What is 'Capital Budgeting'

Capital budgeting is the process in which a business determines and evaluates potential expenses or
investments that are large in nature. These expenditures and investments include projects such as building
a new plant or investing in a long-term venture. Often times, a prospective project's lifetime cash inflows
and outflows are assessed in order to determine whether the potential returns generated meet a sufficient
target benchmark, also known as "investment appraisal."
Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However,
because the amount of capital available at any given time for new projects is limited, management needs
to use capital budgeting techniques to determine which projects will yield the most return over an
applicable period of time. Various methods of capital budgeting can include throughput analysis, net
present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.
MAJOR APPRAISAL TECHIQUES:
1. DCF Analysis: DCF analysis is similar or the same to NPV analysis in that it looks at the
initial cash outflow needed to fund a project, the mix of cash inflows in the form of
revenue, and other future outflows in the form of maintenance and other costs. These
costs, save for the initial outflow, are discounted back to the present date. The resulting
number of the DCF analysis is the NPV. Projects with the highest NPV should be ranked
over others, unless one or more are mutually exclusive.
2. Payback Analysis: Payback analysis is the most simple form of capital budgeting
analysis and is therefore the least accurate. However, this method is still used because
it's quick and can give managers a "back of the napkin" understanding of the efficacy of
a project or group of projects. This analysis calculates how long it will take to recoup the
investment of a project. The payback period is identified by dividing the initial
investment by the average yearly cash inflow.

Need and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge investments of funds, but
the available funds are limited, therefore the firm before investing projects, plan
are control its capital expenditure.
2. Huge Risk: Capital expenditure is long-term in nature or permanent in nature.
Therefore financial risks involved in the investment decision are more. If higher
risks are involved, it needs careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed
back. Once the decision is taken for purchasing a permanent asset, it is very
difficult to dispose off those assets without involving huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also increases
the revenue in long-term and will bring significant changes in the profit of the
company by avoiding over or more investment or under investment. Over
investments leads to be unable to utilize assets or over utilization of fixed assets.

Therefore before making the investment, it is required carefully planning and

analysis of the project thoroughly.
5. Difficult to make decision in Capital budgeting: 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.
6. Long term Effect on Profitability: Capital expenditures have great impact on business
profitability in the long run. If the expenditures are incurred only after preparing capital
budget properly, there is a possibility of increasing profitability of the firm.
7. Maximize the worth of Equity Shareholders: The value of equity shareholders is
increased by the acquisition of fixed assets through capital budgeting. A proper capital
budget results in the optimum investment instead of over investment and under
investment in fixed assets. The management chooses only most profitable

capital project which can have much value. In this way, the capital
budgeting maximize the worth of equity shareholders.
INFORMATION REQUIRED FOR CAPITAL BUDGETING DECISIONS

1. Costs & Benefits of proposals.

2. Required rate of return
3. Economic Life of project.
4. Available Funds.
5. Risk of Obsolescence.
6. Intangible Factors like Prestige of Firm., Morale of employees etc.
What are the three major categories of cash flows in a capital budgeting project? What is
the format for calculating each type of cash flow?
The three major categories of cash flows in a capital budgeting project are the (1) initial
investment, (2) operating cash flows, and (3) terminal cash flows.
A format for calculating the initial investment is:
Format for Calculating the Initial Investment
Purchase price of a new assets
+

Expenses associated with placing the asset in service

Opportunity cost of any existing assets employed in the project

Initial net operating working capital (NOWC) required

Proceeds from selling an existing asset

+/-

Tax effects from selling an existing asset

Initial investment

A format for calculating the operating cash flows is:

Format for Calculating Operating Cash Flows
Operating revenues
-

Operating expenses

Depreciation
Earning Before Interest & Tax

Interest
Taxable income (Profit Before Tax)

Income taxes
Net income (Profit After Tax)

Depreciation

Increase in net operating working capital (NOWC)

Operating cash flows

Note: For finding operating cash flows generally Profit after tax but before depreciation is
taken into consideration. It is calculated as
Cash Inflow = ((EBIT- Interest Expense)* (1- Tax Rate)) + Depriciation
Here EBIstands for Earning Before Interest & tax; from this depreciation expenses has
already been deducted.
A format for calculating the terminal cash flows is:
Format for Calculating Terminal Cash Flows
Salvage value
Cost of removing assets and shutting down
Salvage value before taxes

Tax effects on disposal of an asset

Net salvage value
+
Recovery of NOWC
Terminal cash flows

TECHNIQUES OF CAPITAL BUDGETING

Some of the major techniques used in capital budgeting are as follows:

1. Payback period:
The payback (or payout) period is one of the most popular and widely recognized traditional
methods of evaluating investment proposals, it is defined as the number of years required to
recover the original cash outlay invested in a project, if the project generates constant annual
cash inflows, the payback period can be computed dividing cash outlay by the annual cash
inflow.
Payback period = Cash outlay (investment) / Annual cash inflow = C / A
Advantages:
1. A company can have more favourable short-run effects on earnings per share by setting
up a shorter payback period.
2.

The riskiness of the project can be tackled by having a shorter payback period as it may
ensure guarantee against loss.

3.

As the emphasis in pay back is on the early recovery of investment, it gives an insight to
the liquidity of the project.
Limitations:

1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it
does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback
period.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by
financial statements, to measure the profit abilities of the investment proposals. The accounting
rate of return is found out by dividing the average income after taxes by the average investment.
ARR= Average income/Average Investment

Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows
(inflows and outflows) of an investment proposal, using the cost of capital as the appropriate
discounting rate, and finding out the net profit value, by subtracting the present value of cash
outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in the initial
year (tg), will be:

Where A1, A2. represent cash inflows, K is the firms cost of capital, C is the cost of the
investment proposal and n is the expected life of the proposal. It should be noted that the cost of
capital, K, is assumed to be known, otherwise the net present, value cannot be known.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.

3. It is consistent with the objective of maximizing the welfare of the owners.

Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firms cost of capital is known. But in
practice, to understand cost of capital is quite a difficult concept.
3. It may not give satisfactory answer when the projects being compared involve different
amounts of investment.
4. Internal Rate of Return Method:
The internal rate of return (IRR) equates the present value cash inflows with the present value
of cash outflows of an investment. It is called internal rate because it depends solely on the
outlay and proceeds associated with the project and not any rate determined outside the
investment, it can be determined by solving the following equation:

Advantages:
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.
5. It is compatible with the firms maximising owners welfare.
Limitations:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates
under certain circumstances.

3. It implies that the intermediate cash inflows generated by the project are reinvested at the
internal rate unlike at the firms cost of capital under NPV method. The latter assumption seems
to be more appropriate.
5. Profitability index:
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 A,
1. It gives due consideration to the time value of money.
2. It requires more computation than the traditional method but less than the IRR method.
3. It can also be used to choose between mutually exclusive projects by calculating the
incremental benefit cost ratio.
Definition of Capital Rationing
It can be defined as a process of distributing available capital among the various investment
proposals in such a manner that the firm achieves maximum increase in its value.
Based on the source of restriction imposed on the capital, the capital rationing is divided into
two types viz. hard capital rationing and soft capital rationing.
Soft Capital Rationing: It is when the restriction is imposed by the management.
Hard Capital Rationing: It is when the capital infusion is limited by external sources.
Advantages and Disadvantages of Capital Rationing
Capital Rationing Decisions
Capital rationing decisions by managers are made to attain the optimum utilization of the
available capital. It is not wrong to say that all the investments with positive NPV should be
accepted but at the same time the ground reality prevails that the availability of capital is limited.
The option of achieving the best is ruled out and therefore, rational approach is to make most
out of the on hand capital.
Capital Rationing Method
The method of capital rationing can be bifurcated in four steps. The steps are
1. Evaluation of all the investment proposals using the capital budgeting techniques of
Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI)
2. Rank them based on various criterion viz. NPV, IRR, and Profitability Index
3. Select the projects in descending order of their profitability till the capital budget
exhausts based on each capital budgeting technique.
4. Compare the result of each technique with respect to total NPV and select the best out
of that.

Capital Budgeting Calculation with Example

Assume that we have the following list of projects with below-mentioned cash outflow and their
evaluation results based on IRR, NPV and PI along with their respective rankings. The capital
ceiling for investment is say 650.
Evaluation
Initial
Projects Cash
Outflow

IRR

NPV

Ranking
PI

IRR

NPV

PI

350

19%

150

1.43

300

28%

420

2.4

250

26%

10

1.04

150

20%

100

1.67

100

37%

110

2.1

100

25%

130

2.3

In the table, if we select based on individual method, we will arrive at following result:
IRR
Projec
ts

ICO

NPV

NPV

IRR

Projec
ts

ICO

PI
NPV

Projec
ts

ICO

NPV

PI

100

110

37%

300

420

300

420

2.4

300

420

28%

350

150

100

130

2.3

250

10

26%

Total

650

570

100

110

2.1

Total

650

540

150

100

1.67

Total

650

760

The results are quite obvious and we will go with B,F,E and D to achieve maximum value of
760.

NOTE: FOR ILLUSTRARTIONS ON ABOVE: AS SOLVED IN CLASS OR

REFER M R AGRARWAL ON PROJECT MANAGEMENT