Prepared By Nethra. Reference from “Financial Management”, K Y Khan and P K Jain Page 1

CAPITAL BUDGETING

We can explain it as that decisions which are taken for buying long term and fixed assets.

Working capital decisions and current assets investment decision do not come under capital

budgeting.

When we take the decision whether particular fixed asset should be purchased or not, its

planning will be capital budgeting. In capital budgeting, we fix our total investment in best

project which will provide us higher return. For capital budgeting, we use

different techniques for evaluating different projects. All techniques are called capital

budgeting techniques.

Capital: operating assets used in production.

Budget: Plan that details projected cash flows during some period.

Capital Budgeting: Process of analyzing projects and deciding which ones to include in the

capital budget.

Criteria: project should maximize shareholder’s value.

Definition:

“Capital budgeting decisions relate to long-term assets which are in operation and yield a

return over a period of time. They, therefore involve current outlays in return for series of

anticipated flow of future benefits.”

“A firms decision to invest its current funds most efficiently in long term assets in

anticipating of an expected flow of benefits over a series of years”

Importance of capital Budgeting:

Huge Investment - Capital budgeting requires huge investments of funds, but funds

are limited therefore the firm before investing projects; plan on control its capital

expenditure.

E.g. purchase of fixed assets land & building, Relating to expansion, addition of fixed

assets.

Defines the firm’s strategic direction- What project should be done defines the

direction either to expand the business or not to expand.

Long term affect-Capital budgeting decision have long term impact for many years

hence it is import to make right decision before taking up the project .

Risk involved- Capital expenditure involves higher risk hence careful planning of

capital budgeting is needed.

Irreversible-Wrong decision can have serious consequences and are irreversible.

Once decision is taken for purchasing a permanent asset, it is very difficult to dispose

of those assets without involving huge losses.

Difficulties:

Capital expenditure decisions are of considerable significance.

Prepared By Nethra. Reference from “Financial Management”, K Y Khan and P K Jain Page 2

Risk –future is uncertain benefits from investments are received in some future period

which is uncertain.

Failure to forecast- correctly will lead to errors which can be corrected at

considerable expense.

Different time periods - cost incurred and benefits received at different time period

hence cannot be comparable due to time value of money.

Calculation is not possible – It is not possible to calculate in strict quantitative terms

all the benefits or the costs relating to a particular investment decision.

Evaluation Techniques:

It is included in the methods of appraising an investment proposal such as objective,

quantified and based on economic costs and benefits. The methods of appraising capital

expenditure proposal can be classified into two broad categories.

TRADITIONAL (NON DISCOUNTED CASH FLOW)

Average Rate of Return

The average rate of return method of evaluating proposed capital expenditure is also known

as the accounting rate of return method. It means the average rate of return or profit taken for

considering the project evaluation. It is simply the return on investment.

ARR= Profit after tax (Net profit)

Book value of investment (original investment over the life of the project)

Accept /Reject criteria

If the actual accounting rate of return is more than the predetermined required rate of Return,

the project would be accepted. If not it would be rejected.

Pay-back Period

Pay-back period is the time required to recover the initial investment in a project. It is the

exact amount of time required for a firm to recover its initial investment in a project as

calculated from cash inflows.

Payback period = Initial investment

Annual cash inflows

Accept /Reject criteria

Shorter the payback period more desirable the project is.

METHODS

TRADITIONAL

(NON DISCOUNTED CASH FLOW)

Payback period method

Average Rate of Return method

TIME ADJUSTED

(DISCOUNTED CASH FLOW)

Net Present Value

Internal rate of return

Profitability Index

Prepared By Nethra. Reference from “Financial Management”, K Y Khan and P K Jain Page 3

DISCOUNTED CASHFLOW (Time Adjusted)

Net Present Value

It is one of the modern methods for evaluating the project proposals.

In this method cash inflows are considered with the time value of the money.

It is found by subtracting a projects initial investment from the present value of its cash

inflows discounted at the firm’s cost of capital.

n

t

- Initial investment

Ct=cash flow at the end of the year t.

n=life of the project.

k=discount rate.

Accept/Reject criteria

NPV >0, accept and NPV <0, reject.

Internal Rate of Return

Internal rate of return is time adjusted technique and covers the disadvantages of the

traditional techniques. It is the discounted rate that equates the present values of the cash

inflows with the initial investment associated with a project, thereby causing NPV =0.

Rate of return the project earns.

nvestment

n

t

= internal rate of return.

Accept/Reject criteria

If the present value of the sum total of the compounded reinvested cash flows is greater than

the present value of the outflows, the proposed project is accepted. If not it would be rejected.

Profitability index or benefit-cost ratio

It is similar to NPV approach. It measures the present value if returns per rupee invested,

while NPV is based on the difference between the present value of the future cash inflows

and the present value if cash outlays.

PI = Present value cash inflows (Benefit)

Present value if cash outflows (cost)

Accept/Reject criteria

PI value exceeds one; project is accepted .PI equals one the firm is indifferent to project.