Capital budgeting involves planning expenditures for long-term assets that provide returns over several years. It is an important process that requires evaluating projects carefully due to their large size, long-term implications, and irreversible nature. Key aspects of capital budgeting include identifying and evaluating investment proposals, determining which provide the highest expected rates of return, and preparing a capital expenditure budget. Various techniques can be used to evaluate projects, including payback period, accounting rate of return, net present value, internal rate of return, and risk-adjusted methods that account for uncertainty in projected cash flows.

1. Capital Budgeting
By
Dr. R. Prema
Associate Professor

2. 3.1 Definition, Importance of capital budgeting
Meaning:
It is a process of making decisions regarding
investments in fixed assets which are not meant for sale
such as machinery, plant, building etc., and the benefits
of which are expected to be received over a number of
years in future.
Definition:
“Capital budgeting involves the planning of
expenditures for assets, the returns from which will be
realized in future time periods” – Milton H. Spencer.

3. Importance of capital budgeting
Long term implications
Large investment
Irreversible decisions
 Most difficult to make
Long term effect on profitability
 Maximization of shareholders wealth

4. 3.2 Objectives of a capital expenditure budget
It determines the capital projects on the basis of its
urgency and its expected rate of return.
It estimates the expenditure that would have to be
incurred on capital projects approved by the management
together with the sources from which the required funds
would be obtained.
It restricts the capital expenditure within the authorized
limits.

5. 3.3 Classifications of Projects
A) Business projects
B) Developmental Projects
C) Technical Projects

6. 3.4 Capital budgeting processes
i)Identification of investment proposals
ii) Screening the proposals
iii) Evaluation of various proposals
iv) Fixing priorities
v)Final approval and preparation of capital
expenditure budget
vi) Implementing proposals
vii) Performance review

7. 3.5 Capital Budgeting Evaluation Techniques
A) Traditional Methods
i) Urgency method ii) Pay-Back period method
B) Accounting rate of return method (or) Average rate of return
method
C) Discounted cash flow methods
i) The Net Present Value Method (NPV)
ii) Present value Index Method (PI)
iii) Internal Rate of Return Method (IRR
iv) Discounted pay-back period Method

8. Pay-Back period method
• Pay-back period method is also called pay-off
or pay out method.
• It represents the number of years required to
recover the original investment by savings
before depreciation but after the payment of
taxes.
• It attempts to measure the period of time it
takes to recover the original cost of a project.

9. Pay-Back period method
Example-1: A project costs Rs 100,000 and
yields annual cash inflow of Rs 20,000 for 8
years. Calculate payback period.
Solution:
Payback period
= Initial Outlay of the project / Annual
cash inflow
= 100,000 / 20,000 = 5 years.

10. Example-2:
ABC ltd is considering two projects. Each requires an
investment of $ 10,000. The net cash inflows from
investment in the two projects X and Y are as follows: You
are required to suggest which project should be accepted
if the standard payback period is 3 years.
Years X Cash inflow ($) Y Cash inflow ($)
1 2000 5000
2 4000 4000
3 3000 3000
4 2000 1000

11. Calculation of Payback period
Payback period for X
= 3 years + [(10,000-9000) / 2000] *12 = 3 years and 6 months.
Payback period for Y
= 2 years + [(10,000-9000) / 3000] *12 = 2 years and 4(3.9)
months.
Comment: Project Y should be accepted. Because which is
having lesser payback period than project X.
Year Cash inflow ($)
X
Cumulative
cash inflow ($)
Cash inflow ($)
Y
Cumulative cash
inflow ($)
1 2000 2000 5000 5000
2 4000 6000 4000 9000
3 3000 9000 3000 12000
4 2000 11000 1000 13000

12. Accounting rate of return method
• Under this method the capital investment proposals
are judged on the basis of their relative profitability.
• It is also known as ‘Average Rate of Return’. In this
method, the accounting concept of profit (Net profit
after tax and depreciation) is used rather than cash
inflows.
• According to this method the various projects are
ranked in order of the rate of earnings or rate of
return. The project with higher rate of return is
selected as compared to the one with lower rate of
return.
Annual average net earning
ARR = --------------------------------------------------------- X 100
Original investment (or) Average Investment

13. Accounting rate of return method
Example-3: Calculate the average rate of return for
Project-X and Y from the following:
Particulars Project – X Project – Y
Investment 30,000 40,000
Net Profit : Year 1
Year 2
Year 3
Year 4
Year 5
6,000
6,000
4,000
4,000
-
12,000
10,000
8,000
6,000
4,000

14. Solution:
A.R.R = (Average Annual Profit / Average Investment) ×
100
For Project-X:
Average Annual Profit = (6000+6000+4000+4000) / 4 = 5000
Average Investment = 30000 / 2 = 15,000
ARR = (5000 / 15000) × 100 = 33.333%
For Project-Y:
Average Annual Profit = (12000+10000+8000+6000+4000)/5 = 8000.
Average Investment = 40000 / 2 = 20000
ARR = (8000 / 20000) × 100 = 40%
Decision: Since the return on investment of Project Y is
higher than Project X. Hence, Project Y is to be
considered for investment.

15. C) Discounted cash flow methods
i) The Net Present Value Method (NPV)
This method is also called excess present value
method or net gain method. The net present value is the
difference between the total present value of future cash
inflows and the total present value of future cash
outflows.
Accept / Reject Criterion:
NPV > Zero (or) If NPV is positive accept the project
NPV < Zero (or) If NPV is negative reject the project
NPV = Zero Indifferent (or) Indeterminate

16. The Net Present Value Method (NPV)
Example-4: From the following information calculate the net
present value of the two projects and suggest which of the two
projects should be accepted assuming a discount rate of 10%.
Project – X Project – Y
Initial Investment 20,000 30,000
Estimated life 5 years 5 years
Scrap value 1,000 2,000
The profit before depreciation and after taxes is as follows:
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000

17. Calculation of Net Present Value (NPV)
Decision: From the above analysis it is clear that the net present value of project-Y is
higher than the net present value of project-X. Hence, it is suggested that project-Y
should be selected.
Year
PV Factor
@10%
Project – X Project – Y
Cash Flow
Present
Value
Cash Flow
Present
value
1 0.909 5000 4545 20000 18180
2 0.826 10000 8260 10000 8260
3 0.751 10000 7510 5000 3755
4 0.683 3000 2049 3000 2049
5 0.621 2000 1242 2000 1242
5 (Scrap) 0.621 1000 621 2000 1242
Total Present value 24227 34728
Less: Initial investment 20000 30000
Net Present Value 4227 4728

18. ii) Present value Index Method (PI)
or Profitability Index Method (PI)
It is also called as excess present value index
method. Under this method a present value index is
found out by comparing the total present value of future
cash inflows and the total present value of future cash
outflows.
Present value of future cash inflows
Profitability index = -------------------------------------------------
Present value of future cash outflows
Accept / Reject Criterion:
PI > 1 accept the project
PI < 1 reject the project
In case of more than one project, project with higher
present value index will be accepted.

19. Present value Index Method (PI)
Example- 5:
The initial cash outlay of a project is Rs 50,000
and it generates cash inflows of Rs 20,000; Rs
15,000; Rs 25,000; and Rs 10,000 in four
years. Using present value index method,
appraise profitability of the proposed
investment assuming 10% rate of discount.

20. Calculation of profitability index
Profitability index
= Present value of cash inflows / Present value of
cash outflows
= 56,175 / 50,000 = 1.1235
Decision: PI>1. Hence, the proposal can be
accepted.
Year Cash inflows PV factor @
10%
Present
value
1
2
3
4
20,000
15,000
25,000
10,000
0.909
0.826
0.751
0.683
18,180
12,390
18,775
6,830
Total present value 56,175

21. Internal Rate of Return Method (IRR)
• Since the discount rate is determined internally, this method is
called as the internal rate of return method.
• The internal rate of return is the maximum rate of interest that
could be paid for the capital employed over the economic life of
an investment without any loss on the project.
• It is that rate at which the sum of discounted cash inflows equals
the sum of discounted cash outflows.
Difference in calculated present value
and required net cash outlay
IRR = Base rate + -------------------------------------------- x Differences in rates
Difference in calculated present values
Accept / Reject Criterion:
Single project – A project is accepted if IRR exceeds the cut-off rate.
Two or More projects – A project giving a higher internal rate of
return would be preferred.

22. Particulars Project – A ($) Project – B ($)
Cost 11,000 10,000
Cash Inflows: Year 1
Year 2
Year 3
Year 4
6,000
2,000
1,000
5,000
1,000
1,000
2,000
10,000
Internal Rate of Return Method (IRR)
Example - 6: A company has to select one of the
following two projects:
Using the IRR method, suggest which project is
preferable?

23. Calculation of IRR (Project-A)
Cash Outlay = $ 11,000.
Difference in calculated present value
and required net cash outlay
IRR = Base rate + ------------------------------------------------- x Differences in rates
Difference in calculated present values
IRR = 10% + [(11272-11000)/(11272-10844)] × (12%-10%)
IRR = 10%+1.27% = 11.27%
Year Cash inflow PV@10% P.V PV@12% P.V
1 6000 0.909 5454 0.893 5358
2 2000 0.826 1652 0.797 1594
3 1000 0.751 751 0.712 712
4 5000 0.683 3415 0.636 3180
Total P.V 11272 10844

24. Calculation of IRR (Project-B)
Cash Outlay = $10,000
IRR = 10% + [(10067-10000)/(10067-9474)] × (12%-10%)
IRR = 10%+0.226% = 10.226%
Decision: Project-A is preferable. Because, it has higher
IRR compared to Project-B.
Year Cash inflow PV@10% P.V PV@12% P.V PV@15% P.V
1 1000 0.909 909 0.893 893 0.870 870
2 1000 0.826 826 0.797 797 0.756 756
3 2000 0.751 1502 0.712 1424 0.658 1316
4 10000 0.683 6830 0.636 6360 0.572 5720
Total P.V 10067 9474 8662

25. Discounted pay back method
• One of the major disadvantages of simple
payback period is that it ignores the time value
of money.
• To counter this limitation, an alternative
procedure called discounted payback period
may be followed, which accounts for time
value of money by discounting the cash
inflows of the project.
Decision rule: If the discounted payback period is
less that the target period, accept the project.
Otherwise reject.

26. Discounted pay-back period Method
Example – 7:
Compute discounted pay back method and
comment on the results.
Initial outlay – 80,000; Estimated life – 5 years;
Profit after tax: 1st year - Br 6000; 2nd year – Br
14000; 3rd year – 24,000; 4th year – 16000; 5th year
– nil;
Depreciation has been calculated under straight
line method. The cost of capital may be taken at
20% p.a.

27. Depreciation
= Original investment / Estimated life of years
= 80,000 / 5 = 16,000
Calculation of discounted Payback period
Discounted payback period
= 4 years + (80,000-77,730)/6432 *12
= 4 years + 4.2 months
= 4 years 4 months
Ye
ar
Profit
after tax
Depreciati
on
Profit after
tax but before
depreciation(Cash
inflow)
PV
factor @ 20%
Present
value
Cumulative
present value
1
2
3
4
5
6,000
14,000
24,000
16,000
Nil
16,000
16,000
16,000
16,000
16,000
22,000
30,000
40,000
32,000
16,000
0.833
0.694
0.579
0.482
0.402
18,326
20,820
23,160
15,424
6,432
18,326
39,146
62,306
77,730
84,162

28. 3. 6 CAPITAL BUDGETING UNDER UNCERTAINTY
3.6.1 Definition of Risk and uncertainty
According to Lunce Dunan and Howard
Raiffa, “Risk involves situations in which the
profitabilities of a particular event occurring are
known, whereas uncertainty, these
profitabilities are not known”.
3.6.2 Risk in capital budgeting
The term risk with reference to capital
budgeting decision denotes the variability that is
likely to occur in future between the estimated
returns and the actual returns from the project.

29. i) Risk adjusted discount rate

30. Example - 8: From the following data, state which project is
better?
Risk-less discount rate is 5%. Project – A is less risky as
compared to Project – B. The management considers risk
premium rates at 5% and 10% respectively appropriate for
discounting the cash flows.
Cash flows Project – A $ Project – B $
Year – 0
Year – 1
Year – 2
Year – 3
-10,000
4,000
4,000
2,000
-10,000
5,000
5,000
3,000

31. Calculation of Risk Adjusted Discount Rate:
Project – A : 5% + 5% = 10%
Project – B : 5% + 10% = 15%
Calculation of Discounted Cash Flows
Decision: Project - B is superior to Project - A. Because, it
gives positive NPV. Hence, Project - B should be
preferred.
Year
Project – A Project – B
Cash Flow DF @ 10%
Present
Value
Cash
Flow
DF @ 10%
Present
Value
1 4000 0.909 3636 5000 0.870 4350
2 4000 0.826 3304 6000 0.756 4536
3 2000 0.751 1502 3000 0.658 1974
Total Present Value
Less: Initial investment
8442
10000
10860
10000
NPV -1558 860

32. ii) Certainty equivalent co-efficient

33. Example - 9: Two projects X and Y, each
involve an investment of $ 40,000. The expected
cash inflows and the certainty coefficients are as
under:
The cost of capital of the projects is 10%. Find
out which project is preferable.
Year
Project – X Project – Y
Cash inflow
Certainty
coefficient
Cash inflow
Certainty
coefficient
1
2
3
25000
20000
20000
0.8
0.7
0.9
20000
30000
20000
0.9
0.8
0.7

34. Calculation of Cash Flows with Certainty
Year
Project – X Project – Y
Cash
inflow
Certainty
Coefficient
Certain
Cash
inflow
Cash
inflow
Certainty
Coefficient
Certain
Cash
inflow
1 25000 0.8 20000 20000 0.9 18000
2 20000 0.7 14000 30000 0.8 24000
3 20000 0.9 18000 20000 0.7 14000

35. Calculation of Net Present Value
Decision: Project – Y is superior to Project – X.
Because, the NPV of Project – Y is more than that of
Project – X. Hence, Project – Y should be accepted.
Year
Project – X Project – Y
Certain
Cash
inflow
DF @
10%
Present
Value
Certain
Cash
inflow
DF @ 10%
Present
Value
1 20000 0.909 18180 18000 0.909 16362
2 14000 0.826 11564 24000 0.826 19824
3 18000 0.751 13518 14000 0.751 10514
Total Present Value
Less: Initial investment
43262
40000
46700
40000
NPV 3262 6700

36. iii) Sensitivity Analysis

37. Example - 10: ABC Ltd., is considered two mutually
exclusive projects X and Y. From the following
information, you are required to give your considered
opinion for helping the management in arriving at a
decision.
Particulars Project – X Project – Y
Initial Cash Outlays $.40,000 $ 40,000
Cash Flow Estimates: (t = 1 to 15)
Worst
Most-likely
Best
6,000
8,000
10,000
0
8,000
16,000
Required rate of return 10% 10%
Economic life 15 years 15 years

38. Present value of $ 1 annuity for 15 years at 10% discount is 7.606.
Calculation of NPV
Project – X (Initial investment $ 40,000)
Calculation of NPV
Project – Y (Initial investment $ 40,000)
Decision: From the above analysis it is clear that the project Y is more
risky than Project X. But it will depend upon the management whether
they would like to take project X or Y depending upon the risk they want
to undertake. If the management is ready to face risk then it can select
Project Y. Otherwise it should go for X.
Circumstances Cash inflow DF @ 10% for 15 years Total Present Value Net Present Value
Worst
Most likely
Best
6000
8000
10000
7.606
7.606
7.606
45636
60848
76060
5636
20848
36060
Circumstances Cash inflow DF @ 10% for 15 years Total Present Value Net Present Value
Worst
Most likely
Best
0
8000
16000
7.606
7.606
7.606
0
60848
121696
-40000
20848
81696

39. iv) Profitability assignment
v) Standard deviations
vi) Co-efficient of variation method

40. Example - 11: A company is considering two mutually exclusive
projects X and Y. Project X costs $ 30,000 and Project costs
$36,000. You have been given below the net present value
probability distribution for each project.
i. Compute the expected net present value of Projects X and Y.
ii. Compute the risk attached to each project i.e., standard
deviation of each probability distribution.
iii. Which project do you consider more risky and why?
iv. Compute the profitability index of each project.
Project X Project Y
NPV Estimate $ Probability NPV Estimate $ Probability
3000
6000
12000
15000
0.1
0.4
0.4
0.1
3000
6000
12000
15000
0.2
0.3
0.3
0.2

41. i. Computation of Expected Net Present
Value of Projects X and Y
Project – X Project – Y
NPV
Estimate $
Probability
Expected
NPV $
NPV
Estimate $
Probability
Expected
NPV $
3000
6000
12000
15000
0.1
0.4
0.4
0.1
300
2400
4800
1500
3000
6000
12000
15000
0.2
0.3
0.3
0.2
600
1800
3600
3000
Total 9000 Total 9000

42. ii. Computation of Standard Deviation: For Project – X
Standard deviation ( ) = ʃ Ʃfd2 / n = ʃ 14,400,000 / 1 = 3,795
For Project – Y
Standard deviation ( ) = ʃ Ʃfd2 / n = ʃ 19,800,000 / 1 = 4,450
NPV Estimate (Cash
inflows) $
Deviation from Mean
(d) (9000)
Square of Deviation (d)2 Probability (f)
Weighted square
Deviation (fd)2
3000
6000
12000
15000
-6000
-3000
+3000
+6000
36,000,000
9,000,000
9,000,000
36,000,000
0.1
0.4
0.4
0.1
3,600,000
3,600,000
3,600,000
3,600,000
n = 1 Ʃfd2 = 14,400,000
NPV Estimate (Cash
inflows) $
Deviation from
Mean (d) (9000)
Square of Deviation
(d)2
Probability (f)
Weighted square
Deviation (fd)2
3000
6000
12000
15000
-6000
-3000
+3000
+6000
36,000,000
9,000,000
9,000,000
36,000,000
0.2
0.3
0.3
0.2
7,200,000
2,700,000
2,700,000
7,200,000
n = 1 Ʃfd2 = 19,800,000

43. iii. As the standard deviation of Project Y is more than
that of Project X, Project Y is said to be more risky.
iv. Computation of Profitability Index:
Profitability Index = Total PV of cash inflows / Project Cost
Total PV of cash inflows = Expected NPV + Project cost
Expected NPV = Total PV of Cash Inflows - Project cost
For Project - X: Expected NPV = $ 9000
Total PV of cash inflows = 9000+30000 = $ 39000.
Profitability Index = $ 39,000 / $ 30000 = 1.3
For Project - Y: Expected NPV = $ 9000
Total PV of cash inflows = 9000+36000 = $ 45,000.
Profitability Index = $ 45,000 / $ 36,000 = 1.25

44. vii) Decision tree analysis

45. Example - 12: X Ltd is considering the purchase of a
new plant requiring a cash outlay of Br 20,000. The
plant is expected to have a useful life of 2 years without
any salvage value. The cash flows and their associated
probabilities for the two years are as follows:
1st year Cash flows Profitability
i)
ii)
iii)
8000
11000
15000
0.3
0.4
0.3

46. 2nd year: if cash flows in 1st year are:
Presuming that 10% is the cost of capital, you plot the
above data in the form of a decision tree and suggest
whether the project should be taken up or not.
8000 11000 15000
Cash
flows
Prob
ability
Cash
flows
Prob
ability
Cash
flows
Proba
bility
i)
ii)
iii)
4,000
10,000
15,000
0.2
0.6
0.2
13,000
15,000
16,000
0.3
0.4
0.3
16,000
20,000
24,000
0.1
0.8
0.1

47. Computation of net present values
Decision Tree
******
Alterna
tives
Cash flow Present values @ 10% DF NPV
1st year 2nd year 1st year 2nd year Total
a) i)
ii)
iii)
8,000
8,000
8,000
4,000
10,000
15,000
7,272
7,272
7,272
3,304
8,260
12,390
10,576
15,532
19,662
-9,424
-4468
-338
b) i)
ii)
iii)
11,000
11,000
11,000
13,000
15,000
16,000
9,999
9,999
9,999
10,738
12,390
13,216
20,737
22,389
23,215
737
2389
3215
C) i)
ii)
iii)
15,000
15,000
15,000
16,000
20,000
24,000
13,635
13,635
13,635
13,216
16,520
19,824
26,851
30,155
33,459
6851
10155
13459