Capital budgeting is the process of analyzing potential long-term investments and projects to determine which ones are worth undertaking. It involves analyzing projects with large capital expenditures that will impact the firm's future. Some key techniques for capital budgeting include net present value (NPV), internal rate of return (IRR), and profitability index. NPV and IRR are consistent with maximizing shareholder wealth if all cash flows are considered and the time value of money is incorporated. Capital rationing occurs when a firm has more projects with positive NPVs than available funds to invest, requiring some worthwhile projects to be declined due to artificial budget constraints.

1. What is capital budgeting ?
 Analysis of potential additions to fixed assets.
 Long-term decisions; involve large expenditures.
 Very important to firm’s future.
 The process ofdetermining which potential long-term projects are
worth undertaking, by comparing their expected discounted cash
flows with their internal rates of return.
 Capital budgeting addresses the issue of strategic long-term
investment decisions.
 Capital budgeting can be defined as the process ofanalyzing,
evaluating, and deciding whether resources should be allocated to a
project or not.
 Process ofcapital budgeting ensure optimal allocation of resources
and helps management work towards the goal of shareholder
wealth maximization.

2. Types of CapitalBudgetingDecisions
 Should we add a new productto our existing productline?
 Should we expand into a new market?
 Should we replace our existing machinery?
 Should we buy fully automatic or semiautomatic machinery?
 Where to locate manufacturing facility?
 Should we outsourcecomponents and parts?
Why CapitalBudgetingis so Important?
 Involve massive investment of resources
 Are not easily reversible
 Have long-term implications for the firm
 Involve uncertainty and risk for the firmDue to the above factors, capital
budgeting decisions becomecritical and must be evaluated very carefully.
 Any firm that does not follow the capital budgeting process will not be
maximizing shareholder wealth and management will not be acting in the
best interests of shareholders.
 RJR Nabisco’s smokeless cigarette project example
 Similarly, Euro-Disney, ConcordePlane, Saturn of GM all faced
problems due to bad capital budgeting, while Intel became global leader
due to sound capital budgeting decisions in 1990s.

3. Techniques of CapitalBudgeting
 Analysis PaybackPeriod Approach
 Discounted PaybackPeriod Approach
 Net Present Value Approach
 Internal Rate of Return
 Profitability Index
Which Techniqueshould we follow?
 A techniquethat helps us in selectingprojects that
are consistentwith the principleof shareholder
wealth maximization.
 A techniqueis consideredconsistentwith wealth
maximization if
o It is based on cash flows
o Considers all the cash flows
o Considers time value of money
o Is unbiased in selecting projects

4. Payback PeriodApproach
 The amountof time needed to recover the initial investment
 The numberof years it takes including a fraction of the year to
recover initial investment is called paybackperiod
 To compute paybackperiod, keep adding thecash flows till the sum
equalsinitial investment
 Simplicity is the main benefit, but suffers from drawbacks
 Techniqueis not consistent with wealth maximization—Why?
DiscountedPaybackPeriod
 Similar to payback period approachwith one difference that it
considers time value of money
 The amount of time needed to recover initial investment given the
present value of cash inflows
 Keep adding the discounted cashflows till the sum equals initial
investment
 All other drawbacks of the payback period remains in this approach
 Not consistent with wealth maximization

5. Net Present Value Approach
 Based on the dollar amount of cash flows
 The dollar amount of value added by a project
 NPV equals the present value of cash inflows minus initial investment
 Technique is consistent with the principle of wealth maximization—
Why?
 Accept a project if NPV > 0
Internal Rate of Return
 The rate at which the net present value of cash flows of a project is zero,
I.e., the rate at which the present value of cash inflows equalsinitial
investment
 Consistent with wealth maximization
 Accept a project if IRR > Cost of Capital
ProfitabilityIndex(PI)
 A part of discounted cash flow family
 PI = PV of Cash Inflows/initial investment
 Accept a project if PI > 1.0, which meanspositive NPV

6.  Usually, PI consistent with NPV
 PI may be in conflict with NPV if
 Projects are mutuallyexclusive
 Scale of projects differ
 Pattern of cash flows of projects is different
 When in conflict with NPV, use NPV
Capital Rationing
 Many companies specify an overall limit on the total budget for
capital spending. There is no
 conceptual justification for such budget ceiling, because all projects
that enhance long run profitability should be accepted.
 The factors for putting limit
 Net present values or IRR may strongly influence the overall
budget amount
 Top management’s philosophy toward capital spending.
 Same managers are highly growth minded whereas others are not.
 The outlook for future investment opportunities that may not be
feasible if extensive
 current commitments are undertake.
 The funds provided by the current operations less dividends.
 The feasibility of acquiring additional capital through borrowing or
sale of additional stock. Lead-time and costs of financial market
transactions can influence spending.

7.  Period of impending change in management personnel, when the
status quo is maintained.
Management attitudes toward not.
Capital Rationing occurs when a company has more amounts of
capital budgeting projects with positive net present values than it
has money to invest in them. Therefore, some projects that should
be accepted are excluded because financial capital is limited. This
is known as artificial constraint because the management may
dictate the amount to be invested for project purposes.
It is also the artificial constraints because the amount is not based
on the product marginal analysis in which the return for each
proposalis related to the costof capital and projects
with net present values are accepted.
A company may adopt a posture of capital rationing because it is
fearful of too much growth or hesitant to use external sources of
financing.
Types of Capital Rationing
•
Hard Capital Rationing: This arises when constraints are
externally determined.
This will not occur under perfect market
•
Soft Capital Rationing: This arises with internal, management-
imposed limits on
investment expenditure.

8. Reasons for Capital Rationing
There are basically two types of reasons of capital rationing.
•
External Reasons
These arise when a firm is unable to borrow from the outside. For example if
the firm is under financial distress, tight credit conditions, firm has a new
unproven product. Borrowing limits are imposed by banks particularly in
relation to smaller firms and individuals.
Internal Reasons
o
Private owned company: Owners might decide that expansion is a trouble
not worth taking. For example there may that management fear to lose their
control in the company.
Divisional Constraints: Upper management allocates a fixed amount for each
division as part of the overall corporate strategy. This arise from a point of
view of a department, cost centre or wholly owned subsidiary, the budgetary
constraints determined by senior management or head office.
o
Human Resource Limitations: Company does not have enough middle
management to manage the new expansions
Dilution: For example, there may be a reluctance to issue further equity by
management fearful of losing control of the company.
Debt Constraints:
Earlier debt issues might prohibit the increase in the firms debt beyond a
certain level, as stipulated in previous debt contracts.
Forexample bondholders requiring in the bond contract, that they would
accept a maximum Debt-to-Asset ratio = 40%.

9. Capital Rationing could be said to signal a managerial failure to convince
suppliers of funds of the value of the available projects. Although there may be
something in this argument, in practice it is not a well-informed judgement.
Furthermore, even if there were no limits on the total amounts of available
finance, in reality the price may vary with the size as well as the term of the
loan. the total amounts of available finance, in reality the price may vary with
the size as well as the term of the loan.