Capital budgeting is the process in which a business determines and evaluates potential expenses or investments that are large in nature. These expenditures and investments include projects such as building a new plant or investing in a long-term venture. Often times, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the potential returns generated meet a sufficient target benchmark, also known as "investment appraisal."

1. L-12
Capital Budgeting
Meaning of capital budgeting
Significance
Capital budgeting process
Investment criteria
Methods of capital budgeting
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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2. Capital Budgeting
Capital budgeting is the process in which a business
determines and evaluates potential expenses or
investments that are large in nature.
These expenditures and investments include projects such
as building a new plant or investing in a long-term venture.
Often times, a prospective project's lifetime cash inflows
and outflows are assessed in order to determine whether
the potential returns generated meet a sufficient target
benchmark, also known as "investment appraisal."
Developed by Dr.IKRAM UL HAQ CHOUDHARY , CPA, PhD 2

3. 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.
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4. • “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
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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5. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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6. Capital budgeting process involves the following
1. Project generation: Generating the proposals for
investment is the first step.
The investment proposal may fall into one of the following
categories:
• Proposals to add new product to the product line,
• proposals to expand production capacity in existing lines
• proposals to reduce the costs of the output of the existing
products without altering the scale of operation.
• Sales campaining, trade fairs people in the industry, R and D
institutes, conferences and seminars will offer wide variety of
innovations on capital assets for investment.
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CHOUDHARY , CPA,PhD
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7. 2. Project Evaluation: it involves two steps
• Estimation of benefits and costs: the benefits and
costs are measured in terms of cash flows. The
estimation of the cash inflows and cash outflows
mainly depends on future uncertainities. The risk
associated with each project must be carefully
analysed and sufficeint provision must be made for
covering the different types of risks.
• Selection of an appropriate criteria to judge the
desirability of the project: It must be consistent with
the firm’s objective of maximising its market value.
The technique of time value of money may come as a
handy tool in evaluation such proposals.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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8. 3. Project Selection: No standard administrative
procedure can be laid down for approving the
investment proposal. The screening and selection
procedures are different from firm to firm.
4. Project Evaluation: Once the proposal for capital
expenditure is finalised, it is the duty of the finance
manager to explore the different alternatives available
for acquiring the funds. He has to prepare capital
budget. Sufficient care must be taken to reduce the
average cost of funds. He has to prepare periodical
reports and must seek prior permission from the top
management. Systematic procedure should be
developed to review the performance of projects during
their lifetime and after completion.
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CHOUDHARY , CPA,PhD
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9. The follow up, comparison of actual performance with
original estimates not only ensures better forecasting
but also helps in sharpening the techniques for
improving future forecasts.
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CHOUDHARY , CPA,PhD
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10. 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
• Accounting practice
• Trend of earnings
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CHOUDHARY , CPA,PhD
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11. 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
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CHOUDHARY , CPA,PhD
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12. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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13. 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.
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CHOUDHARY , CPA,PhD
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14. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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15. 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
• It can readily be calculated by using the accounting data.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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16. 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. -
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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17. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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18. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
18

19. Net present value method
It recognises 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
19

20. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
20

21. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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22. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
22

23. 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.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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24. Step 1:Calculation of cash outflow
Cost of project/asset xxxx
Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx
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CHOUDHARY , CPA,PhD
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25. 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
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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26. Note:
• Depreciation = St.Line method
• PBDT – Tax is Cash inflow ( if the tax amount is given)
• PATBD = Cash inflow
• Cash inflow- Scrap and working capital must be added.
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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27. 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 IRR
Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
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28. Thank You
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CHOUDHARY , CPA,PhD
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