Capital budgeting

1. Capital Budgeting
An introduction

2. Capital Budgeting: Meaning
• The investment decisions involving commitment of Current funds of the firm in its
long term assets are known as Capital Budgeting.
• Capital Budgeting involves investment of current cash outlays or a series of cash
outlays in long term assets of the firm in return for future benefits in form of cash
inflows.
• It is also known as Capital Expenditure decisions.
• It is a situation where the lump sum funds are invested in the initial stages of a
projects and the returns are expected over a period of time.

3. Capital Budgeting: Meaning
Charles T. Horngren defined “capital budgeting as a long term planning for
making and financing proposed capital outlays.”
According to R.N. Anthony, “ Capital expenditure is defined as “ any
investment involving commitment of funds now with the expectations of
earning a satisfactory return on these funds over a period of time in future.”
According of John J. Hampton, “Capital Budgeting is concerned with the
firm’s formal process for the acquisition and investment of capital.”

4. Capital Budgeting
Capital budgeting incorporates decisions such as:
• Acquisition of long term assets like plants, machineries, buildings etc.
• Modification of the existing facilities for enhancing capacities
• Replacement of existing assets for cost reduction or profit maximization
• Development of new products or their new use.
• Manufacturing process improvement
• Research and Development
• Incorporation of new technology
• Acquisition of new business

5. Importance of Capital Budgeting Decision
• Long term implications
• Substantial Commitment of funds
• Change the Risk complexion of the firm
• Irreversible decision
• Influence the capacity and strength to compete
• Difficult and complex Decision

6. Objective of Capital Budgeting
• The main objective of financial management is wealth maximization.
• Maximization of wealth of the firm indicates the maximization of
value of owner’s share capital.
• Maximization of wealth is a useful and meaningful objective criterion
to take all type of finance function’s decisions including capital
budgeting decision.

7. Problems in Capital Budgeting
• Risk and Uncertainity
• Time Element
• Measurement problem
• Capital Rationing

8. Types of Investment Projects
• Replacement or Modernization decisions
• Growth or Expansion projects
• Diversification projects
• New project or New firm
• Mandatory projects

9. Kinds of Investment Decisions
• Independent projects (Accept /Reject Decisions)
• Mutually Exclusive Projects
• Contingent Decisions
• Capital Rationing Decisions

10. Capital Budgeting process
• Project Generation
• Preliminary Screening
• Detailed project Evaluation
• Project Selection and its Implementation
• Control of Capital Expenditure

11. Capital Budgeting : Decision Making Procedure
• Estimation of Cost and Benefits of an investment Proposal
• Estimation of minimum required rate of return
• Application of suitable Capital Budgeting technique

12. Principles of Cash flow Estimations
• Consider only relevant and incremental cash flows
• Calculate cash flows on after tax basis
• Ignore sunk cost
• Include opportunity costs
• Calculate operating cash flows and exclude interest payments
• Incorporate changes in working capital investment

13. Principles of Cash flow Estimations
• Include side effects of the project
• Incorporate anticipated inflation
• Add back depreciation and any other non cash item to after tax profit (PAT)

14. Estimation of relevant cash flows

15. Estimation of relevant cash flows

16. Conventional and Non Conventional Cash
flows
• Conventional Cash flows: initial investment is followed
by a series of cash inflows over a period of time.
• Non conventional cash flows: there are more than one
cash flows which is is followed by a series of cash
inflows over a period of time.