Capital budgeting involves identifying and selecting investment projects for long-term returns, affecting a firm's growth and risk. It includes project classification, types, and various techniques such as net present value (NPV), internal rate of return (IRR), and profitability index (PI) to evaluate the viability of projects. Decision criteria are established for acceptance based on financial metrics like payback period, NPV, IRR, and PI.

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Capital Budgeting
When should growing trees be
harvested, or when should
aging mango juice be bottled?

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Concept of Capital Budgeting
The process of
identifying, analyzing,
and selecting investment
projects whose returns
(cash flows) are
expected to extend
beyond one year.
Should we
build this
plant?

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Significance of Capital Budgeting
i. To influence the firm’s growth in the long
run.
ii. To affect the risk of the firm.
iii. To involve huge amount of funds.
iv. It can not easily be changed without
considerable financial loss.

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The Capital Budgeting Process
 Select projects based on a value-maximizing
acceptance criterion.
 Re-evaluate implemented investment projects
continuously and perform post audits for
completed projects.

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Classification of Investment Project
Proposals
i. New Products or expansion of existing
products.
ii. Replacement of existing equipment or
buildings.
iii. Research and development.
iv. Exploration.
v. Other (e.g., safety or pollution related)

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Types of Project
 Independent Project: The
acceptance the one
project’s does not eliminate
the acceptance of others.
 Mutually Exclusive Project :
The acceptance the one
project’s eliminates the
acceptance of others.

7. Techniques of Capital Budgeting
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Capital Budgeting
Technique
Discounting
Criteria Non-discounting Criteria
Net present
value (NPV)
Internal rate of
return (IRR)
Profitability
index (PI)
Payback period
(PB)
Accounting rate of
return
(ARR)
Discounted
payback period
Net Terminal
Value (NTL)

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Techniques of Capital Budgeting
i. Pay Back Period (PBP): It refers to the
number of years required to recover the
initial investment in the form of cumulative
cash inflows.

9. Decision Criterion:
If actual PBP is less than standard
PBP accept the project and vice
versa.
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ii. Net Present Value (NPV): It is one of the
capital budgeting techniques, recognizing
the time value of money.
NPV = ∑ {Net Period Cash Flow / (1+R)T} - Initial
Investment
where R is the rate of return, and T is the number
of time periods.

11. Decision Criterion:
If NPV is greater than zero accept
the project and vice versa.
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iii. Internal Rate of Return (IRR): The discount
rate of a project which makes it NPV equal
to zero.
Decision Criterion:
Accept the project if IRR is greater than cost
of capital and vice versa.

13. Profitability Index Technique
 Profitability index (PI) also known as Benefit
Costs Ratio measures the present value of
returns (cash inflows) peer taka invested. It is
a relative measure which is obtained by
dividing the present value of future cash
inflows by the present of cash out flows.
Symbolically –
 PI = PV of cash inflows/PV of cash out flows
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14.  Acceptance Rule:
 A project will qualify for acceptance if
its PI exceeds 1, the rules are as
follows:
 Accept if PI > 1,
 Reject if PI < 1, and
 May accept if PI = 1
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