Capital Budgeting

Meaning of capital budgeting

Significance of capital budgeting

Capital budgeting process

Investment criteria

Methods of capital budgeting

 The process through which different projects are
evaluated is known as capital budgeting

Capital budgeting is defined as the firms formal

process for the acquisition and investment of
capital. It involves firms decisions to invest its
current funds for addition, disposition,
modification and replacement of fixed assets.

Capital budgeting is long term planning for

making and financing proposed capital outlays-
Charles T Horngreen.
 Capital budgeting consists in planning
development of available capital for the purpose of
maximising the long term profitability of the
concern Lynch

The main features of capital budgeting are

a. potentially large anticipated benefits
b. a relatively high degree of risk
c. relatively long time period between the initial
outlay and the anticipated return.
- Oster Young
Significance of capital budgeting
The success and failure of business mainly
depends on how the available resources are being
utilised.
Main tool of financial management
All types of capital budgeting decisions are
exposed to risk and uncertainty.
They are irreversible in nature.
Capital rationing gives sufficient scope for the
financial manager to evaluate different proposals
and only viable project must be taken up for
investments.
Capital budgeting offers effective control on cost
of capital expenditure projects.
It helps the management to avoid over
investment and under investments.
Capital budgeting process involves the following
1. Project generation: Generating the proposals for
investment is the first step.
The investment proposal may fall into one of the
following categories:
Proposals to add new product to the product line,

Proposals to expand production capacity in existing

lines
Proposals to reduce the costs of the output of the
existing products without altering the scale of
operation.
Sales campaigning, trade fairs, R and D institutes,
conferences and seminars will offer wide variety of
innovations on capital assets for investment.
2. Project Evaluation: it involves two steps
Estimation of benefits and costs: the benefits and
costs are measured in terms of cash flows. The
estimation of the cash inflows and cash outflows
mainly depends on future uncertainities. The risk
associated with each project must be carefully
analysed and sufficeint provision must be made
for covering the different types of risks.
Selection of an appropriate criteria to judge the
desirability of the project: It must be consistent
with the firms objective of maximising its market
value. The technique of time value of money may
come as a handy tool in evaluation such
proposals.
3. Project Selection: No standard administrative
procedure can be laid down for approving the
investment proposal. The screening and selection
procedures are different from firm to firm.
Once the proposal for capital expenditure is finalized, it
is the duty of the finance manager to explore the different
alternatives available for acquiring the funds. He has to
prepare capital budget. Sufficient care must be taken to
reduce the average cost of funds. He has to prepare
periodical reports and must seek prior permission from the
top management. Systematic procedure should be developed
to review the performance of projects during their lifetime
and after completion.
The follow up, comparison of actual performance
with original estimates not only ensures better
forecasting but also helps in sharpening the
techniques for improving future forecasts.
Factors influencing capital budgeting
Availability of funds
Structure of capital
Taxation policy
Government policy
Lending policies of financial institutions
Immediate need of the project
Earnings
Capital return
Economical value of the project
Working capital
Accounting practice
Methods of capital budgeting
Traditional methods
Payback period

Accounting rate of return method

Discounted cash flow methods

Net present value method

Profitability index method

Internal rate of return

Pay back period method
It refers to the period in which the project will
generate the necessary cash to recover the initial
investment.
It does not take the effect of time value of money.
It emphasizes more on annual cash inflows,
economic life of the project and original
investment.
The selection of the project is based on the earning
capacity of a project.
It involves simple calcuation, selection or rejection of
the project can be made easily, results obtained is
more reliable, best method for evaluating high
risk projects.
PBP is used as a first screening method , it gives an indication of
rough measure of liquidity . Under this method accumulation of
cash flows is made year after year until it meets the initial capital
outlay ,to identify the recovery time of the capital amount
invested.

PBP = Initial investment

Annual cash in flow
1) If PBP > Target period Accept the proposal
2) If PBP < Target period Reject the proposal
3) If PBP = Target period -- Further analysis is required
* Target period is the minimum period targeted by management to
cover initial investment .
Accounting Rate of Return method
IT considers the earnings of the project of the economic life.
This method is based on conventional accounting
concepts. The rate of return is expressed as percentage of
the earnings of the investment in a particular project. This
method has been introduced to overcome the
disadvantage of pay back period. The profits under this
method is calculated as profit after depreciation and tax of
the entire life of the project.
This method of ARR is not commonly accepted in
assessing the profitability of capital expenditure. Because
the method does to consider the heavy cash inflow during
the project period as the earnings with be averaged. The
cash flow advantage derived by adopting different kinds
of depreciation is also not considered in this method.
 Average rate of return also known as accounting rate of return is
defined as average cash inflows (Benefits) against unit investment

ARR = Average cash inflows (Benefits ) * 100

Initial investment
1) If ARR > Target rate Accept the proposal
2) If ARR < Target rate Reject the proposal
3) If ARR = Target rate Further analysis is required
* Target rate is the minimum rate of return targeted by management
ARR is otherwise called as return on capital employed method .
Discounted cash flow method
Time adjusted technique is an improvement over pay
back method and ARR. An investment is
essentially out flow of funds aiming at fair
percentage of return in future. The presence of
time as a factor in investment is fundamental for
the purpose of evaluating investment. Time is a
crucial factor, because, the real value of money
fluctuates over a period of time. A rupee received
today has more value than a rupee received
tomorrow. In evaluating investment projects it is
important to consider the timing of returns on
investment. Discounted cash flow technique takes
into account both the interest factor and the return
after the payback 'period.
Discounted cash flow technique involves the
following steps:
Calculation of cash inflow and out flows over the
entire life of the asset.
Discounting the cash flows by a discount factor

Aggregating the discounted cash inflows and

comparing the total so obtained with the
discounted out flows.
Net present value method
It recognises the impact of time value of money. It is
considered as the best method of evaluating the
capital investment proposal.
It is widely used in practice. The cash inflow to be
received at different period of time will be
discounted at a particular discount rate. The
present values of the cash inflow are compared
with the original investment. The difference
between the two will be used for accept or reject
criteria. If the different yields (+) positive value ,
the proposal is selected for invesment. If the
difference shows (-) negative values, it will be
rejected.
Internal Rate of Return
It is that rate at which the sum of discounted cash
inflows equals the sum of discounted cash
outflows. It is the rate at which the net present
value of the investment is zero.
It is the rate of discount which reduces the NPV of an
investment to zero. It is called internal rate
because it depends mainly on the outlay and
proceeds associated with the project and not on
any rate determined outside the investment.
Step 1:Calculation of cash outflow

Cost of project/asset xxxx

Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx
Step 2: Calculation of cash inflow
Sales xxxx
Less: Cash expenses xxxx
PBDT xxxx
Less: Depreciation xxxx
PBT xxxx
less: Tax xxxx
PAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx
Note:
Depreciation = St.Line method

PBDT Tax is Cash inflow ( if the tax amount is

given)
PATBD = Cash inflow

Cash inflow- Scrap and working capital must be

added.
Step 3: Apply the different techniques
Pay back period= No. of years + Amt to recover/
total cash of next years.
ARR = Average Profits after tax/ Net investment
x 100
NPV= PV of cash inflows PV of cash outflows

Profitability index = PV of cash inflows/ PV of

cash outflows
IRR :

Pay back factor: Cash outflow/ Avg cash inflow

p.a.
Find IRR range
PV of Cash inflows for IRR range and then calculate
IRR