Capital budgeting is the process of evaluating potential capital expenditures. It involves analyzing proposed investments in fixed assets and choosing those that will provide the best return. The key steps in capital budgeting are: evaluating investment proposals, screening proposals, analyzing the proposals using techniques like net present value (NPV), internal rate of return (IRR), and payback period, setting priorities, approval of budget, implementation, and performance review. NPV and IRR are discounted cash flow methods that account for the time value of money, making them generally preferred over traditional methods like payback period and accounting rate of return.

1. 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
Horngreen.

3. • “Capital budgeting consists in planning development of
available capital for the purpose of maximising the long term
profitability of the concern” – Lynch
• 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 utilised.
• 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
Investment proposals
Screening the proposals
Evaluation of various proposals
Fixing priorities
Final approval and preparation of capital expenditure
budget
Implementing proposal
Performance review

6. Factors influencing capital budgeting
• Availability of funds
• Structure of capital
• Taxation policy
• Government policy
• Lending policies of financial institutions
• Immediate need of the project
• Earnings
• Capital return
• Economical value of the project
• Working capital

7. Methods of capital budgeting
Traditional methods
• Payback period
• Accounting rate of return method
Discounted cash flow methods
• Net present value method
• Profitability index method
• Internal rate of return

8. 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 calcuation, selection or rejection of
the project can be made easily, results obtained is
more reliable, best method for evaluating high risk
projects.

9. Cons
• It is based on principle of rule of thumb,
• 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.

10. Example: 1
• Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs 12,500
for 7 years. The payback period for the project is:
• Pay back period= 50000 = 4Years
12500

11. Example: 2
• Unequal cash flows In case of unequal cash inflows, the
payback period can be found out by adding up the cash
inflows until the total is equal to the initial cash outlay.
• Suppose that a project requires a cash outlay of Rs
20,000, and generates cash inflows of Rs 8,000; Rs 7,000;
Rs 4,000; and Rs 3,000 during the next 4 years. What is
the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months

12. Improvement in the traditional
approach to pay back period
method
• A) Post pay- back profitability method.
• B) Post pay -back period method.
• C) Discounted pay- back method.
• D) Pay – back reciprocal method.

13. A) Post pay- back profitability method.
• One of the serious limitation of pay-back period method is it
does not take into account the cash inflow earned after pay-
back period and hence the profitability of the project cannot
be assessed.
• Hence an, improvement over this method can be made by
taking into account the returns receivable beyond pay-back
period.
• Post pay-back profitability index = Post pay- back profits*100
Investment

14. Example:

15. Solution:

16. 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.
• This method of ARR is not commonly accepted in assessing
the profitability of capital expenditure. Because the method
does to consider the heavy cash inflow during the project
period as the earnings with be averaged. The cash flow
advantage derived by adopting different kinds of depreciation
is also not considered in this method.

17. 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.
Merits
• It is very simple to understand and use.
• This method takes into account saving over the entire
economic life of the project. Therefore, it provides a better
means of comparison of project than the pay back period.
• This method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects and

18. Demerits
• 1. It ignores time value of money.
• 2. It does not consider the length of life of the projects.
• 3. It is not consistent with the firm's objective of maximizing
the market value of shares.
• 4. It ignores the fact that the profits earned can be
reinvested. -
Average rate of return = Average annual profits *100
Net investment in the project

19. Example:

20. Discounted cash flow method
Time adjusted technique is an improvement over pay back
method and ARR. An investment is essentially out flow of
funds aiming at fair percentage of return in future.
The presence of time as a factor in investment is
fundamental for the purpose of evaluating investment. Time
is a crucial factor, because, the real value of money fluctuates
over a period of time. A rupee received today has more value
than a rupee received tomorrow.
In evaluating investment projects it is important to consider
the timing of returns on investment. Discounted cash flow
technique takes into account both the interest factor and the
return after the payback 'period.

21. Discounted cash flow technique involves the following
steps:
• Calculation of cash inflow and out flows over the
entire life of the asset.
• Discounting the cash flows by a discount factor
• Aggregating the discounted cash inflows and
comparing the total so obtained with the discounted
out flows.

22. C) Discounted pay- back
method.

23. 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 invesment. If the difference
shows (-) negative values, it will be rejected.

24. 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.

25. Example: 1

26. Solution: Project x
Year Cash Flows Present value @10%(
Discount Factor)
Present value of
cash lows
1 5000 .909 4,545
2 10000 .826 8,260
3 10000 .751 7,510
4 3000 .683 2,049
5 2000 .621 1,242
5 1000 .621 621
Total cash Inflow 24,227
Present value of all cash
inflow
24,227
Less: Present value of Initial
investment
20,000
NPV: 4,227

27. Solution: Project Y
Year Cash Flows Present value @10%(
Discount Factor)
Present value of
cash lows
1 20000 .909 18,180
2 10000 .826 8,260
3 5000 .751 3,755
4 3000 .683 2,049
5 2000 .621 1,242
5 2000 .621 1,242
Total cash Inflow 34,728
Present value of all cash
inflow
34,728
Less: Present value of Initial
investment
30,000
NPV: 4,728

28. Example: 1

29. Solution: Present value of cash outflow
Year Cash Flows Present value @10%(
Discount Factor)
Present value of
cash lows
1 150000 1 1,50,000
2 30000 .909 27,270
Total cash outflows 1,77,270

30. Solution:
Year Cash Flows Present value @10%(
Discount Factor)
Present value of
cash lows
1 20000 .909 18,180
2 30000 .826 24,780
3 60000 .751 45,060
4 80000 .683 54,640
5 30000 .621 18,600
5 40000 .621 24,800
Total cash Inflow 1,86,060
Present value of all cash
inflow
1,86,060
Less: Present value of Initial
investment
1,77,270
NPV: 8,790

31. 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.

32. Merits of IRR method
• It consider the time value of money
• Calculation of casot of capital is not a prerequisite for adopting IRR
• 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 maximising the welfare of the equity
shareholders.
• It considers cash inflows throughout the life of the project.

33. 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.

35. NPV versus IRR
• Usually, NPV and IRR are consistent with each other. If
IRR says accept the project, NPV will also say accept
the project and both the techniques are similar in the
sense that both are modern techniques of capital
budgeting and both takes into account the time value
of money.
• IRR can be in conflict with NPV if
Investing or Financing Decisions
Projects are mutually exclusive
Projects differ in scale of investment
Cash flow patterns of projects is different
If cash flows alternate in sign—problem of multiple IRR
• If IRR and NPV conflict, use NPV approach

36. Profitability Index (PI)
• A part of discounted cash flow family
• PI = PV of Cash Inflows / initial investment
• Accept a project if PI ≥ 1.0, which means positive
NPV and is rejected in case the profitability index
is less than one.
• Usually, PI consistent with NPV

37. Advantages of PI
• This method is slight modification of the NPV method. The NPV has one
drawback that it is not easy to rank projects on the basis of this method
particularly when the costs of the project differ significantly. To evaluate
such projects, the profitability index method is most suitable.

38. Example:
• The initial ash outlay of the project is Rs 50,000 and it generates cash
inflow of Rs. 20,000, 15,000, 25,000 and 10,000 in four years. Using the
present value index method, appraise profitability of proposed investment
assuming 10% rate of discount.

40. Which technique is superior?
• Although our decision should be based on
NPV, but each technique contributes in its
own way.
• Payback period is a rough measure of
riskiness. The longer the payback period,
more risky a project is
• IRR is a measure of safety margin in a project.
Higher IRR means more safety margin in the
project’s estimated cash flows
• PI is a measure of cost-benefit analysis. How
much NPV for every dollar of initial investment

41. Step 1:Calculation of cash outflow
Cost of project/asset xxxx
Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx

42. Step 2: Calculation of cash inflow
Sales xxxx
Less: Cash expenses xxxx
PBDT xxxx
Less: Depreciation xxxx
PBT xxxx
less: Tax xxxx
PAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx

43. Step 3: Apply the different techniques
• Pay back period= No. of years + Amt to recover/
total cash of next years.
• ARR = Average Profits after tax/ Net investment x
100
• NPV= PV of cash inflows – PV of cash outflows
• Profitability index = PV of cash inflows/ PV of cash
outflows
• IRR :
Pay back factor: Cash outflow/ Avg cash inflow p.a.
Find IRR range
PV of Cash inflows for IRR range and then calculate

44. references
• https://www.slideshare.net/.../profit-maximization-vs-wealth-
maximization-50539341
• https://keydifferences.com/difference-between-profit-maximization-and-
wealth-maximization.html
• https://www.investopedia.com/terms/t/timevalueofmoney.asp
• https://efinancemanagement.com › Sources of Finance

45. Suggested Readings
 Chandra, Prasanna “Financial Management”, Tata McGraw
Hill, New Delhi
 James C Van Horne, Financial Management, Prentice-Hall,
New Delhi
 Khan M.Y. & Jain P.K, Financial Mangement, Tata McGraw
Hill, New Delhi
 Pandey I.M “Financial Management”, Vikas Publishing
House, New Delhi
 Reference Material –
 Maheshwari S.N. “Principles of Financial Management”,
Sultan Chand & Sons, New Delhi
 Kulkarni P.V. “Financial Management”, Himalaya Publishing
House, Mumbai