This document discusses capital budgeting, which refers to the process of evaluating potential long-term investment projects. It describes the key aspects of capital budgeting including its meaning, significance, and common methods used. The capital budgeting process involves generating project proposals, evaluating them by estimating costs and benefits, selecting projects, and reviewing performance. Traditional methods for evaluating projects include payback period and accounting rate of return. Discounted cash flow methods, like net present value and internal rate of return, are also covered. The document provides details on how to calculate and apply each of these evaluation methods.

1. Capital Budgeting
Meaning of capital budgeting
Significance
Capital budgeting process
Investment criteria
Methods of capital budgeting

2. MEANING
 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 Horn green.

3.  The main features of capital budgeting are
a. potentially large anticipated benefits
b. a relatively high degree of risk
c. relatively long time period between the initial
outlay and the anticipated return.
- Oster Young

4. Significance of capital budgeting
 The success and failure of business mainly
depends on how the available resources are
being utilized.
 Main tool of financial management
 All types of capital budgeting decisions are
exposed to risk and uncertainty.
 They are irreversible in nature.
 Capital rationing gives sufficient scope for the
financial manager to evaluate different
proposals and only viable project must be
taken up for investments.
 Capital budgeting offers effective control on
cost of capital expenditure projects.
 It helps the management to avoid over
investment and under investments.

5. Capital budgeting process involves the following
1. Project generation: Generating the proposals for
investment is the first step.
The investment proposal may fall into one of the following
categories:
 Proposals to add new product to the product line,
 proposals to expand production capacity in existing
lines
 proposals to reduce the costs of the output of the
existing products without altering the scale of
operation.
 Sales campaigning , trade fairs people in the industry,
R and D institutes, conferences and seminars will offer
wide variety of innovations on capital assets for
investment.

6. 2. Project Evaluation: it involves two steps
 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
uncertainties. The risk associated with each
project must be carefully analyzed and
sufficient 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
maximizing its market value. The technique
of time value of money may come as a
handy tool in evaluation such proposals.

7. 3. 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.
4. Project Evaluation: Once the proposal for
capital expenditure is finalized, 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.

8. The follow up, comparison of actual
performance with original estimates not
only ensures better forecasting but also
helps in sharpening the techniques for
improving future forecasts.

9. Factors influencing capital budgeting
 Availability of funds
 Structure of capital
 Government policy
 Lending policies of financial institutions
 Immediate need of the project
 Earnings
 Capital return
 Economical value of the project
 Working capital
 Trend of earnings

10. Methods of capital budgeting
Traditional methods
 Payback period
 Accounting rate of return method
Discounted cash flow methods
 Net present value method
 Internal rate of return

11. Pay back period method
It refers to the period in which the project will
generate the necessary cash to recover the initial
investment.
It does not take the effect of time value of money.
It emphasizes more on annual cash inflows,
economic life of the project and original
investment.
The selection of the project is based on the earning
capacity of a project.
It involves simple calculation, selection or rejection of
the project can be made easily, results obtained is
more reliable, best method for evaluating high risk
projects.

12. Cons
 Does not recognize importance of time value
of money,
 Does not consider profitability of economic life
of project,
 Does not recognize pattern of cash flows,
 Does not reflect all the relevant dimensions of
profitability.

13. Accounting Rate of Return method
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.
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.

14. Net present value method
It recognizes 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
investment. If the difference shows (-)
negative values, it will be rejected.

15. Pros:
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows
by using a discount rate equal to the cost of
capital.
It is consistent with the objective of maximizing
the welfare of owners.
Cons:
It is very difficult to find and understand the
concept of cost of capital
It may not give reliable answers when dealing
with alternative projects under the conditions
of unequal lives of project.

16. Internal Rate of Return
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.

17. Merits of IRR method
 It consider the time value of money.
 IRR attempts to find the maximum rate of
interest at which funds invested in the project
could be repaid out of the cash inflows arising
from the project.
 It is not in conflict with the concept of
maximizing the welfare of the equity
shareholders.
 It considers cash inflows throughout the life of
the project.

18. Cons
 Computation of IRR is tedious and difficult to
understand
 Both NPV and IRR assume that the cash inflows
can be reinvested at the discounting rate in
the new projects. However, reinvestment of
funds at the cut off rate is more appropriate
than at the IRR.
 IT may give results inconsistent with NPV
method. This is especially true in case of
mutually exclusive project.

19. Thank You