Dr.
Sandeep Malu
Associate Professor
SVIM, Indore
Email: [email protected]
Capital Budgeting
• Capital budgeting is a company’s formal process used for
evaluating potential expenditures or investments that are
significant in amount. It involves the decision to invest the
current funds for addition, disposition, modification or
replacement of fixed assets. The large expenditures include the
purchase of fixed assets like land and building, new
equipments, rebuilding or replacing existing equipments,
research and development, etc. The large amounts spent for
these types of projects are known as capital expenditures.
Capital Budgeting is a tool for maximizing a company’s future
profits since most companies are able to manage only a limited
number of large projects at any one time.
FEATURES OF CAPITAL BUDGETING
1) It involves high risk
2) Large profits are estimated
3) Long time period between the initial
investments and estimated returns
CAPITAL BUDGETING PROCESS
1. Project identification and generation
2. Project Screening and Evaluation
3. Project Selection
4. Implementation
5. Performance review
FACTORS AFFECTING CAPITAL BUDGETING
Availability of Funds Working Capital
Structure of Capital Capital Return
Management decisions Need of the project
Accounting methods Government policy
Taxation policy Earnings
Lending terms of financial institutions Economic value of the project
Capital Budgeting Decisions
The crux of capital budgeting is profit maximization. There
are two ways to it; either increase the revenues or reduce the
costs. The increase in revenues can be achieved by expansion
of operations by adding a new product line. Reducing costs
means representing obsolete return on assets.
• Accept / Reject decision
• Mutually exclusive project decision
• Capital rationing decision
IMPORTANCE OF CAPITAL BUDGETING
1) Long term investments involve risks
2) Huge investments and irreversible ones
3) Long run in the business
Capital Budgeting
Techniques/Methods
There are different methods adopted for capital budgeting. The
traditional methods or non discount methods include: Payback
period and Accounting rate of return method. The discounted
cash flow method includes the NPV method, profitability
index method and IRR.
Payback Period Method
As the name suggests, this method refers to the
period in which the proposal will generate cash to
recover the initial investment made. It purely
emphasizes on the cash inflows, economic life of the
project and the investment made in the project, with
no consideration to time value of money. Through
this method of selection of a proposal is based on the
earning capacity of the project. With simple
calculations, selection or rejection of the project can
be done, with results that will help gauge the risks
involved.
Accounting Rate of Return Method
(ARR)
• This method helps to overcome the disadvantages of the
payback period method. The rate of return is expressed as a
percentage of the earnings of the investment in a particular
project. It works on the criteria that any project having ARR
higher than the minimum rate established by the management
will be considered and those below the predetermined rate are
rejected.
• This method takes into account the entire economic life of a
project providing a better means of comparison. It also ensures
compensation of expected profitability of projects through the
concept of net earnings.
ARR= Average income/Average Investment
Discounted Cash Flow Method
The discounted cash flow technique calculates the cash
inflow and outflow through the life of an asset. The cash
inflows are discounted through a discounting factor. The
discounted cash inflows and outflows are then compared.
This technique takes into account the interest factor and the
return after the payback period.
Net Present Value Method
(NPV)
This is one of the widely used method for evaluating capital
investment proposals. In this technique the cash inflow that is
expected at different periods of time is discounted at a
particular rate. The present values of the cash inflow are
compared to the original investment. If the difference between
them is positive (+) then it is accepted or otherwise rejected.
This method considers the time value of money and is
consistent with the objective of maximizing profits for the
owners.
NPV = PVB – PVC
PVB = Present value of benefits, PVC = Present value of Costs
Internal Rate of Return Method (IRR)
• This is defined as the rate at which the net present value of the
investment is zero. The discounted cash inflow is equal to the
discounted cash outflow. This method also considers time
value of money. It tries to arrive to a rate of interest at which
funds invested in the project could be repaid out of the cash
inflows. However, computation of IRR is a tedious task.
• It is called as internal rate because it depends solely on the
outlay and proceeds associated with the project and not any
rate determined outside the investment.
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IR < k = reject
Profitability Index (PI) Method
It is the ratio of the present value of future cash benefits, at
the required rate of return to the initial cash outflow of the
investment. It may be gross or net, net being simply gross
minus one. The formula to calculate profitability index (PI)
or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay
PI = NPV (benefits) / NPV (Costs)
All projects with PI > 1.0 is accepted.
