SCHOOL OF BUSINESS STUDIES

Depatment of marketing and supply chain

management

FINANCIAL
MANAGEMENT
TOPIC: CAPITAL BUDGETING
Presented by :- Submitted To :-
Madhusudan Barik DR. Vinay Kumar
 CONTENTS

CONCEPT OF CAPITAL
BUDGETING
TECHNIQUES OF CAPITAL
BUDGETING
1. NET PRESENT VALUE METHOD
2. ACCOUNTING RATE OF RETURN METHOD
3. INTERNAL RATE OF RETURN METHOD
CONCLUSION
 Introduction
Capital budgeting is the process businesses use to
evaluate potential major investments or expenditures. It's a
critical decision-making tool for determining whether a
company should invest in long-term projects or assets,
such as purchasing new equipment, launching a new
product, expanding into a new market, or upgrading
infrastructure.
The primary goal of capital budgeting is to assess whether
the future returns from an investment will justify its initial
cost. The process involves estimating the expected cash
flows that will be generated by the investment over time
and comparing those to the costs involved in making the
investment.
 What is the importance of
capital Budgeting?
Capital budgeting is extremely important for businesses for several reasons. It helps
companies make well-informed decisions about long-term investments, manage risk, and
ensure they are effectively using their resources. Here's a breakdown of the key reasons why
capital budgeting is crucial:

1. Resource Allocation
Capital budgeting allows businesses to decide how to allocate their limited financial
resources among various investment opportunities. Since large investments often require
substantial funds, effective capital budgeting ensures that resources are directed toward the
most profitable and strategically important projects.

2. Maximizing Shareholder Value

One of the main goals of a business is to maximize shareholder value. Capital budgeting
helps companies identify projects that are expected to generate high returns on investment,
which ultimately contributes to higher profitability and, in turn, increases the value of the
company’s stock.
3. Risk Management
Long-term investments often come with significant uncertainty and risk. By analyzing
potential cash flows, the time value of money, and other factors, capital budgeting helps
businesses assess the risks associated with each investment. This allows them to avoid
high-risk projects or at least take appropriate measures to mitigate risk.
4. Informed Decision-Making
Without a systematic approach like capital budgeting, businesses might make decisions
based on intuition, guesswork, or short-term gains, which could be detrimental in the long
run. Capital budgeting provides a structured framework for evaluating investments,
ensuring that decisions are made based on solid financial data and sound reasoning.
5. Financial Planning and Forecasting
Capital budgeting helps in planning and forecasting future financial needs. By assessing
the costs and potential returns of projects, companies can better forecast their cash
flows, funding requirements, and future financial position. This is important for
maintaining healthy cash flow management and avoiding financial strain.
 Net present value
method {NPV}
Net Present Value (NPV) is one of the most widely
used and accepted techniques for evaluating
investment projects.
It calculates the difference between the present value
of a project’s expected cash inflows and the present
value of its cash outflows.
Key Concepts of NPV:
1. Time Value of Money: Money today is worth more than the same amount of
money in the future due to the opportunity to earn a return on it. NPV takes this
into account by discounting future cash flows.
2. Cash Flows: NPV considers all relevant cash flows over the life of the project,
including both inflows (revenues or savings) and outflows (expenses, initial
investment).
3. Discount Rate: The discount rate used in NPV calculations is typically the
company's cost of capital or the required rate of return. It reflects the risk of the
project and the return expected by investors.
4. Decision Rule:
If NPV > 0, the project is expected to add value to the firm, and the
investment should be accepted.
If NPV < 0, the project will decrease the firm’s value, and the investment
should be rejected.
If NPV = 0, the project will break even, meaning it will neither create nor
destroy value. In this case, other factors may need to be considered to make
a decision.
Advantages of NPV Method:
1. Time Value of Money: NPV takes into account the time value of money, which reflects that
money today is worth more than the same amount in the future.
2. Objective Decision-Making: NPV provides a clear, objective measure of an investment’s value,
helping in better decision-making.
3. Considers All Cash Flows: NPV considers all cash inflows and outflows over the life of the
project.
4. Maximizes Shareholder Wealth: By selecting projects with a positive NPV, firms increase their
value and maximize shareholder wealth.
Disadvantages of NPV Method:
1. Estimation of Cash Flows: NPV relies on accurate forecasting of future cash flows, which can
be difficult and uncertain.
2. Choice of Discount Rate: The NPV outcome is sensitive to the choice of the discount rate, which
can be subjective and impact results.
3. Ignores Project Size: NPV doesn’t account for the size of the project, which means a small
project with a high NPV might be less valuable than a large project with a lower NPV.
4. Doesn't Consider Non-financial Factors: NPV focuses only on financial aspects and
doesn't account for non-financial factors like strategic benefits or social impacts.
 PRACTICAL PROBLEM
A company has an initial investment of RS.5,00.000 and future cash flows are
shown in the table. calculate NPV of the project.use discount rate of 10%

INITIAL
5,00,000
INVESTMENT

YEARS CASH INFLOWS DISCOUNT FACTOR PV OF CASH INFLOWS

1 80,000 0.909 72,720

2 1,00,000 0.826 82,600

3 1,10,000 0.751 82,610

4 1,10,000 0.683 75,130

5 1,50,000 0.621 93150

TOTAL 4,06,210
ACCOUNTING RATE OF RETURN
{ARR}
The Accounting Rate of Return (ARR) is a capital budgeting technique
used to evaluate the profitability of an investment based on accounting
information, typically using net income or operating profit rather than cash
flows. It measures the return generated by an investment relative to the
initial cost, expressed as a percentage.
Formula for ARR:
ARR = Average annual profit
*100
Initial Investment
Where:
Average Annual Accounting Profit = The average annual profit (or
net income) the project is expected to generate over its life.
Initial Investment = The total cost or initial outlay for the project
or investment.
Advantages of ARR Method:
1. Simple to Understand: ARR is easy to calculate and understand, making it accessible for
decision-makers.
2. Uses Accounting Information: It uses readily available accounting data (average profits and
investment), which is often easy to obtain.
3. Comparison Across Projects: ARR provides a straightforward method for comparing the
profitability of different projects.
4. Focus on Profitability: It emphasizes the average profitability over the life of the project, which
can be useful for evaluating long-term returns.
Disadvantages of ARR Method:
1. Ignores Time Value of Money: ARR does not account for the time value of money, potentially
leading to misleading results.
2. Based on Accounting Profit: It uses accounting profits instead of cash flows, which can be
affected by depreciation and other accounting policies.
3. No Risk Adjustment: ARR does not consider the risk or uncertainty of future cash flows, unlike
other methods like NPV or IRR.
4. Inconsistent with Shareholder Wealth Maximization: It may not always align with maximizing
shareholder wealth, as it focuses on accounting profits rather than actual cash flows.
Example:
If an investment requires an initial outlay of $100,000 and is
expected to generate an average annual accounting profit of
$20,000, the ARR would be:

ARR = 20,000 * 100

1,00,000
= 20%
 INTERNAL RATE OF RETURN
{IRR}
IRR is the discount rate that makes the Net Present Value (NPV) of all
cash flows from a particular investment equal to zero. In other words,
it is the rate at which the present value of future cash flows equals the
initial investment.
It represents the expected annualized rate of return for a project or
investment.
Advantages of IRR:
Simple to Understand: IRR is easy to interpret as a percentage rate, making it
accessible to most stakeholders.
Time Value of Money Consideration: It takes into account the time value of money,
just like NPV.
Comparison Across Projects: IRR allows you to compare the profitability of different
projects.
Disadvantages of IRR:
Multiple IRRs: For projects with alternating positive and negative cash flows, there
can be multiple IRRs, which complicates decision-making.
Ignores Scale: IRR doesn't account for the size of the project. A small project with a
high IRR may not be as valuable as a large project with a lower IRR.
Assumption of Reinvestment at IRR: IRR assumes that all intermediate cash flows
are reinvested at the same rate (IRR), which may not always be realistic.
 PRACTICAL PROBLEM

Company A is considering an investment in a project that requires an

initial outlay of $100,000. The project is expected to generate the
following cash inflows for the next four years:
Year 1: $30,000
Year 2: $35,000
Year 3: $40,000
Year 4: $45,000
The company needs to determine the Internal Rate of Return (IRR) for the
project to assess whether it should go ahead with the investment.
 CONCLUSION

The choice of capital budgeting technique depends

on the nature of the project, the company’s goals,
and the information available. NPV and IRR are
often considered the most reliable methods
because they both take the time value of money into
account, but each method has its own strengths
and weaknesses. In practice, companies often use a
combination of these techniques to ensure robust
decision-making.
 BIBLIOGRAPHY
Investopedia - Capital Budgeting
https://www.investopedia.com/terms/c/capitalbudgeting.asp

Corporate Finance Institute (CFI)

https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-budgeting/

AccountingTools - Capital Budgeting

https://www.accountingtools.com/articles/capital-budgeting.html

Investing Answers - Capital Budgeting

https://www.investinganswers.com/financial-dictionary/capital-budgeting

Harvard Business Review

https://hbr.org/
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