CAPITAL BUDGETING- DEFINITON - STEPS INVOLVED IN THE CAPITAL BUDGETING AND DIFFERENT TECHNIQUES OF CAPITAL BUDGETING

1. CAPITAL BUDGETING
MR.N.DEVARAM, ASSISTANT PROFESSOR, SRCAS

2. CAPITAL BUDGETING
 The term capital budgeting or investment decision means planning for capital
assets. Capital budgeting decision means the decision as to whether or not to
invest in long-term projects such as setting up of a factory or installing a machinery
etc. It includes the financial analysis of the various proposals regarding capital
expenditure to evaluate their impact on the financial condition of the company for
the purpose to choose the best out of the various alternatives.

3. DEFINITION OF CAPITAL BUDGETING
 According to Charles T. Horngren, “Capital Budgeting is long-
term planning for making and financing proposed capital
outlays.”

4. NATURE OF CAPITAL BUDGETING
 It is a long-term investment decision.
 It is irreversible in nature.
 It requires a large amount of funds.
 It is most critical and complicated decision for a finance manager.
 It involves an element of risk as the investment is to be recovered in
future.

5. STEPS IN THE CAPITAL BUDGETING PROCESS
 1) Identifying the investment opportunities
 2) Gathering investment proposals
 3) Deciding on projects for capital budgeting
 4) Preparation and Appropriation in Capital Budgeting
 5) Implementation of Capital Budgeting
 6) Performance review

6. CAPITAL BUDGETING TECHNIQUES
Traditional methods
Discounted Cash flow methods

7. TRADITIONAL METHODS
 These methods are based on the principles to determine the
desirability of an investment project on the basis of its useful
life and expected returns. These will not take into account the
concept of „time value of money , which is a significant factor
‟
to determine the desirability of a project in terms of present
value.

8. PAY-BACK PERIOD METHOD:
 According to James. C. Vanhorne, “The payback period is the number
of years required to recover initial cash investment.
 If the annual cash Inflows are constant or uniform, the pay back
period can be computed by dividing cash outlay by annual cash
Inflows.

9. AVERAGE RATE OF RETURN
 Accounting Rate of Return (ARR) is the average net income
an asset is expected to generate divided by its average
capital cost, expressed as an annual percentage.
 According to Soloman, accounting rate of return on an
investment can be calculated as the ratio of accounting net
income to the initial investment.

10.  Accounting Rate of return (on Original Investment)
 ARR = Average Annual Profit / Initial Investment
 Accounting Rate of return (on Average Investment)
 ARR = Average Annual Profit / Average Investment
 Average Investment = Initial Investment/2

11. DISCOUNTED CASH FLOW METHODS:
 The traditional method does not take into consideration the
time value of money. They give equal weight age to the present
and future flow of incomes. The DCF methods are based on the
concept that a rupee earned today is more worth than a rupee
earned tomorrow. These methods take into consideration the
profitability and also time value of money.

12. DISCOUNTED CASH FLOW TECHNIQUES INCLUDES
 Net present value method
 Profitability Index method
 Internal rate of return method
 Modified Internal rate of return method

13. NET PRESENT VALUE METHOD:
 The NPV takes into consideration the time value of money.
The cash flows of different years and valued differently and
made comparable in terms of present values for this the net
cash inflows of various period are discounted using required
rate of return which is predetermined.

14. PROFITABILITY INDEX METHOD:
Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI
approach measures the present value of returns per rupee invested. It is observed
in shortcoming of NPV that, being an absolute measure, it is not a reliable method to
evaluate projects requiring different initial investments. The PI method provides
solution to this kind of problem.

15. INTERNAL RATE OF RETURN METHOD:
The IRR for an investment proposal is that discount rate which equates the present
value of cash inflows with the present value of cash out flows of an investment. The
IRR is also known as cutoff or handle rate. It is usually the concern s cost of capital.
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16. MODIFIED INTERNAL RATE OF RETURN METHOD:
 The modified internal rate of return (MIRR) is the return on an investment,
considering not only the cash flows of the investment, but the earnings on these
cash flows based on a specific reinvestment rate. Modified internal rate of return
(MIRR) is a capital budgeting tool which allows a project cash flows to grow at a
rate different than the internal rate of return.