The process through which different projects are evaluated is known as capital budgeting
Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of capital. It involves firm’s 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.
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 firm’s objective of maximising its market value. The technique of time value of money may come as a handy tool in evaluation such proposals.
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.
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.
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.
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.
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.
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.
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.