Capital Budgeting

MBA II Sem.










Neelam kalla
Assistant Professor
DMS. FCMS. JNVU

Capital Budgeting
Capital Budgeting is an important
technique of management which
widely used for the evaluation of
various capital investment
proposals and for choosing the
appropriate source of finance and
for implementation of chosen
investment proposals.
Capital Budgeting
Capital Budgeting is the process of
determining which real investment
projects should be accepted and
given an allocation of funds from
the firm.
To evaluate capital budgeting
processes, their consistency with
the goal of shareholder wealth
maximization is of utmost
importance.
Meaning and
Definitions of Capital
Budgeting
C.B. consist in planning the
development of available
capital for the purpose of
maximizing the long-term
profitability ( Return on
Investment) of the firm.
- R.M.Lynch
The process through which different
projects are evaluated is known as
capital budgeting
Capital budgeting is defined as the
firms formal process for the acquisition
and investment of capital. It involves
firms decisions to invest its current
funds for addition, disposition,
modification and replacement of fixed
assets.
Capital budgeting is long term planning
for making and financing proposed
capital outlays- Charles T Horngreen.
Capital budgeting consists in planning
development of available capital for the
purpose of maximising the long term
profitability of the concern Lynch
The main features of capital budgeting
are
a. potentially large anticipated benefits
b. a relatively high degree of risk
c. relatively long time period between the
initial outlay and the anticipated return.
- Oster Young

Definitions of Capital
Budgeting
Capital budgeting involves
the planning of expenditures
for assets, the return from
which will be realized in
future time period.
-Milton H.
Spencer
Features of Capital
Budgeting
Evaluation of Proposals
Tool of Control
Optimal selection
Helps to Maintain co-ordination
Capital Expenditure decision
Proper Management of finance
To Avoid and reduce losses

Significance of capital
budgeting

The success and failure of business mainly
depends on how the available resources
are being utilised.
Main tool of financial management
All types of capital budgeting decisions are
exposed to risk and uncertainty.
They are irreversible in nature.
Capital rationing gives sufficient scope for the
financial manager to evaluate different
proposals and only viable project must be
taken up for investments.
Capital budgeting offers effective control on cost
of capital expenditure projects.
It helps the management to avoid over
investment and under investments.
Importance of Capital
Budgeting
Long term effects
Affect the capacity and strength to
compete
Irreversible decisions
Substantial Commitments
Most Difficult to make
Determine the future growth of an
organisation

Types of Capital
Budgeting Decision
Expansion Project Decision
Replacement Project Decision
New Firm
Existing Firm
Diversification
Modernization Decision
Research & development Project
Decision
Housekeeping Projects Decision
Problems in Capital
Budgeting
Future Uncertainty
Time Element
Measurement Problem

Capital budgeting process involves the following
1. Project generation: Generating the proposals for
investment is the first step.
The investment proposal may fall into one of the following
categories:
Proposals to add new product to the product line,
proposals to expand production capacity in existing
lines
proposals to reduce the costs of the output of the
existing products without altering the scale of
operation.
Sales campaining, trade fairs people in the industry, R
and D institutes, conferences and seminars will offer
wide variety of innovations on capital assets for
investment.


2. Project Evaluation: it involves two steps
Estimation of benefits and costs: the benefits and
costs are measured in terms of cash flows. The
estimation of the cash inflows and cash outflows
mainly depends on future uncertainities. The risk
associated with each project must be carefully
analysed and sufficeint provision must be made
for covering the different types of risks.
Selection of an appropriate criteria to judge the
desirability of the project: It must be consistent
with the firms objective of maximising its market
value. The technique of time value of money may
come as a handy tool in evaluation such
proposals.
3. Project Selection: No standard administrative
procedure can be laid down for approving the
investment proposal. The screening and selection
procedures are different from firm to firm.
4. Project Evaluation: Once the proposal for
capital expenditure is finalised, it is the duty of the
finance manager to explore the different
alternatives available for acquiring the funds. He
has to prepare capital budget. Sufficient care must
be taken to reduce the average cost of funds. He
has to prepare periodical reports and must seek
prior permission from the top management.
Systematic procedure should be developed to
review the performance of projects during their
lifetime and after completion.
The follow up, comparison of actual performance with
original estimates not only ensures better
forecasting but also helps in sharpening the
techniques for improving future forecasts.

Procedure of Capital
Budgeting
Origin of Investment Proposals
Presentation of Proposals
Screening the Proposals
Estimation of Cost & Benefits of
the Proposals
Estimation of required rate of
return
Project selection
Final Decision on Project

Factors influencing capital
budgeting
Availability of funds
Structure of capital
Taxation policy
Government policy
Lending policies of financial institutions
Immediate need of the project
Earnings
Capital return
Economical value of the project
Working capital
Accounting practice
Trend of earnings

Valuation
Techniques
Traditional
Techniques
Pay-Back
period
Average
Rate of
returns
Modern
Techniques
Net Present
Value
Profitability
Index
Internal
Rate of
return
Pay back period method
It refers to the period in which the project will
generate the necessary cash to recover the initial
investment.
It does not take the effect of time value of money.
It emphasizes more on annual cash inflows, economic
life of the project and original investment.
The selection of the project is based on the earning
capacity of a project.
It involves simple calcuation, selection or rejection of
the project can be made easily, results obtained is
more reliable, best method for evaluating high risk
projects.

Cons
It is based on principle of rule of thumb,
Does not recognize importance of time value
of money,
Does not consider profitability of economic
life of project,
Does not recognize pattern of cash flows,
Does not reflect all the relevant dimensions
of profitability.
Accounting Rate of Return method
IT considers the earnings of the project of the economic life.
This method is based on conventional accounting concepts.
The rate of return is expressed as percentage of the earnings
of the investment in a particular project. This method has
been introduced to overcome the disadvantage of pay back
period. The profits under this method is calculated as profit
after depreciation and tax of the entire life of the project.
This method of ARR is not commonly accepted in assessing
the profitability of capital expenditure. Because the method
does to consider the heavy cash inflow during the project
period as the earnings with be averaged. The cash flow
advantage derived by adopting different kinds of
depreciation is also not considered in this method.
Accept or Reject Criterion: Under the method, all project,
having Accounting Rate of return higher than the minimum
rate establishment by management will be considered and
those having ARR less than the pre-determined rate. This
method ranks a Project as number one, if it has highest ARR,
and lowest rank is assigned to the project with the lowest
ARR.
Merits
It is very simple to understand and use.
This method takes into account saving over the entire
economic life of the project. Therefore, it provides a better
means of comparison of project than the pay back period.
This method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects and
It can readily be calculated by using the accounting data.
Demerits
1. It ignores time value of money.
2. It does not consider the length of life of the projects.
3. It is not consistent with the firm's objective of
maximizing the market value of shares.
4. It ignores the fact that the profits earned can be
reinvested. -


Discounted cash flow method
Time adjusted technique is an improvement over pay
back method and ARR. An investment is essentially
out flow of funds aiming at fair percentage of return
in future. The presence of time as a factor in
investment is fundamental for the purpose of
evaluating investment. Time is a crucial factor,
because, the real value of money fluctuates over a
period of time. A rupee received today has more
value than a rupee received tomorrow. In evaluating
investment projects it is important to consider the
timing of returns on investment. Discounted cash
flow technique takes into account both the interest
factor and the return after the payback 'period.
Discounted cash flow technique involves the following
steps:
Calculation of cash inflow and out flows over the
entire life of the asset.
Discounting the cash flows by a discount factor
Aggregating the discounted cash inflows and
comparing the total so obtained with the
discounted out flows.

Net present value method
It recognises the impact of time value of money. It is
considered as the best method of evaluating the
capital investment proposal.
It is widely used in practice. The cash inflow to be
received at different period of time will be
discounted at a particular discount rate. The
present values of the cash inflow are compared
with the original investment. The difference
between the two will be used for accept or reject
criteria. If the different yields (+) positive value ,
the proposal is selected for invesment. If the
difference shows (-) negative values, it will be
rejected.
Pros:
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows by
using a discount rate equal to the cost of capital.
It is consistent with the objective of maximizing the
welfare of owners.
Cons:
It is very difficult to find and understand the concept
of cost of capital
It may not give reliable answers when dealing with
alternative projects under the conditions of unequal
lives of project.
Demerits
1. It ignores time value of money.
2. It does not consider the length of life of the projects.
3. It is not consistent with the firm's objective of
maximizing the market value of shares.
4. It ignores the fact that the profits earned can be
reinvested. -


Discounted cash flow method
Time adjusted technique is an improvement over pay
back method and ARR. An investment is essentially
out flow of funds aiming at fair percentage of return
in future. The presence of time as a factor in
investment is fundamental for the purpose of
evaluating investment. Time is a crucial factor,
because, the real value of money fluctuates over a
period of time. A rupee received today has more
value than a rupee received tomorrow. In evaluating
investment projects it is important to consider the
timing of returns on investment. Discounted cash
flow technique takes into account both the interest
factor and the return after the payback 'period.
Discounted cash flow technique involves the following
steps:
Calculation of cash inflow and out flows over the
entire life of the asset.
Discounting the cash flows by a discount factor
Aggregating the discounted cash inflows and
comparing the total so obtained with the
discounted out flows.

Net present value method
It recognises the impact of time value of money. It is
considered as the best method of evaluating the
capital investment proposal.
It is widely used in practice. The cash inflow to be
received at different period of time will be
discounted at a particular discount rate. The
present values of the cash inflow are compared
with the original investment. The difference
between the two will be used for accept or reject
criteria. If the different yields (+) positive value ,
the proposal is selected for invesment. If the
difference shows (-) negative values, it will be
rejected.
Pros:
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows by
using a discount rate equal to the cost of capital.
It is consistent with the objective of maximizing the
welfare of owners.
Cons:
It is very difficult to find and understand the concept
of cost of capital
It may not give reliable answers when dealing with
alternative projects under the conditions of unequal
lives of project.
Internal Rate of Return
It is that rate at which the sum of discounted
cash inflows equals the sum of discounted
cash outflows. It is the rate at which the net
present value of the investment is zero.
It is the rate of discount which reduces the NPV
of an investment to zero. It is called internal
rate because it depends mainly on the outlay
and proceeds associated with the project and
not on any rate determined outside the
investment.
Merits of IRR method
It consider the time value of money
Calculation of casot of capital is not a
prerequisite for adopting IRR
IRR attempts to find the maximum rate of
interest at which funds invested in the
project could be repaid out of the cash
inflows arising from the project.
It is not in conflict with the concept of
maximising the welfare of the equity
shareholders.
It considers cash inflows throughout the life
of the project.
Cons
Computation of IRR is tedious and difficult
to understand
Both NPV and IRR assume that the cash
inflows can be reinvested at the discounting
rate in the new projects. However,
reinvestment of funds at the cut off rate is
more appropriate than at the IRR.
IT may give results inconsistent with NPV
method. This is especially true in case of
mutually exclusive project.