Capital budgeting is the process of evaluating long-term investment projects. It involves estimating the future cash flows of a project, including initial costs and future annual cash inflows. Discounted cash flow methods like NPV, IRR and profitability index are commonly used to evaluate projects, but simpler methods like payback period and average rate of return are also used in practice due to uncertainty and limited funds. While NPV is preferred in theory, profitability index may be better when funds are constrained. Multiple techniques are often considered together to make capital budgeting decisions.

1. Capital Budgeting
Sandeep Vyas

2. Meaning of Capital Budgeting
Capital Budgeting is the process of evaluating
and selecting long term investments proposals
that are consistent with the goals of
shareholders (owners) wealth maximisation.
It is a process relating to the long term
investment of capital funds in which future
profitability of capital investment proposal is
studied.
Future profitability: inflow of profits or/and
reduction in costs.

3. In capital budgeting, decisions are taken on long
term assets (more than one year) which yield
returns (cash inflows) over a period of time
(during their economic life) but involve investment
(capital expenditure or cash outflows) at present.
Capital expenditure is using of funds that is
expected to produce benefits over a period of
time exceeding one year.
Thus, Capital Budgeting is the total process of
generating, evaluating, selecting, executing and
following up of capital expenditure alternatives.

4. Estimates of Costs and Benefits or
cash flows of a proposal
In capital budgeting decisions, the costs
and benefits of a proposal are measured
in terms of cash flows. Net Cash inflows
refers to cash revenue minus cash
expenses.
Costs Cash outflows
Benefits Cash inflows

5. Cash flows associated with a proposal
usually involves the following three types
of cash flows:
1. Initial Investment or cash outflows.
2. Net annual cash inflows.
3. Terminal cash inflows.

6. Terminal cash Flows
These are cash inflows for the last or
terminal year of the project and include the
following:
1. Estimated salvage or scrap value of the
project realisable at the end of the
economic life of the project or at the time
of its termination.
2. Working capital released.

7. Computation of Initial Investment
PARTICULARS Rs.
Purchase price of the asset
(including duties, taxes if any) xxx
Add: Insurance, Freight and installation
Costs xxx
Add: opportunity cost (if any) xxx
Add: increase in working capital xxx
Less: cash inflows in the form of scrap
or salvage value of the old asset (in case
of replacement decision) xxx
Less: decrease in working capital xxx

8. Net annual cash inflows or operating cash
flows =
Sales-Expenses-Depreciation-Tax +
Depreciation
OR
EBT- Tax + Depreciation

9. Net annual cash inflows may also be determined
by making profitability statement:
Particulars Rs.
Annual Sales Revenue xxx
Less: operating expenses including depreciation xxx
Income before tax xxx
Less: Income tax xxx
Net income after tax (PAT,EAT) xxx
Add: Depreciation xxx
NET CASH FLOWS xxx
(Net annual cash inflows)

10. Profitability Statement (in cost reduction decisions)
(A) ESTIMATED SAVINGS Rs.
Estimated savings in direct wages xxx
Estimated savings in scrap xxx
Total Savings (a) xxx
(B) ESTIMATED ADDITIONAL COSTS Rs.
Additional cost of maintenance xxx
Additional cost of supervision xxx
Add: Cost of indirect material xxx
Additional depreciation xxx
Total Additional costs (b) xxx
Net Savings before tax (a-b) xxx
Less : Income tax xxx
Net savings after tax xxx
Add : Additional Depreciation xxx
NET SAVINGS AFTER TAX OR CASH INFLOWS XXX

11. Cash outflows in a replacement
situation
1. Cost of the new machine.
2. + Installation Cost.
3. (+)Increase or (-)decrease in
working capital.
4. - sale proceeds of existing machine.

12. Types of capital budgeting
decisions
From the view point of firm’s existence :
1. New firm
2. Existing firm
a) Replacement and modernisation decision
b) Expansion
c) Diversification

13. From the view point of decision situation
1. Accept Reject decisions
2. Mutually Exclusive decisions
3. Capital Rationing

14. Capital Budgeting decisions and
funds availability
Every firm has only limited funds available
and these funds should be used judicially i.e.
wealth of shareholders should be maximised
Therefore only those decisions are to be
implemented which fulfil the following two
conditions :
1. The cost of the project does not exceed the
funds available
2. The benefits expected from the project are
more than the cost

15. Techniques of Capital Budgeting
Non-Discounting Techniques:
1. Payback Method.
2. Average Rate of Return.
Discounting Techniques:
1. NPV Method.
2. IRR Method.
3. Profitability Index.

16. Merits and Demerits of
Appraisal Methods

17. NPV Method
Advantages
1. Recognition of time value of money
2. All cash flows are considered
3. Profitability objective
4. Follows wealth maximization principle

18. NPV
Limitations
1. Difficult to obtain estimates of future cash flows due
to uncertainty of future
2. Difficult to measure precisely the discount rate
3. Caution must be exercised while evaluating
alternative projects with unequal lives
4. A project with a higher NPV may require higher
investment which can not be suitable for company
having funds constraints
5. In comparison to Payback period this is difficult to
understand and calculate

19. IRR
Advantages
1. Recognition of time value
2. All cash flows
3. Easier to understand
4. It does not use the concept of cost of capital rather
it itself provides a rate of return which is indicative
of the profitability of the proposal
5. Maximisation of shareholders wealth
6. Proposal selection
7. More practical

20. IRR
Drawbacks
1.Calculation is complicated
2.In mutually exclusive the IRR rule may
pick up the project to the exclusion of
others which may not be the most
profitable and consistent with the
objectives of firm

21. Profitability Index
The profitability index is an appraisal technique
applied to capital budgeting
The method divides the projected capital inflow by the
projected capital outflow to determine the profitability
of a project.
It is arrived at by dividing total present value of cash
inflows by total present value of cash outflows:
P.I = Total PV of Cash inflows/Total PV of cash outflows
or initial investment.
• It tells that if you invest one rupee in a project how
much will you get in return.
• Decision criterion = Accept the project if PI is more
than 1 and reject if PI is less than 1

22. PI Method
It satisfies almost all requirements of a sound
investment criterion
It considers the elements of capital budgeting
such as the time value of money totality of
benefits and so on
Conceptually it is a sound method of capital
budgeting
Although based on the NPV it is a better
evaluation technique than NPV in a situation
of capital rationing.

23. Appraisal of ARR Method
Advantages
It is easy to calculate
Simple to understand and use
Total benefits associated with the project
are considered
Proper decision making

24. Disadvantages
1. Use of accounting income instead of cash
flows. The cash flow approach is superior over
the accounting income for project appraisal
2. Does not take into account the time value of
money
3. The ARR criterion does not differentiate
between the size of investment required for each
project. Competing investment proposals may
have the same ARR but may require different
average investments

25. Pay Back Method
Advantages
1. Easy to calculate and simple to understand
2. An improvement over the ARR approach as it
is based on real cash flow analysis.

26. Demerits
1. It completely ignores all cash inflows
after the pay back period which can be
very misleading ( table 9.8 page 9.31
Khan and Jain)
2. It ignores time value of money

27. Conflicts in Decision Making

28. NPV versus IRR
Superiority of IRR over NPV :
1. Basis – IRR gives percentile result while
NPV gives result in absolute amount
2. Required Rate of Return – For
calculating IRR, required rate of return is
not a pre- requisite while it is must for
NPV

29. Superiority of NPV over IRR
1. NPV shows the expected increase in
wealth of shareholders
2. NPV gives better ranking as compared to
IRR

30. Comparison between NPV and IRR
Basis NPV IRR
1. Cash Flows Cash flows are
discounted at pre
determined discount rate
based on cost of capital
Cash flows are not
discounted at
predetermined rate but
arrived at by trial and
error method
2. Reinvestment Cash flows are
presumed to be
reinvested at the cut off
rate
Cash inflows are
presumed to be
reinvested at the internal
rate of return

31. NPV versus Profitability Index
Year Project A Project B
0 (50000) (35000)
1 40000 x(.909) 30000x(.909)
2 40000 (.826) 30000x(.826)
PV of C.I 69400 52050
P. I 69400/50000= 1.38 52050/35000= 1.48
NPV 69400-50000 = 19400 52050-35000= 17050

32. Project A is acceptable under the NPV method,
while project B under the P.I method
While comparing these two capital budgeting
techniques NPV method should be given
preference and project with higher NPV should
be selected as it increases shareholder’s wealth
But when Capital Rationing is considered P.I
method should be given preference over NPV
method

33. Appraisal Methods in Practice
Most of the proposals are meant either for the
replacement of some worn out equipment
forming part of a production complex or for
adding capacity at some stage of production
to ensure better balancing of capacities at
various stages. In such cases it is difficult to
evaluate independently the cost effectiveness
of proposed investments. They are usually
labelled ‘urgent’ leaving no room for thinking.

34. Project proposals are reviewed at two or
three levels before a final decision and the
judgement of reviewing authorities is
regarded more important than detailed
analysis
It is difficult to estimate accurately the costs
and revenues associated with capital
investments
In many cases only one type of equipment or
machinery satisfies the specific requirements

35. The most commonly used method for
evaluating investments of small size is the
payback method. Reasons are insufficient
funds, returns are not assured so project with
shorter payback period is selected,
components have a life of two to three years,
shorter the payback period higher the return.
For larger investments average rate of return
is commonly used as the main criterion while
payback period is used as the secondary.

36. Discounted cash flow techniques are
gaining importance particularly in the
evaluation of large investments