Capital budgeting is the process of planning long-term investments and allocating funds. It involves analyzing potential capital projects to determine which will be most profitable. Some key aspects of capital budgeting include evaluating projects based on cash flows rather than accounting profits, considering opportunity costs and tax implications, and ensuring project rates of return exceed the required cost of capital. Common techniques for evaluating projects include net present value analysis, internal rate of return, payback period, and profitability index. Capital budgeting helps firms make optimal investment decisions to maximize long-term value.

1. FINANCIAL MANAGEMENT
CAPITAL BUDGETING
PRESENTED BY :- ANIL
RANA

2. CAPITAL BUDGETING
Capital budgeting or 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. CHARACTERISTICS OF CAPITAL BUDGETING
Capital expenditure for long period
Forecasting
Planning asset capacities

4. PRINCIPLES OF CAPITAL BUDGETING
Capital budgeting has five principles that play a crucial role in the
allocation of money and the process of capital budgeting.
The five principles are:-
(1) decisions are based on cash flows, not accounting income,
(2) cash flows are based on opportunity cost,
(3) The timing of cash flows are important,
(4) cash flows are analyzed on an after tax basis,
(5) financing costs are reflected on project’s required rate of return.

5. PRINCIPLES OF CAPITAL BUDGETING
 (1) Relevant cash flows are based on incremental cash flows:- This represents
the changes in cash flow if the project is undertaken. Aspects of cash flow that
affect capital budgeting are sunk costs and externalities. These are both costs that
cannot be avoided. Sunk costs are costs that are unavoidable, even if the project is
undertaken. Externalities are side effects of a project that affect other firm cash
flows.
 (2) Cash flows are based on opportunity cost:- In other words, it is the cash
flow that will be lost due to the financing of a project. These are cash flows that
are accumulated by assets the firm already owns and would be sunk if the project
under consideration is undertaken.
 (3) The timing of cash flow is crucial:- because it is dependent on the time
value of money. Cash flow that is received now will be worth more in the future if
it were to be received later.

6. PRINCIPLES OF CAPITAL BUDGETING
 (4) Cash flows are measured on an after tax basis:- It is useless to measure
cash flow before taxes because it is not its present value. Firm’s value is based on
cash flow that a firm gets to keep, not the money that is sent to the government.
 (5) Financing costs are reflected on project’s required rate of return:- Rate of
return is an aspect of financing that has potential risks. Project’s that are expected
to have a higher rate of return than their cost of capital will increase the value of
the firm.

7. CAPITAL BUDGETING TECHNIQUES / METHODS
 Payback period method
 Average rate of return method (ARR)
 Internal Rate of Return (IRR)
 Net present Value (NPV) Method
 Profitability Index (PI)
 Adjusted net present value
 Discounted benefit cost ratio
 Undiscounted benefit cost ratio
 Net terminal value
 Annual benefit cost ratio
 Net cost criterion
 Capital allocation
 Cut-off point

8. CAPITAL BUDGETING TECHNIQUES / METHODS
Payback period method:-
This method refers to the period in which the proposal will
generate cash to recover the initial investment made. It purely
emphasizes on the cash inflows, economic life of the project and
the investment made in the project, with no consideration to
time value of money. Through this method selection of a
proposal is based on the earning capacity of the project.
Payback period = Cash outlay (investment)
/ Annual cash inflow

9. CAPITAL BUDGETING TECHNIQUES / METHODS
Average rate of return method (ARR)
This method helps to overcome the disadvantages of the payback
period method. The rate of return is expressed as a percentage of
the earnings of the investment in a particular project. It works on
the criteria that any project having ARR higher than the minimum
rate established by the management will be considered and those
below the predetermined rate are rejected.
ARR= Average income/Average Investment

10. CAPITAL BUDGETING TECHNIQUES / METHODS
Internal Rate of Return (IRR)
This is defined as the rate at which the net present value of the
investment is zero. The discounted cash inflow is equal to the
discounted cash outflow. This method also considers time value of
money.
It is called internal rate because it depends solely on the outlay and
proceeds associated with the project and not any rate determined
outside the investment.
It can be determined by solving the following equation:-
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IR < k = reject

11. CAPITAL BUDGETING TECHNIQUES / METHODS
Net present Value (NPV) Method
This is one of the widely used methods for evaluating capital
investment proposals. In this technique the cash inflow that is
expected at different periods of time is discounted at a particular
rate. The present values of the cash inflow are compared to the
original investment. If the difference between them is positive (+)
then it is accepted or otherwise rejected
The equation for the net present value, assuming that all cash
outflows are made in the initial year , will be:

12. CAPITAL BUDGETING TECHNIQUES / METHODS
Profitability Index (PI)
It is the ratio of the present value of future cash benefits, at the
required rate of return to the initial cash outflow of the investment. It
may be gross or net, net being simply gross minus one. The formula to
calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A
PI = NPV (benefits) / NPV (Costs)

13. IMPORTANCE OF CAPITAL BUDGETING
 Long term investments involve risks: Capital expenditures are long term
investments which involve more financial risks. That is why proper
planning through capital budgeting is needed.
 Huge investments and irreversible ones: As the investments are huge
but the funds are limited, proper planning through capital expenditure is a
pre-requisite. Also, the capital investment decisions are irreversible in
nature, i.e. once a permanent asset is purchased its disposal shall incur
losses.
 Long run in the business: Capital budgeting reduces the costs as well as
brings changes in the profitability of the company. It helps avoid over or
under investments. Proper planning and analysis of the projects helps in
the long run.

14. WHAT IS 'CAPITAL RATIONING'
Capital rationing is the act of placing restrictions on the amount
of new investments or projects undertaken by a company. This is
accomplished by imposing a higher cost of capital for
investment consideration or by setting a ceiling on specific
portions of a budget. Companies may want to implement
capital rationing in situations where past returns of an
investment were lower than expected.

15. TWO TYPES OF CAPITAL RATIONING
The first type of capital rationing is referred to as "HARD CAPITAL
RATIONING." This occurs when a company has issues raising
additional funds, either through equity or debt. The rationing arises
from an external need to reduce spending, and can lead to a
shortage of capital to finance future projects.
The second type of rationing is called "SOFT CAPITAL RATIONING"
or internal rationing. This type of rationing comes about due to the
internal policies of a company. A fiscally conservative company, for
example, may have a high required return on capital in order to
accept a project, self-imposing its own capital rationing.

16. EXAMPLE OF CAPITAL BUDGETING:
Capital budgeting for a small scale expansion involves three steps: recording
the investment's cost, projecting the investment's cash flows and comparing
the projected earnings with inflation rates and the time value of the
investment.
For example:- equipment that costs Rs15,000 and generates a Rs5,000
annual return would appear to "pay back" on the investment in 3 years.
However, if economists expect inflation to rise 30 percent annually, then the
estimated return value at the end of the first year ( Rs 20,000) is actually worth
Rs15,385 when you account for inflation (Rs20,000 divided by 1.3 equals
Rs15,385). The investment generates only Rs 385 in real value after the first
year.

17. Conclusion:
According to the definition of Charles T. Hrongreen , “Capital
Budgeting is a long-term planning for making and financing
proposed capital outlays.”
One can conclude that capital budgeting is the attempt to
determine the future.