CAPITAL BUDGETING

- Long term planning for proposed capital outlays

and their financing.
 DEFINITION:

Capital Budgeting decision may be defined as

“ the firm’s decision to invest its current fund

more efficiently in long-term activities in
anticipation of an expected flow of future
benefit over a series of years.”
 Capital Budgeting is a complex process which may
be divided into the following phases :-

Identification of potential investment opportunities.

Assembling of proposed investments.

Decision Making

Preparation of Capital Budget and appropriations

Implementation

Performance Review.
BASIC FEATURES OF CAPITAL BUDGETING
DECISIONS :-

Current funds are exchanged for future benefits;

Investment in long-term activities; and

Future benefits will occur to the firm over series

of years.
What are the factors that give rise to
the need for capital investments ?
Wear and tear of old equipments.

Obsolescence.

Variation in product demand necessitating change in

volume of production.
Product improvement requiring capital additions.

Learning-curve effect.

Expansion

Change of plant site.

Diversification.

Productivity improvement.
IMPORTANCE OF CAPITAL BUDGETING :-

Long-term implications;

Involvement of large amount of funds;

Irreversible decisions;

Risk and uncertainty;

Difficult and Complicated exercise.

INVESTMENT DECISION
MAKING
 FACTORS INFLENCING INVESTMENT
DECISION:-
Management outlook;

Competitor’s Strategy;

Opportunities created by technological change;

Market forecast;

Fiscal incentives;

Cash flow budget;

Non-Economic factors.
 Rationale of Capital Budgeting Decisions:-

The main rationale is EFFICIENCY.

The main objective of the firm is to maximize

profit either by way of increased revenue or by
cost reduction.
 KINDS OF

CAPITAL BUDGETING DECISIONS

 Business firms are generally confronted with
these 3 types of Capital Budgeting Decisions:

Accept – Reject decisions

Mutually exclusive decisions

Capital Rationing decisions

 ACCEPT-REJECT DECISIONS :

If the proposal is accepted, the firm incurs the

investment and not otherwise.

Broadly, all those investment proposals which

yield a rate of return greater than cost of capital

are accepted and the others are rejected.

 MUTUALLY EXCLUSIVE DECISIONS :

It includes all those projects which compete

with each other in a way, that acceptance of one

precludes the acceptance of other or others.

Thus, some technique has to be used for

selecting the best among all and eliminates

other alternatives.
 Refers to the situations where the firm have
more acceptable investments requiring greater
amount of finance than is available with the
firm.

It is concerned with the selection of a group of

investments out of many investment proposals
ranked in the descending order of the rate of
return.
In evaluating a capital expenditure proposal,
2 broad phases are involved:-

Defining the stream of costs and benefits

associated with the investment, and

Appraising the stream of costs and benefits to

determine the worthwhileness of the
investment.
In defining the costs and benefits of a capital
expenditure proposal, the following principles
must be borne in mind:-

Cash Flow Principle

post-tax Principle

incremental Principle

long-term funds Principle

interest exclusion Principle.

To evaluate the stream of costs and benefits,
several appraisal criteria have been suggested.
The important ones are as follows:-

Payback Period

Average Rate of Return

Net Present Value

Benefit Cost Ratio

Internet Rate of Return.

 The NET PRESENT VALUE of a project is

equal to the sum of the present values of all the

cash flows(outflows and inflows) associated with

the project.

A Project is acceptable if its net present value

exceeds zero.
 The BENEFIT COST RATIO, also referred to
as Profitability Index, is defined as :

Present Value of Benefits

Present Value of costs

A project is acceptable if its Benefits Cost Ratio >

1.
The INTERNAL RATE OF RETURN , of a

project is the discount rate which makes its net

present value = 0.

A project is acceptable if its IRR > the cost of

capital.
The PAYBACK PERIOD , is the length of time

required to recover the initial cash outlay on the

project.

According to this criterion, a project is acceptable

if its payback period is less than a certain

specified Payback Period.

 The AVERAGE RATE OF RETURN , also

called the Accounting Rate of Return, may be

defined as :-

Profit after taxes

Book Value of the investment

Project is acceptable if its ARR exceeds certain

cut-off rate of return.

CHOICE OF METHODS
 Business enterprise is confronted with large

number of investment criteria for selection of

investment proposals. It should like to choose the

best among all.

If a choice is to be made, the NET PRESENT

VALUE method generally is considered to be

superior theoretically because :-

It is simple to operate as compared to Internal
Rate of Return method ;

It does not suffer from the limitations of

multiple rates;

The reinvestment assumption of the Net

Present Value Method is more realistic than
internal Rate of Return Method.
 On the other hand, some scholars have

advocated for Internal Rate of Return method

on the following grounds :

It is easier to visualize and to interpret as
compared to Net Present Value method;

It suggests the max. rate of return and even in

the absence of cost of capital, it gives good
idea of the projects profitability.

The IRR method is preferable over NPV

method in the evaluation of risky projects.
A wide variety of measures are used in practice

for appraising investments. These include

measures suggested by capital budgeting

literature and several non-standard measures.

The most commonly used method for evaluating

small-size investments is the payback method.

For larger investments, the Average Rate of

Return and, in more recent years, discounted

cash flow methods are commonly employed.

ANY
ANYQUESTIONS?
QUESTIONS?