MODULE 22: CAPITAL BUDGETING

OVERVIEW

For an entrepreneur, choosing what to invest in should not be an exercise of instinct. With
capital budgeting methods, managers can appraise various projects simultaneously, with the
result indicating which one will have the highest impact on company value. This part you will
develop understanding how capital budgeting as a very powerful financial tool enables an
entrepreneur to analyses the investment in a capital asset, a new project, a new company, or
even the acquisition of a company, and the cost justification for the investment. Furthermore,
you will get to know the concepts, nature and process of capital budgeting.

LEARNING OBJECTIVES

• Desire the nature of capital budgeting

• Explain the scope and importance of capital budgeting
• Different techniques of capital budgeting

22.1 CONCEPT OF CAPITAL BUDGETING

Capital budgeting is a planning process that is used to determine the worth of long-term
investments of an organization.

The long- term investments of the organization can be made in purchasing a new machinery,
plant, and technology.

It helps in planning capital required for completing long-term projects.

The selection of a project is a major investment decision for an organization. Therefore,

capital budgeting decisions are included in the selection of a project.

G. C. Philipattos states that, “Capital budgeting is concerned with the allocation of the
firm’s scarce financial resources among the available market opportunities. The
consideration of investment opportunities involves the comparison of the expected future
streams of earnings from a project; with the immediate and subsequent stream of
expenditures for it.”

22.2 NATURE OF CAPITAL BUDGETING

The nature of capital budgeting can be explained as under:

• Capital expenditure plans involve a huge investment in fixed assets.

• Capital budgeting decisions involve the exchange of current funds for the benefits to
be achieved in the future.
• The funds are invested in non-flexible long-term funds.
 • Preparation of capital budget plans involves forecasting of profits over years in
advance, to judge the profitability of projects.
• Since it is based on future estimates, any error may lead to serious consequences.
The problem will be followed for a series of years.

22.3 IMPORTANCE OF CAPITAL BUDGETING

Capital Budgeting decisions affect the fixed assets only which are the sources of earning
revenue, i.e., the profitability of the firm, special attention must be given to their treatment.

Capital budgeting decisions have gained greater importance because:

1. Impact of Capital Budgeting in Long-Term

The effects of capital budgeting will extend into the future and will have to be suffered for a
longer period than the consequences of current operating expenditure.

A wrong investment decision can endanger the very survival of the firm.

Capital budgeting changes the risk complexion of the enterprise.

2. Involvement of Large Sum of Funds in Capital Budgeting:

Capital investment decisions require large amount of funds, the supply of which is restricted
by scarce capital resources.

A wrong/incorrect decision would result in losses and affect profits from other investments
as well.

3. The Impact of Capital Budgeting is not Reversible:

The capital budgeting decisions are not easily reversible.

The absence of a market for second-hand capital goods for the possibility of conversion of
such capital assets into other usable assets, results in a heavy loss to the firm.

4. Capital Budgeting is the most Complex Decision:

It is a difficult task to estimate the accurate future benefits and costs in terms of money as
there are external factors like economic, political, and technological forces that affect the
benefits and costs.

22.4 CAPITAL BUDGETING PROCESS

1. Project Identification and Generation: Proposal for investments are generated based on
addition of a new product line or expanding the existing one. It may be a proposal to either
increase the production or reduce the costs of outputs.

2. Project Screening and Evaluation: This step judges the desirability of a proposal by
matching the objective of the firm to maximize its market value. The time value of money has
to be considered.

The total cash inflow and outflow in consideration of the uncertainties and risks associated
with the proposal has to be analyzed. Provisioning has to be done for the same.

3. Project Selection: The approval of an investment proposal is done based on the selection
criteria and screening process defined for every firm, keeping in mind the objectives of the
investment being undertaken. Once the proposal has been finalized, the different alternatives
for raising or acquiring funds must be explored which is called preparing the capital budget.
The average cost of funds has to be reduced. Periodical reports and tracking the project for
the lifetime need to be fixed in the initial phase itself. Profitability, Economic constituents,
viability and market conditions stand as vital criteria for final approval.

4. Implementation: The different responsibilities like implementing the proposals,

completing of the project within the requisite time period and reduction of cost are allotted.
The management monitors the implementation of the proposals.

5. Performance Review: The comparison of actual results with the standard ones is done.
The unfavorable results are identified and difficulties of the projects are removed for further
execution of the proposals.

Factors Affecting Capital Budgeting:

The following factors affect capital budgeting:

Availability of Funds

Working Capital

Structure of Capital

Capital Return

Management decisions

Need of the project

Accounting methods

Government policy
 Taxation policy

Earnings

Terms of Lending of Financial Institutions

Economic value of the project

22.5 PRINCIPLES OF CAPITAL BUDGETING PROCESS

The capital budgeting process is based on the following five principles:

The capital budgeting decisions are based on the incremental cash flows of the project, and
not on the accounting income generated by it. Sunk costs are not considered in the analysis.

The external factors that can impact the implementation of the project and eventually the
cash flow of the company must be fully considered while preparing/planning the capital
budgeting.

All the cash flows of the project should be based on the opportunity costs. The existing cash
flows already generated by an asset of the company which may be forgone, if the project
under analysis is undertaken should be analyzed.

The time value of money concept states that, cash flows of the project received earlier has
more value than the cash flows received later.

All the cash flows from the project should be analyzed only after providing for taxes.

The financing costs pertaining to a project should not be considered while evaluating
incremental cash.

22.6 EVALUATION TECHNIQUES IN CAPITAL BUDGETING

The techniques in capital budgeting are calculated as follows:

I. Non-Discounted Cash Flow Technique (NDCF)

1. Payback period

2. Accounting Rate of Return method

II. Discounted Cash Flow Technique (DCF)

1. Net present value method

2. Internal Rate of Return Method

3. Profitability index.

They are discussed in detail as follows:

I. Non-Discounted Cash Flow Technique

1. Payback Period:

The payback (or payout) period is defined as the number of years required to recover the
original cash outlay invested in a project.

If the project generates constant annual cash inflows, the payback period can be
computed dividing cash outlay by the annual cash inflow.

Accept-Reject Criteria: The projects with the lesser payback are selected.

2. Accounting Rate of Return Method:

The Accounting rate of return (ARR) method uses accounting information, as revealed by
financial statements, to measure the profit capacities of the investment proposals. The
formula for ARR is given below:

Where,

Average Income = Average of post-tax operating profit

Average Investment = (Book value of investment in the beginning + book value of

investments at the end) / 2

Accept-Reject Criteria: The decision criteria lean to the projects having the rate of return
higher than the minimum desired returns.

II. Discounted Cash Flow Technique

1. Net Present Value Method (NPV):

The net present value (NPV) method is a process of calculating the present value of cash
flows (inflows and outflows) of an investment proposal, using the cost of capital as the
appropriate discounting rate, and finding out the net profit value, by subtracting the present
value of cash outflows from the present value of cash inflows.

The equation for the net present value is:

It is assumed in the above equation that, all the cash outflows are made in the initial year
(t)

2. Internal Rate of Return Method (IRR):

The Internal Rate of Return or IRR is a rate that makes the net present value of any project
equal to zero.

The internal rate of return (IRR) equates the present value cash inflows with the present
value of cash outflows of an investment.

It is called internal rate because it depends solely on the outlay and proceeds associated
with the project. In the Internal rate of return method, the value of NPV is assumed as zero
and the discount rate that satisfies this condition is found out.

The formula to calculate IRR is:

Where,

CFo = Investment

Ct = Cash flow at the end of year t r = internal rate of return

n = life of the project

Accept - Reject criteria:

If IRR > Cost of Capital, Accept the proposal

If IRR < Cost of Capital, Reject the proposal

If IRR = Cost of Capital, it is an indeterminate situation whether to Accept or Reject the

proposal.

3. Profitability Index (PI):

 The Profitability Index shows the relationship between the benefits and cost of the project.
Hence it is also called as the benefit-cost Ratio. It is the ratio of the present value of future
cash benefits, at the required rate of return to the initial cash outflow of the investment. It
may be gross or net, net being simply gross minus one.

The formula to calculate the profitability index (PI) is as follows.

The profitability Index helps in giving ranks to the projects based on its value, the higher
the value the top rank the project gets. Therefore, this method helps in the Capital Rationing.

Accept – Reject Criteria:

PI > 1 (NPV is Positive) -> Accept

PI < 1 (Negative) -> Reject

PI = 1 -> May Accept or Reject Merits of Profitability Index

22.7 COMPARISON OF NPV AND IRR

Both NPV and IRR will give the same results (i.e. acceptance or rejections) regarding an
investment proposal in following two situations.

1. When the project under consideration involve conventional cash flow. i.e. when an initial
cash outlays is followed by a series of cash inflows.

2. When the projects are independent of one another i.e., proposals the acceptance of which
does not preclude the acceptance of others and if the firm is not facing a problem of funds
constraint.

The reasons for similarity in results in the above cases are simple. In NPV method a
proposal is accepted if NPV is positive.

NPV will be positive only when the actual rate of return on investment is more than the cut
off rate.

In case of IRR method a proposal is accepted only when the IRR is higher than the cut off
rate.

Thus, both methods will give consistent results since the acceptance or rejection of the
proposal under both of them is based on the actual return being higher than the required rate
i.e.
 NPV will be positive only if r > k,

NPV will be negative only if r < k,

NPV would be zero only if r = k

22.8 COMPARISON OF MIRR AND IRR

MIRR is superior to the regular IRR in two ways.

1. MIRR assumes that project cash flows are reinvested at the cost of capital whereas the
regular IRR assumes that project cash flows are reinvested at the project's own IRR. Since
reinvestment at cost of capital (or some other explicit rate) is more realistic than
reinvestment at IRR, MIRR reflects better the true profitability of a project.

2. The problem of multiple rates does not exist with MIRR. Thus, MIRR is a distinct
improvement over the regular IRR but we need to take note of the following:

If the mutually exclusive projects are of the same size, NPV and MIRR lead to the same
decision irrespective of variations in life.

If the mutually exclusive projects differ in size, there may be a possibility of conflict
between NPV and IRR. MIRR is better than the regular IRR in measuring true rate of return.
However, for choosing among mutually

SUMMARY

This module has explained the nature of capital budgeting, the classification of capital
budgeting, its characteristics, advantages and disadvantages. It has also highlighted how
project decisions are made and pinned the criteria for selection.

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