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1. ‘CAPITAL
BUDGETING’

2. Contents-
 Introduction
 Definition
 Cases of capital budgeting
 Concept of capital budgeting
 Importance of capital budgeting
 Process of capital budgeting
 Techniques of capital budgeting
 Merits and demerits of capital budgeting
 Accept and reject criteria
 References

3. INTRODUCTION-
 The finance manager concerned with the investment decision ,
popularly known as capital budgeting decision, require
comparison of cost against benefits over the long period.
 For Example :
 The deployment finances of additional plant and equipment
cannot be recovered in the short run. Such investment may affect
revenues for the period ranging from 2 to 20 years or more.
Such investment decision involve a careful consideration of
various factors profitability, safety, liquidity and solvency.

4. DEFINITION-
 Capital budgeting is the planning process used to determine whether
an organizations long term investments such as new machinery ,
replacement machinery ,new plants new products and research
development projects are worth the funding of cash through the firms
capitalization structure (debt ,equity or retained earnings)..

5. CASES OF CAPITAL BUDGETING-
 Replacement
 Expansion
 Diversification
 Research and development
 Miscellaneous

6. CONCEPT OF CAPITAL BUDGETING-
 The term capital budgeting refers to long term planning for
proposed outlays (Expenditure)and their financing.
 It may defined as “the firms formal financial process for the
acquisition and investment of capital”
 It is the decision making process by which the firm evaluate
the purchase of major fixed asset.

7. IMPORTANCE OF CAPITAL
BUDGETING-
INVOLVEMENT OF HEAVY FUND-
Capital budgeting decisions require large capital outlays. It is therefore
absolutely necessary that the firm should carefully plan they are put to most
profitable use.
LONG TERM IMPLICATION-
The effect of capital budgeting decision will be felt by the firm over a long
period and therefore they have decisive influence on the rate and direction
of the growth of the firm.

8. CONT..
 IRREVERSIBLE DECISION-
In most cases, capital budgeting decisions are irreversible.
This is because it is very difficult to find a market for the capital
assets. The only alternative will be to scrap the capital assets
so purchased or sell them at a substantial loss in the event of
the decision being proved wrong.
MOST DIFFICULT TO MAKE-
The capital budgeting decision require an assessment of future
events which are uncertain . It is really difficult task to estimate
the probable future events, the probable benefits and cost
accurately in quantitative terms because of economic ,political,
social , and technological factors.

9. PROCESS OF CAPITAL BUDGETING-
 Capital budgeting is a difficult process to the investment of available
funds. The benefit will attained only in the near future but, the future is
uncertain.
 Identification of various investments proposals
 Screening or matching the proposals
 Evaluation
 Fixing priority
 Final approval
 Implementing
 Performance review of feedback

10. TECHNIQUES OF CAPITAL
BUDGETING-
 Pay Back Method
 Accounting rate of return
 Net Present Value
 Profitability Index

11. PAY BACK PERIOD-
 The payback period is the length of time required to recover
the initial cost of the project. The payback period is the length
of time required to recover the initial cost of the project. The
payback period therefore can be looked upon as the length
of time required for a proposal to break even on its net
investment.
 CALCULATION OF PAYBACK PERIOD-
 When Annual Inflow are Equal.
 When the Annual Cash Inflow are Unequal

12. MERITS-
 Simple to calculate
 Liquidity Indications
 Break even of investment can be calculated.
 DEMERITS-
Ignores the profitability factor.
Its is the method of recovery.
Ignores salvage Value.
Ignores the time value of money.

13. ACCEPT / REJECT CRIETERIA-
 If the actual pay-back period is less than the predetermined pay-back
period, the project would be accepted. If not, it would be rejected.

14. EXAMPLE-

15. CONT…

16. AVERAGE RATE OF RETURN-
 Average rate of return means the average rate of return or profit taken for
considering the project evaluation. This method is one of the traditional
methods for evaluating the project proposals:
 MERITS-
 1.It is easy to calculate and simple to understand.
 2. It is based on the accounting information rather than cash inflow.
 3. It is not based on the time value of money.
 4. It considers the total benefits associated with the project.
 DEMERITS-
 It ignores the time value of money.
 It ignores the reinvestment potential of a project.

17. ACCEPT / REJECT CRITERIA-
 If the actual accounting rate of return is more than the
predetermined required rate of return, the project would be
accepted. If not it would be rejected.

18. PROFITIBILITY INDEX-
 It is also a time adjusted method of evaluating investment proposal .
Profitability index also called as Benefit- Cost ratio or desirability factor is
relationship between present value of cash inflow and the present value of
cash outflow.
 FORMULA-
Present Value of Cash Inflow
Profitability Index =
Present Value of Cash Outflow
/Investment

19. MERITS-
 It is consistent with goal of maximizing the shareholders wealth.
 It uses cash flow.
 It recognized the time value of money.
DEMERITS-
The main demerit of this method is that is requires detailed long term
forecast of incremental benefits and costs. Its also have the difficulty in
determining appropriate discount rate.