CONCEPT OF CAPITAL BUDGETING

Capital budgeting is a process of planning that is used to ascertain

the long-term investments of the firm. The long-term investment of
a firm may be for new machinery, new plants, replacement
machinery, new products and the research and development
projects.
Judging the capital requirement of a business is the most important
step while raising the fund or capital for a business. A part of the
collected capital is generally used for capital investment by the
business while a substantial part is kept as working capital. The
major purpose of capital budgeting is to recognize and also
prioritize the capital investments on the basis of maximum returns
to the business.

Capital budgeting can also be considered as a managerial tool

required for managing the collected capital of the business. The
core responsibility of the financial managers is to choose the
investments in a way so as to generate good rates of return. Hence,
this is the job of the financial manager to decide whether a
particular investment should be included in the portfolio or not.
This entire task is called capital budgeting. The financial manager
needs to have a sound knowledge on evaluating, selecting and
comparing projects.

The concept of capital budgeting gives immense importance on the

project selection of a business. This is because the business is
experiencing capital expenditure on every project that is generating
cash flow in the future. If the capital expenditure is large, proper
capital budgeting should be used to ensure future earning of the
business.
NATURE OF CAPITAL BUDGETING

• Capital expenditure plans involve a huge investment in fixed

assets.

• Capital expenditure once approved represents long-term

investment that cannot be reserved or withdrawn without
sustaining a loss.

• Preparation of coital budget plans involve forecasting of

several years profits in advance in order to judge the
profitability of projects. Capital budgeting decisions are of
paramount importance in financial decision. So it needs
special care on account of the following reasons.

IMPORTANCE OF CAPITAL
BUDGETING
1. Long-term Implications:

A capital budgeting decision has its effect over a long time span
and inevitably affects the company’s future cost structure and
growth. A wrong decision can prove disastrous for the long-term
survival of firm. On the other hand, lack of investment in asset
would influence the competitive position of the firm. So the capital
budgeting decisions determine the future destiny of the company.

2. Involvement of large amount of funds:

Capital budgeting decisions need substantial amount of capital

outlay. This underlines the need for thoughtful, wise and correct
decisions as an incorrect decision would not only result in losses
but also prevent the firm from earning profit from other
investments which could not be undertaken.

3. Irreversible decisions:

Capital budgeting decisions in most of the cases are irreversible

because it is difficult to find a market for such assets. The only
way out will be scrap the capital assets so acquired and incur heavy
losses.

4. Risk and uncertainty:

 Capital budgeting decision is surrounded by great number of
uncertainties. Investment is present and investment is future. The
future is uncertain and full of risks. Longer the period of project,
greater may be the risk and uncertainty. The estimates about cost,
revenues and profits may not come true.

5. Difficult to make:

Capital budgeting decision making is a difficult and complicated

exercise for the management. These decisions require an over all
assessment of future events which are uncertain. It is really a
marathon job to estimate the future benefits and cost correctly in
quantitative terms subject to the uncertainties caused by economic-
political social and technological factors.
Which Technique should we
follow?

• A technique that helps us in selecting projects that are

consistent with the principle of shareholder wealth
maximization.

• A technique is considered consistent with wealth

maximization if
o It is based on cash flows
o Considers all the cash flows
o Considers time value of money
o Is unbiased in selecting projects

TECNIQUES OF CAPITAL
BUDGETING
1. Payback Period Approach

Payback period is the first formal and basic capital budgeting

technique used to assess the viability of the project. It is defined as
the time period required for the investment’s returns to cover its
cost. Payback period is easy to apply and easy to understand
technique; therefore, widely used by investors

• The amount of time needed to recover the initial investment

• The number of years it takes including a fraction of the year
to recover initial investment is called payback period
• To compute payback period, keep adding the cash flows till
the sum equals initial investment
• Simplicity is the main benefit, but suffers from drawbacks
• Technique is not consistent with wealth maximization—
Why?

Formula / Equation:
The formula or equation for the calculation of payback period is as
follows:
 Payback period = Investment required / Net annual cash
inflow*

*If new equipment is replacing old equipment, this becomes

incremental net annual cash inflow.

To illustrate the payback method, consider the following example:

Example:
York company needs a new milling machine. The company is
considering two machines. Machine A and machine B. Machine A
costs $15,000 and will reduce operating cost by $5,000 per year.
Machine B costs only $12,000 but will also reduce operating costs
by $5,000 per year.

Required:

• Calculate payback period.

• Which machine should be purchased according to payback
method?

Calculation:

Machine A payback period = $15,000 / $5,000 = 3.0 years

Machine B payback period = $12,000 / $5,000 = 2.4 years

According to payback calculations, York company should

purchase machine B, since it has a shorter payback period than
machine A.

Discounted Payback Period

 • Similar to payback period approach with one difference that
it considers time value of money
• The amount of time needed to recover initial investment
given the present value of cash inflows
• Keep adding the discounted cash flows till the sum equals
initial investment
• All other drawbacks of the payback period remains in this
approach
• Not consistent with wealth maximization

2.Accounting Rate of Return

(ARR)
Various proposals are ranked in order to rate of earnings on the
investment in the projects concerned. The project which shows
highest rate of return is selected and others are ruled out.

The Accounting rate of Return is found out by dividing the average

income after taxed by the average investment, i.e., average net
value after depreciation. The accounting rate of return, thus, is an
average rate and can be determined by the following equation.

Accounting Rate of Return (ARR) = Average income / Average

investment

There are two variants of the accounting rate of return (a) Original
Investment Method, and (b) Average Investment Method.

(a) Original Investment Method. Under this method average

annual earnings or profits over the life of the project are divided by
the total outlay of capital project, i.e., the original investment. Thus
ARR under this method is the ratio between average annual profits
and original investment established. We can express the ARR in
the following way.

ARR= Average annual profits over the life of the project /

Original Investment

(b) Average Investment Method: Under average investment

method, average annual earnings are divided by the average
amount of investment. Average investment is calculated, by
dividing the original investment by two or by a figure representing
the mid-point between the original outlay and the salvage of the
investment. Generally accounting rate of return method is
represented by the average investment method.

Rate of return. Rate of Return, as the term is used in our

foregoing discussion, may be calculated by taking (a) income
before taxes and depreciation, (b) income before tax and after
depreciation. (c) income before depreciation an after tax, and (d)
income after tax an depreciation, as the numerator. The use of
different concepts of income or earnings as well as of investment is
made. Original investment or average investment will give
different measures of the accounting rate of return.

Merits of Accounting Rate of Return

Method
The following are the merits of the accounting rate of Return
method

(1) It is very simple to understand and use.

(2) Rate of return may readily be calculated with the help of
accounting data.
(3) They system gives due weight age to the profitability of the
project if based on average rate of Return. Projects having higher
rate of Return will be accepted and are comparable with the returns
on similar investment derived by other firm.
(4) It takes investments and the total earnings from the project
during its life time.

Demerits of Return Method

The method suffers from the following weaknesses
(1) It uses accounting profits and not the cash-inflows in appraising
the projects.
(2) It ignores the time-value of money which is an important factor
in capital expenditure decisions. Profits occurring in different
periods are valued equally.
(3) It considers only the rate of return and not the length of project
lives.
(4) The method ignores the fact that profits can be reinvested.
(5) The method does not determine the fair rate of return on
investment. It is left at the discretion of the management. So, use
of arbitrary rate of return cause serious distortion in the selection
of capital projects.
(6) The method has different variants, each of which produces a
different rate of return for one proposal due to the diverse version
of the concepts of investment and earnings.

It is clear from the above discussion that the system is not much
useful except in evaluating the long-term capital proposals.