CAPITAL

BUDGETING
Meaning and nature of Capital Budgeting

 Process of making investment decisions in

capital expenditures.
 Investment decisions- expansion, acquisition,
modernization, replacement of long-term assets,
 Expenditure incurred in one point of time
whereas benefits are realized at different point of
time in future.
 Long term investment decisions.
Importance of Capital Budgeting

1. Large Investments
2. Long term commitment of funds
3. Irreversible Decisions
4. Long-term Effect on Profitability
5. Difficulties of Investment Decisions
6. National Importance
 1. Large Investments
 Involve large investment of funds.
 But the funds available with the firm are
always limited and demand for the funds far
exceeds the resources.
 Hence , it is very important to plan and control
its capital expenditure.
2. Long term commitment of funds

 Funds are for long term or more or less on

permanent basis.
 Long term commitment of funds increases the
financial risk involved in the investment
decision.
 Greater the risk involved, greater is the need
for careful planning of capital expenditure.
 3. Irreversible Decisions

 Decisions are of irreversible in nature.

 Once the decision for acquiring a permanent

asset is taken, it becomes very difficult to
dispose of the assets without incurring heavy
losses.
4. Long-term Effect on Profitability

 Not only the present earnings of the firm are

affected by the investments in capital assets.
 The future growth and profitability of the firm
depends upon the investment decisions taken
today.
 An unwise decision may prove disastrous and
fatal to the very existence of the concern.
5.Difficulties of Investment Decisions

 Decision extends to a series of years beyond

the current accounting period.
 Uncertainties of future
 Higher degree of risk.
 6. National Importance

 It determines employment, economic activities

and economic growth.
CAPITAL BUDGETING PROCESS
1. Identification of Investment proposals
2. Screening of Proposals
3. Evaluation of various Proposals
4. Fixing priorities
5. Final approval and preparation of Capital
Expenditure Budget
6. Implementing Proposal
7. Performance review
 1. Identification of Investment proposals

 The departmental head analyses various proposals in

the light of corporate strategies and submits the
suitable proposals.
2. Screening of Proposals

 The Expenditure Planning Committee screens

the various proposals received from different
departments.

 They will see whether it is in accordance with

the corporate strategies or selection criteria of
the firm and do not lead to any imbalances.
 3. Evaluation of various Proposals

 Evaluate the profitability of various proposals.

 The methods used are pay back period method,
rate of return method, net present value
method, internal rate of return method etc.
4. Fixing priorities

 After evaluation, the unprofitable or

uneconomic proposals may be rejected.
 But it may not be possible for the firm to
invest immediately in all the acceptable
proposals due to limitation of funds.
 Hence, it is very essential to rank the various
proposals.
 5. Final approval and preparation of
Capital Expenditure Budget

 Proposals meeting the evaluation and other

criteria are finally approved to be included in
the Capital Expenditure Budget.

 The Capital Expenditure Budget lays down the

amount of estimated expenditure to be incurred
on the fixed assets during the budget period.
6. Implementing Proposal

 The project has to be implemented in an

efficient manner.
 A financial manager has to provide guidelines
to the different departments emphasizing on
time management, cost limits and cost control.
 The project has to be controlled by installing
evaluation review techniques.
7. Performance review

 The financial manager has to continuously

compare the actual performance with the
projected performance.
 This will be useful in providing a review of the
performance.
 If he is not satisfied with the performance , the
financial manger must change the manner in
which the work is being done.
 TECHNIQUES OF EVALUATION
1. Tradition techniques
a) Average rate of return (ARR)
b) Payback method (PB)

2. Modern / Discounted cash flow techniques

a) Net Present Value Method (NPV)
b) Internal Rate of Return (IRR)
c) Profitability Index (PI)
 Average Rate of Return (ARR)
 Also called as ‘accounting rate of return’.
 It is a return on investment by using accounting information to
measure profitability of a proposal.
 Its information can be identified from the financial statement of
a firm.
 The project with higher rate of return is selected as compared to
the one with lower rate of return.
 Can also be used to make decision as to accepting or rejecting a
proposal.
ARR = Average Profits (After Tax) x 100
Net Investment in the project
 Accept project when ARR > minimum rate.
 Reject project when ARR< minimum rate.
 Merits of ARR method

1. Simple to calculate and it is easily understandable.

2. As this method is based upon accounting concept of
profits , it can be readily calculated from the
financial data.
3. It considers all the benefits received during the life
of the project.
 Limitations of ARR method

1. It ignores the time value of money.

2. It does not take into consideration the cash
flows which are more important than the
accounting profits.
3. It does not consider the benefits of the earlier
and later years.
Payback Method of Evaluation
 Indicates the length of time, which is required to
recover the initial costs of the project.
 Time required for its cash inflows to be equal to its
cash outflows.
 Where the project generates constant cash inflows,
Payback period= Initial Investment
Annual Cash Inflow
 Where the annual cash inflows are unequal, pay
back period can be found by adding up the cash
inflows until the total is equal to the initial cash
outlay of the project or original cost of the asset.
 Merits of Pay-back period Method
 Simple to understand and easy to calculate.
 It saves in cost, as it requires lesser time and
labour as compared to other methods of capital
budgeting.
 It reduces the loss through obsolescence as a
project with shorter pay-back period is preferred.
 This method is suited to a firm which has shortage
of cash or whose liquidity position is not
particularly good.
 Limitations of Pay-back period
method

 It ignores time value of money.

 It ignores cash flow after payback period.
 It ignores magnitude and timing of cash flows.
 It is only useful measure of capital recovery and
not the measure of profitability.
 It does not give any importance to salvage value.
It does not consider the full economic life of a
proposal.
 Net Present Value Method (NPV)

It takes into consideration the time value of money.

The net present value of all inflows and outflows of cash
occurring during entire life of the project is determined
separately for each by discounting these flows by the
firm’s cost of capital or pre-determined rate.
Firstly , the cash inflows and outflows are worked out.
Then the PV of cash inflows and PV of cash outflows are
calculated at the rate of return acceptable to the
management.
NPV is the excess of the present value of cash inflow
over the present value of cash outflow of the project.
NPV = ∑ CFt - Co
(1+k)t

CFt = Cash Flow in period t.

k = Discount rate.
Co = Initial outlay.

NPV > 0: Accept the proposal.

NPV < 0: Reject the proposal.
NPV = 0: “indifferent condition” it may be accepted by
the firm , it may not accept it.
 Merits of NPV

1. It takes in to account time value of money.

2. It considers cash flow stream in its entirety.
3. It is suitable for evaluation of independent proposals
as well as mutually exclusive projects.
4. It considers the objective of wealth maximization
concept of the shareholders.
 Limitations of NPV method

1. The calculations of these method are tedious.

2. The cost of capital or the discount rate k is difficult
to ascertain and errors may occur.
3. It provides the results of evaluation in absolute
terms . Two projects would be comparable only if
the cash inflow of the proposal is similar.
Internal Rate of Return (IRR)

Takes in to account time value of money.

Cash flows of a project are discounted at a suitable
rate by hit and trial method , which equate the net
present value so calculated to the amount of the
investment.
Discount rate is determined internally- IRR.
Rate of discount at which present value of cash
inflows is equal to the present value of cash
outflows.
IRR is the value at which the net present value of
the project becomes zero.
Calculation of IRR:

a) When cash flows are equal:

1. Calculate payback (PB) period of the project.
2. Find out the PVAF from table according to the
number of years of the project.
3. Note down two values- one greater than and one
less than the payback period, but closest to it. Also
note down the interest rates corresponding to
them.
4. The smaller value will be called L and the interest
rate against it will be called IL and the higher value
will be called H and the interest rate against it will be
called IH
5. Now use the formula:

IRR = IL + (L-PB) X (IH - IL)

(L-H)
PB = Payback period.
IL = Lower rate of interest.
IH = Higher rate of interest.
L = Discount factor at lower rate.
H = Discount factor at higher rate.
• When higher rate of interest is used there will be
a slight change in the formula:

IRR = IH - (PB - H) X (IH - IL)

(L-H)
PB = Payback period.
IL = Lower rate of interest.
IH = Higher rate of interest.
L = Discount factor at lower rate.
H = Discount factor at higher rate.
b) When cash flows are unequal:
1. Calculate the weighted average cash flow after tax .
The weights should be given in the reverse order to
give maximum weight to year 1 where the earliest cash
inflow is expected.
2. Find out the fake payback period of the project.
3. Look into the table and find out the PVAF factor of two
values – one greater than and one less than the payback
period as close as possible to the value.
4. Interpolate and find IRR.
 Merits of IRR

1. It is an important technique takes all cash flows.

2. It takes time value of money into account.
3. It selects projects more than minimum rate of return.
4. It compares with cut off rate and is based on cash
flows rather than accounting rate.
5. It is expressed as a percentage rate.
6. It provides all the advantages for wealth
maximization.
Demerits of IRR

1. The calculations are tedious and time

consuming.
2. IRR is biased towards small projects and
gives importance to larger projects.
 Profitability Index Method or Benefit Cost
Ratio

 Also called as Benefit-Cost ratio or Desirability

Factor.
 Relationship between present value cash inflows
and present value of cash outflows.
 PI = PV of Cash Inflows
Initial Cash Outlay
 PI = PV of Cash Inflows
PV of Cash Outflows
 The proposal is accepted if the profitability index
more than one and rejected in case the profitability
index is less than one.
Merits of PI technique

1. Its is very simple and easy to understand.

2. It conceptualizes time of value of money.
3. It considers all cash flows during the life of
the project.
4. It is accordance with the principles of
financial management.
5. It emphasizes wealth maximization.
Demerits of PI technique

1. The cost of capital which is used to discount

cash flows may create errors in calculation.
2. It is not useful when small projects are to be
compared with a large project.
3. It presumes that intermediate cash flows can
be reinvested at discount rate. This
presumption is not practical in use in business
application.
CAPITAL RATIONING

 A situation where a firm is not in a position to invest in

all profitable projects due to the constraints on
availability of funds.
 Resources are limited and the demand for them far
exceeds their availability.
 So the firm cannot take up all the projects though
profitable, and has to select the combination of
proposals that will yield the greatest profitability.
EXAMPLE: Assume that a firm has only Rs.10
lakhs to invest and more funds cannot be provided.
The various proposals along with their cost and
profitability index are as follows:
Proposal Cost of the Project Profitability Index

1 3,00,000 1.46

2 1,00,000 .098

3 5,00,000 2.31

4 2,00,000 1.32

5 1,50,000 1.25
Qn.) S Ltd. has Rs. 10,00,000 allocated for capital budgeting
purposes. The following are the proposals and ascertained
profitability indexes :
Project Amount (Rs.) Profitability Index
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05

Which of the above investments should be undertaken?

Assume that projects are indivisible and there is no
alternative use of money allocated for capital budgeting.
 Project Amount( Profitabili Cash Net Rank on Rank on
A
Rs.) ty Index Inflows Present the basis the basis
n
(Rs.) Value of P.I. of NPV
s
(NPV)
.
1 2 3 2*3=4 4-2=5 6 7
1 3,00,000 1.22 3,66,000 66,000 1 3
2 1,50,000 0.95 1,42,500 -7,500 5 6
3 3,50,000 1.20 4,20,000 70,000 2 2
4 4,50,000 1.18 5,31,000 81,000 3 1
5 2,00,000 1.20 2,40,000 40,000 2 4
6 4,00,000 1.05 4,20,000 20,000 4 5

1. On the basis of ranking of PI index, S Ltd. May undertake Projects 1,3and

5; NPV=1,76,000.
2. On the basis of NPV method, S Ltd. May undertake projects 3,4 and 5 ;
NPV= 1,91,000.
3. Thus, the company would follow the ranking on the basis of NPV method
and invest in projects 3,4 and 5. By doing so, the NPV of cash inflows will
increase by Rs.15,000 (1,91,000-1,76,000)
 LIMITATIONS OF CAPITAL
RATIONING
1. All the techniques of capital budgeting presume that
various investment proposals under consideration are
mutually exclusive which may not practically be true
in some particular circumstances.
2. Requires estimation of future cash inflows and
outflows, and future is uncertain.
3. Urgency
4. Uncertainty and risk.
5. Certain factors cannot be correctly quantified.
Thank You