Capital Budgeting

And Its techniques

 Capital Budgeting
It is processes of identifying and evaluating capital
project , that is , projects where cash flow to the firm
will received over a period longer than year.

Any corporate decision with an impact on future

earning can be examined using this framework.

Capital is limited resource so optimum utilization of

capital is the responsibility of every financial
manager.

Independent Vs Mutually exclusive projects.
 Capital Budgeting
Process
 The process is divided into four steps:-


Idea generation;

Analyzing project proposal;

Create the firm wide capital budget;

Monitoring decisions and conducting post

audit.
 Categories of Capital
Budgeting Projects

Replacement Projects;

Expansion Projects;

New product or Market development

Project;

Mandatory Projects;

Other Projects.
 Capital Budgeting
Principles
Decisions are based on incremental cash flow ,
not accounting income;

Cash flow are based on Opportunity Cost;

The timing of cash flow is important;

Cash flow are analyzed on an after tax basis;

Financing cost are reflected in the project

required rate of return.
 Capital Budgeting
Techniques
 Pay back Period method


 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.


 Formula-: Full yrs until recovery+ Unrecovered cost at the beginning

of last year
 Cash flow during last
year
 Year (t) 0 1 2 3 4

Project A NCF -2000 1000 800 600 200

CNCF -2000 -1000 -200 400 600

Project B NCF -2000 200 600 800 1200

CNCF -2000 -1800 -1200 -400 800

Tim e va lu e o f m o n e y is th e b ig g e st ch a lle n g e in th is
m e th o d
 N e t P re se n t V a lu e M e th o d
Year (t) Project A Project B
0 -$ 2000 -$ 2000
1 1000 200
2 800 600
3 600 800
4 200 1200

Formula:- n CFt
NPV = ∑
t = 0 (1 + k)t
Where CFt = After tax cash flow at time t
k = Required rate of return for
project
A Positive NPV = Accept the project;
A Negative NPV = Reject the project;
A Zero NPV = No profit no loss .
 In te rn a l R a te o f R e tu rn M e th o d
Year (t) Project A Project B
0 -$ 2000 -$ 2000
1 1000 200
2 800 600
3 600 800
4 200 1200

n CFt
Formula:- NPV = 0 = ∑
t = 0 (1 + IRR)t

Where CFt = After tax cash flow at time t

IRR = Internal rate of return
for project
If IRR > expected rate of return than accept the proje
If IRR < excepted rate of return than reject the proje
 Average Accounting Rate of
Return

 ARR is defined as the ratio of project’s average

net income to its average book value. In
equation form , that is expressed as


 ARR = Average net income

 Average book value


ARR is based on accounting income that

violates the basic principles of capital
budgeting.
Any Question?