Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.   An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments. What are the objectives of Capital budgeting? Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind: 1. Selecting  profitable projects An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.   2. Capital expenditure control Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.   3. Finding the right sources for  funds Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.   The following are the two methods: A) Traditional Method 1. Pay back period method 2. Improvement of traditional approach 3. Rate of Return Method or Accounting Method B) Time adjusted method or discount methods 4. Net Present Value method 5. Internal Rate of Return Method 6. Profitability Index Method

1. FINANCIAL
MANAGEMENT
CAPITAL BUDGETING
By:
Smt.UMA MINAJIGI REUR
HEAD, DEPT. OF COMMERCE & Management
Smt. V G Degree College for Women, Kalaburagi

2. CAPITAL BUDGETING
Capital budgeting, and investment appraisal, is the planning process used
to determine whether an organization's long term investments such as
new machinery, replacement of machinery, new plants, new products,
and research development projects are worth the funding of cash
through the firm's capitalization structure (debt, equity or retained
earnings). It is the process of allocating resources for major capital, or
investment, expenditures. One of the primary goals of capital budgeting
investments is to increase the value of the firm to the shareholders.

3. What is Capital Budgeting?
Capital budgeting is a process of evaluating investments and huge expenses in order
to obtain the best returns on investment.
An organization is often faced with the challenges of selecting between two
projects/investments or the buy vs replace decision. Ideally, an organization would
like to invest in all profitable projects but due to the limitation on the availability of
capital an organization has to choose between different projects/investments.

4. Your mobile phone has stopped working! Now,
you have two choices: Either buy a new one or
get the same mobile repaired. Here, you
may conclude that the costs of repairing the
mobile increases the life of the phone. However,
there could be a possibility that the cost to buy a
new cell phone would be lesser than its repair
costs. So, you decide to replace your cell phone
and you proceed to look at different phones that
fit your budget!
Capital budgeting as a concept affects
our daily lives. Let’s look at an example-

5. Capital Budgeting
Capital Budgeting is a process relating to the long term investment of capital funds in
which future profitability of capital investment proposal is studied, comparison of
earnings with costs in relation to cost of capital is made and finally a decision is taken
whether to invest or not. Thus, Capital Budgeting refers to the total process of
generating evaluating, selecting and follow-up of capital expenditure alternatives.

6. Definitions:
Prof I.M Pandy defines, “Capital Budgeting decision as the firm’s decision to invest it’s
current funds most efficiently in long term activities, in anticipation of an expected
flow of future benefits over a series of years.”
Hampton Johan J has defined Capital Budgeting as, “A firm’s formal planning process
for the acquisition and investment of capital”.

7. Objectives of Capital budgeting
What are the objectives of Capital budgeting?
Capital expenditures are huge and have a long-term effect. Therefore, while
capital budgeting analysis an organization must keep the following
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due
restrictions, an organization needs to select the right mix of profitable
increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital
However, controlling capital costs is also an important objective. Forecasting
expenditure requirements and budgeting for it, and ensuring no investment
are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is
important objective of capital budgeting. Finding the balance between the
borrowing and returns on investment is an important goal of Capital

8. Capital Budgeting Process
Capital Budgeting
Process
The process of
capital budgeting is
as follows:

9. 1. Identifying investment opportunities
An organization needs to first identify an investment opportunity. An investment
opportunity can be anything from a new business line to product expansion to purchasing
a new asset. For example, a company finds two new products that they can add to their
product line.
2. Evaluating investment proposals
Once an investment opportunity has been recognized an organization needs to evaluate
its options for investment. That is to say, once it is decided that new product/products
should be added to the product line, the next step would be deciding on how to acquire
these products. There might be multiple ways of acquiring them. Some of these products
could be:
•Manufactured In-house
•Manufactured by Outsourcing manufacturing the process, or
•Purchased from the market
Capital Budgeting Process

10. 3. Choosing a profitable investment
Once the investment opportunities are identified and all proposals are evaluated an
organization needs to decide the most profitable investment and select it. While
selecting a particular project an organization may have to use the technique of capital
rationing to rank the projects as per returns and select the best option available.
In our example, the company here has to decide what is more profitable for them.
Manufacturing or purchasing one or both of the products or scrapping the idea of
acquiring both.
4. Capital Budgeting and Apportionment
After the project is selected an organization needs to fund this project. To fund the
project it needs to identify the sources of funds and allocate it accordingly.
The sources of these funds could be reserves, investments, loans or any other available
channel.

11. 5. Performance Review
The last step in the process of capital budgeting is reviewing the investment. Initially,
the organization had selected a particular investment for a predicted return. So now,
they will compare the investments expected performance to the actual
performance.
In our example, when the screening for the most profitable investment happened, an
expected return would have been worked out. Once the investment is made, the
products are released in the market, the profits earned from its sales should be
compared to the set expected returns. This will help in the performance review.

12. 1. Identifying investment opportunities
2. Evaluating investment proposals
3. Choosing a profitable investment
4. Capital Budgeting and Apportionment
5. Performance Review
Capital Budgeting Process

13. Methods of Capital Budgeting
The following are the two methods:
A) Traditional Method
1. Pay back period method
2. Improvement of traditional approach
3. Rate of Return Method or Accounting Method
B) Time adjusted method or discount methods
4. Net Present Value method
5. Internal Rate of Return Method
6. Profitability Index Method

14. Pay Back Period Method
Pay back method is popularly known as pay-off or pay-out or replacement period
method.
According to this method, it measures the number of years required to recover the
original cash outlay invested in a project.
It measures the period of time for the original cost of project to be recovered from
the additional earnings of the project itself.
When there are two or more projects, the projects having the lesser number of pay-
back period within the standard recoupment period will be accepted.

15. The pay back period is calculated in the following manner:
1. Calculate annual earnings before depreciation after taxes because they are called
annual cash flows.
2. Divide the initial cost i.e, cost of investment by the annual cash inflow if the annual
earnings is constant.
𝑃𝑎𝑦 𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
3. If the annual earning is constant, in such cases, pay back period can be calculated
by adding up the cash inflows.

16. How to calculate Cost of the project:
Particulars Amount
Cost of land and building, Machine X
Tools and Equipment's XX
Add: Cost of installation and Erection charges X
XXX
Less: Tax concessions X
Cost of project (cash outflows) XX
Cost of project (Cash out flows) is calculated in the following manner:
Note: Salvage value is not considered while calculating cash outflow, because it
is releasable at the particular period.
4. If the annual profit is not constant i.e, unequal (Cumulative method)
The annual cash inflows is accumulated till the recovery of investment and as soon as this amount
recovered it is the expected number of years of pay back.

17. How to calculate pay back period:
If the annual earning is constant:
Calculated Annual earning (i.e, Profit) before depreciation and after taxes is called
Cash inflows.
𝑃𝑎𝑦 𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

18. Calculation of CashFlows After Tax (CFAT)
Method-I
Particulars Amount
Profit before Tax XXX
Less: Tax X
Profit after tax (PAT) XX
Add: Depreciation X
Add: Salvage Value X
Add: Recovery of working capital X
Profit before Depreciation and after tax (Annual Cash Inflows) XXX

19. Particulars Amount
Sales (Cash) XXX
Less: Operating expenses paid in cash X
Less: Depreciation X
Profit before tax XX
Less: Tax X
Profit after tax XX
Add: Depreciation X
Net cash inflows XXX
Calculationof CashFlows After Tax (CFAT)
Method-II

20. Thank You