CAPITAL BUDGETING

The term capital budgeting or investment decision means planning for capital assets.
Capital budgeting decision means the decision as to whether or not to invest in long-term
projects such as setting up of a factory or installing a machinery etc. It includes the financial
analysis of the various proposals regarding capital expenditure to evaluate their impact on
the financial condition of the company for the purpose to choose the best out of the various
alternatives.

Capital expenditure is the expenditure is incurred at one point of time where as the benefits of
the expenditure are realized over a period of time. Capital budgeting can be defined as the
process of deciding whether or not to commit resources to projects whose cost and benefits
are spread over time periods.

Definition of Capital Budgeting

According to Charles T. Horngren, “Capital Budgeting is long-term planning for making and
financing proposed capital outlays.”

According to L.J. Gitman, “Capital Budgeting refers to the total process of generating,
evaluating, selecting and following up on capital expenditure alternatives.”

Nature of Capital Budgeting

 It is a long-term investment decision.

 It is irreversible in nature.
 It requires a large amount of funds.
 It is most critical and complicated decision for a finance manager.
 It involves an element of risk as the investment is to be recovered in future.

Importance of Capital Budgeting

All capital expenditure projects involve heavy investment of funds ,the firm from various
external and internal sources raises these funds .hence it is important for a firm to plan its
capital expenditure.

1. Permanent commitment of funds

The funds capital expenditure projects are not only huge but more or less permanently
blocked These are long term decision .The longer the time the greater the risk is involved
Hence careful planning is essential.

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
2. Irreversible in nature

In most cases, capital budgeting decision are irreversible .once the decision for acquiring a
permanent assets is taken, it is very difficult to reverse the decision .This is because it is
difficult to dispose the assets without incurring heavy losses.

3. Growth and Expansion

Business firm grow, expand, diversify and acquire stature in the industry through their capital
budgeting activities. The success of mobilization and deployment of funds determines .the
future of a firm.

4. Multiplicity of variables

Large number of factors affect the decision on capital expenditure ,They make the capital
expenditure decision the most difficult to make.

5. Top management activity

The net result of capital expenditure' decisions automatically trusts them on the top
management. Only senior managerial personnel can take these decisions and boar
responsibility for them.

Factors (Criteria) Influencing Capital Expenditure Decisions:

1. Availability of funds:

This is the crucial factor affecting all capital expenditure decisions however attractive, some
projects cannot be taken up if they are too big for a firm to mobilize the needed funds.

2. Future earnings:

Every project has to result in cash inflows. The extent of the revenue's anticipated is the most
significant factor which affects the choice of a project.

3. Degree of uncertainty or risk:

This level of risk involved in a project is vital for deciding its desirability.
4. Urgency:

Projects which are to be immediately taken up for firm's survival have to be treated
differently from optional projects.

5. Obsolescence:

It obsolete machinery and plant exist in a firm, their replacement becomes a compulsion.

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
6. Competitors activities

When competitors perform certain activities, they compel a firm to undertake similar
activities to withstand competition.

7. Intangible Factors:

Firm's prestige, workers' safety, social welfare etc, influence Capital budgeting which
may be deemed as emotional factors.

CAPITAL BUDGETING TECHNIQUES

The capital budgeting appraisal methods are techniques of evaluation of investment

proposal will help the company to decide upon the desirability of an investment proposal
depending upon their; relative income generating capacity and rank them in order of their
desirability. These methods provide the company a set of norms on the basis of which either
it has to accept or reject the investment proposal. The most widely accepted techniques used
inestimating the cost-returns of investment projects can be grouped under two categories.

I. Traditional methods
II. Discounted Cash flow methods

I. TRADITIONAL METHODS

These methods are based on the principles to determine the desirability of an investment
project on the basis of its useful life and expected returns. These will not take into account the
concept of „time value of money‟, which is a significant factor to determine the desirability of
a project in terms of present value.

A) PAY-BACK PERIOD METHOD:

It is the most popular and widely recognized traditional method of evaluating the investment
proposals. It can be defined, as „the number of years required to recover the original cash out
lay invested in a project‟. According to Weston & Brigham, “The payb ack period is the

number of years it takes the firm to recover its original investment by net returns before
depreciation, but after taxes”. According to James. C. Vanhorne, “The payback period is the
number of years required to recover initial cash investment.

If the annual cash Inflows are constant or uniform, the payback period can be computed by

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
dividing cash outlay by annual cash Inflows.

If the cash Inflows are not uniform: Payback period is calculated by computing cumulative
cash inflows. Payback period is the period when net cash Inflows is equal to initial
investment

Merits:

 It is one of the earliest methods of evaluating the investment projects.

 It is simple to understand and to compute.
 It is one of the widely used methods in small scale industry sector
 It can be computed on the basis of accounting information available from the books.

Demerits

 It does not take into account the life of the project, depreciation, and scrap value
Interest factor etc.

 It completely ignores cash inflows after the payback period.

 The profitability of the project is completely ignored

 It ignores the time value of money; cash Inflows deceived in different years are
treated equally.

B) ACCOUNTING OR AVERAGE RATE OF RETURN

Accounting Rate of Return (ARR) is the average net income an asset is expected to generate
divided by its average capital cost, expressed as an annual percentage. They typically include
situations where companies are deciding on whether or not to proceed with a specific
investment (a project, an acquisition, etc.) based on the future net earnings expected
compared to the capital cost. This method called accounting rate of return method because it
fees the accounting concept of profit. i.e. income after depreciation and tax as the criterion for
calculation of return.

According to Soloman, ‟ accounting rate of return on an investment can be calculated as the

ratio of accounting net income to the initial investment”.

Accounting Rate of return (on Original Investment)

ARR = Average Annual Profit / Initial Investment

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜fi𝑡 𝑎f𝑡𝑒𝑟 𝐷𝑒𝑝𝑟𝑒𝑐i𝑎𝑡i𝑜𝑛 𝑎𝑛𝑑 𝑇𝑎𝑥
Average Annual Profit =
𝑁𝑜 𝑜f years

Accounting Rate of return (on Average Investment) ARR = Average Annual Profit / Average

Investment

Average Investment = Initial Investment/2

In terms of decision making, if the ARR is equal to or greater than the required rate of return,
accept the project. If the ARR is less than the required rate of return, the project should be
rejected. Higher ARR indicates higher profitability.

Merits:

 This method is easy to understand and simple to calculate.

 This method takes into account the earnings over the entire economic life of the
project.

 It is really a profitability concept since it considers net earnings after depreciation.

 This method is in consistent with the conventional accounting system and easy to
comprehend as it based on percentages.

Demerits:

 It ignores time value of money.

 This method ignores the risk and uncertainty factors

 It uses accounting profits and not the cash inflows in appraising the project.

 It considers only the rate of return and not the life of the project.

Two formulas are used to compute this method. Each method gives different results.
This reduces the reliability of the method.

II. DISCOUNTED CASH FLOW METHODS:

The traditional method does not take into consideration the time value of money.
They give equal weight age to the present and future flow of incomes. The DCF methods are
based on the concept that a rupee earned today is more worth than a rupee earned tomorrow.
These methods take into consideration the profitability and also time value of money.

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
Discounted Cash flow techniques includes

 Net present value method

 Profitability Index method
 Internal rate of return method

A) NET PRESENT VALUE METHOD:

The NPV takes into consideration the time value of money. The cash flows of different years
and valued differently and made comparable in terms of present values for this the net cash
inflows of various period are discounted using required rate of return which is predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the required
rate of return minus the present value of the cost of the investment.” NPV is the difference
between the present value of cash inflows of a project and the initial cost of the project. If
NPV is positive (i.e.greater than 0) Accept the project. If NPV is negative (i.e less than 0)
Reject the project . When comparing NPV values of two or more projects always select a
project with greater NPV. While comparing different NPV values a high NPV value indicates
higher profitability.

Merits:

 It recognizes the time value of money.

 It is based on the entire cash flows generated during the useful life of the asset
 It is consistent with the objective of maximization of wealth of the owners.
 The ranking of projects is independent of the discount rate used for determining the
present value.

Demerits:

 It is different to understand and use.

 The NPV is calculated by using the cost of capital as a discount rate. But the concept
of cost of capital. If self is difficult to understood and determine.
 It does not give solutions when the comparable projects are involved in different
amounts of investment.

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
B) PROFITABILITY INDEX METHOD:

Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI
approach measures the present value of returns per rupee invested. It is observed in
shortcoming of NPV that, being an absolute measure, it is not a reliable method to evaluate
projects requiring different initial investments. The PI method provides solution to this kind
of problem.

It can be defined as the ratio which is obtained by dividing the present value of future cash
inflows by the present value of cash outlays

Using the PI ratio, Accept the project when PI>1 Reject the project when PI<1

Merits:

 PI considers the time value of money as well as all the cash flows generated by the
project.
 At times it is a better evaluation technique than NPV in a situation of capital rationing
especially. For instance, two projects may have the same NPV of Rs. 20,000 but project A
requires an initial investment of Rs. 1, 00,000 whereas B requires only Rs. 50,000. The NPV
method will give identical ranking to both projects, whereas PI will suggest project B should
be preferred. Thus PI is better than NPV method as former evaluate the worth of projects in
terms of their relative rather than absolute magnitude.
 It is consistent with the shareholders‟ wealth maximization.

Demerits:

 Though PI is a sound method of project appraisal and it is just a variation of the NPV,
it has all those limitation of NPV method too.

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
C) INTERNAL RATE OF RETURN METHOD:

The IRR for an investment proposal is that discount rate which equates the present value of
cash inflows with the present value of cash out flows of an investment. The IRR is also
known as cutoff or handle rate. It is usually the concern’s cost of capital.

According to Weston and Brigham “The internal rate is the interest rate that equates the
present value of the expected future receipts to the cost of the investment outlay. The IRR is
not a predetermine rate, rather it is to be trial and error method. It implies that one has to start
with a discounting rate to calculate the present value of cash inflows. If the obtained present
value is higher than the initial cost of the project one has to try with a higher rate. Likewise if
the present value of expected cash inflows obtained is lower than the present value of cash
flow. Lower rate is to be taken up. The process is continued till the net present value becomes
Zero. As this discount rate is determined internally, this method is called internal rate of
return method.

Steps

Step 1: Select 2 discount rates for the calculation of NPVs

You can start by selecting any 2 discount rates on a random basis that will be used to
calculate the net present values in Step 2.

Step 2: Calculate NPVs of the investment using the 2 discount rates

You shall now calculate the net present values of the investment on the basis of each discount
rate selected in Step 1.

Step 3: Calculate the IRR

Using the 2 net present values derived in Step 2, you shall calculate the IRR by applying the
IRR Formula

Step 4: Interpretation
The decision rule for IRR is that an investment should only be selected where the cost of

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
capital (WACC) is lower than the IRR.

Merits:

 It consider the time value of money

 It takes into account the cash flows over the entire useful life of the asset.
 It always suggests accepting to projects with maximum rate of return.
 It is inconformity with the firm’s objective of maximum owner’s welfare.

Demerits:

 It is very difficult to understand and use.

 It involves a very complicated computational work.
 It may not give unique answer in all situations.

Compare and Contrast NPV and IRR Methods:

Similarities between NPV and IRR

• Both are the modern techniques of capital budgeting.

• Both are considering the time value for money.

• Both take into consideration the cash flow throughout the life of the project.

Difference between NPV and IRR

• Concept : Net Present value (NPV) discounts the stream of expected cash flows
associated with a proposed project to their current value, which presents a cash surplus or loss
for the project. IRR whereas, the Internal Rate of Return (IRR) calculates the percentage rate
at which those same cash flows result in a Net Present Value of Zero.

• Purpose: The NPV Method focuses on project surpluses .While the IRR Method
focuses on the breakeven cash flow of a project.

• Expressed in: NPV is expressed in Absolute terms. Whereas, IRR is expressed in

percentage terms.

• Decision Making: Decision making is easy in Net present value but not in IRR.

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)
CAPITAL BUDGETING PROCESS

SURESH PARLA
MBA, M.COM, AP SET, (Ph.D)