CAPITAL
BUDGETING
OVERVIEW
Organizational Responsibility/ Time Duration
Plans Authority
1. Operational Plans Lower Management Short term ≤ 1 yr
2. Tactical Plans Middle Management Medium term 1-5 yrs
3. Strategic Plans Top level Long term ≥ 5 yrs
Management
CAPITAL BUDGETING
the process of identifying, evaluating, planning,
and financing capital decision projects of an
organization
2 types of decision made:
1. Financing Decision- judgement regarding the
method of raising capital to fund an investment.
2. Investment Decision- judgement about which
assets to acquire to achieve the company's stated
objectives.
CHARACTERISTICS OF CAPITAL
INVESTMENT DECISIONS
o Usually require large commitment of resources
o Involve long term commitments
o Are more difficult to reverse than short term
decisions
o Involve so much risk and uncertainty
ADVANTAGES AND DISADVANATGES
ADVANTAGES
Capital budgeting helps a company to
understand various risks involved in an
investment opportunity and how these risks affect
the returns of the company.
It helps a company in a competitive market to
choose its investments wisely.
it allows management to abstain from over
investing and under investing.
ADVANTAGES AND DISADVANATGES
ADVANTAGES
All the techniques/methods of capital budgeting
try to increase shareholders wealth and give the
company an edge in the market.
It helps the company to estimate which
investment option would yield the best possible
return.
It helps the company to make long-term strategic
investments.
ADVANTAGES AND DISADVANATGES
DISADVANTAGES
Most of the times, these techniques are based on
the estimations and assumptions as the future
would always remain uncertain.
A wrong capital budgeting decision taken can
affect the long term durability of the company and
hence it needs to be done judiciously by
professionals who understands the project well.
STAGES IN CAPITAL
BUDGETING PROCESS
1. Identification and definition
2. Search for potential investment decisions
3. Information gathering- both quantitative and
qualitative
4. Selection
5. Financing
6. Implementation and monitoring
TYPES OF CAPITAL
INVESTMENT PROJECTS
1.Independent Projects
projects that are evaluated individually
Cash flows of one project are unaffected
by acceptance of other project
TYPES OF CAPITAL
INVESTMENT PROJECTS
2.Mutually Exclusive Projects
projects that require company to choose
from among specific alternatives
Cash flows of one project can be adversely
impacted by the acceptance of other
project.
CAPITAL INVESTMENT
FACTORS
• Net investment- costs or cash outflows less
cash inflows or savings incidental to the
acquisition of the investment projects
• Cost of Capital- cost of using funds
• Net Returns
CAPITAL INVESTMENT
DECISIONS MODELS
• Nondiscounting models- ignore the time value of
money
1. Payback Period
2. Accounting Rate of Return
• Discounting models- explicitly consider the time
value of money
1. Net Present Value
2. Internal rate of return
PAYBACK PERIOD
ADVANTAGES
Payback is easy to compute an easy to
understand. There is no need to compute or
consider any interest rate
Payback gives information about project’s
liquidity
It is a good surrogate for risk. A quick
payback period indicates a less risky
project.
PAYBACK PERIOD
DISADVANTAGES
Payback Period does not consider Time value of
money
It gives more emphasis on liquidity rather than
profitability.
It does not consider the salvage value of the
project
It ignores the cash flows that may occur after the
payback period.
ACCOUNTING RATE OF
RETURN
ADVANTAGES
It closely parallels accounting concepts of income
measurement and investment return
It facilitates re-evaluation of projects due to the
ready availability of data from accounting records
This method considers income over the entire life
of the project.
It indicates the project’s profitability
ACCOUNTING RATE OF
RETURN
DISADVANTAGES
It does not consider the time value of money
With the computation of book value and income
based on historical cost accounting data, the
effect of inflation is ignored.
NET PRESENT VALUE
ADVANTAGES
Emphasizes cash flows
Recognizes the time value of money
Assumes discount rates as the reinvestment
rates
Easy to apply
NET PRESENT VALUE
DISADVANTAGES
It requires predetermination of the cost of
capital or the discount rate to be used
The NPV of different competing projects may not
be comparable because of differences in
magnitude or sizes of the project
INTERNAL RATE OF RETURN
ADVANTAGES
Emphasizes cash flows
Recognizes the time value of money
Computes the true return of the project
INTERNAL RATE OF RETURN
DISADVANTAGES
Assumes the IRR to be re-investment rate
When the project includes earnings during their
economic life, different rates of return may
result.
