountingformanagement.com
6 www.investopedia.com

c


 c