CAPITAL BUDGETING

Capital Budgeting – Nature and meaning of capital budgeting – Cash flow – Capital
budgeting Techniques – Payback Period- Accounting Rate of Return – Net present Value ,
Internal Rate of Return – Profitably Index Method

Capital Budgeting

Meaning :

Capital budgeting is the process of making investment decisions in long term assets. It is the
process of deciding whether or not to invest in a particular project as all the investment
possibilities may not be rewarding. 

Thus, the manager has to choose a project that gives a rate of return more than the cost
financing such a project. That is why he has to value a project in terms of cost and benefit. 

What is Capital Budgeting?

Capital budgeting is the process that a business uses to determine which proposed fixed asset
purchases it should accept, and which should be declined. This process is used to create a
quantitative view of each proposed fixed asset investment, thereby giving a rational basis for
making a judgment.

Nature of Capital Budgeting:

Capital budgeting is the process of making investment decisions in capital expenditures. A

capital expenditure may be defined as an expenditure the benefits of which are expected to be
received over period of time exceeding one year.

The main characteristic of a capital expenditure is that the expenditure is incurred at one
point of time whereas benefits of the expenditure are realized at different points of time in
future. In simple language we may say that a capital expenditure is an expenditure incurred
for acquiring or improving the fixed assets, the benefits of which are expected to be received
over a number of years in future.

The following are some of the examples of capital expenditure:

(1) Cost of acquisition of permanent assets as land and building, plant and machinery,
goodwill,
(2) Cost of addition, expansion, improvement or alteration in the fixed assets.
(3) Cost of replacement of permanent assets.
(4) Research and development project cost, etc.
Capital expenditure involves non-flexible long-term commitment of funds. Thus, capital
expenditure decisions are also called as long term investment decisions. Capital budgeting
involves the planning and control of capital expenditure. It is the process of deciding whether
or not to commit resources to a particular long term project whose benefits are to be realized
over a period of time, longer than one year. Capital budgeting is also known as Investment
Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure and Analysis
of Capital Expenditure.

Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long term
planning for making and financing proposed capital outlays.”

According to G.C. Philippatos, “Capital budgeting is concerned with the allocation of the
firm’s scarce financial resources among the available market opportunities. The consideration
of investment opportunities involves the comparison of the expected future streams of
earnings from a project with the immediate and subsequent streams of earning from a project,
with the immediate and subsequent streams of expenditures for it”.

Richard and Greenlaw have referred to capital budgeting as acquiring inputs with long-run
return.

In the words of Lynch, “Capital budgeting consists in planning development of available

capital for the purpose of maximizing the long term profitability of the concern.”

From the above description, it may be concluded that the important features which
distinguish capital budgeting decision from the ordinary day to day business decisions
are:

(1) Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in future;

(2) The future benefits are expected to be realized over a series of years;

(3) The funds are invested in non-flexible and long term activities;

(4) They have a long term and significant effect on the profitability of the concern;

(5) They involve, generally, huge funds;

(6) They are irreversible decisions.

(7) They are ‘strategic’ investment decisions, involving large sums of money, major
departure from the past practices of the firm, significant change of the firm’s expected
earnings associated with high degree of risk, as compared to ‘tactical’ investment decisions
which involve a relatively small amount of funds that do not result in a major departure from
the past practices of the firm.
Need and Importance of Capital Budgeting:

Capital budgeting means planning for capital assets.

Capital budgeting decisions are vital to any organisation as they include the decisions as
to:

(a) Whether or not funds should be invested in long term projects such as setting of an
industry, purchase of plant and machinery etc.

(b) Analyze the proposal for expansion or creating additional capacities.

(c) To decide the replacement of permanent assets such as building and equipment’s.

(d) To make financial analysis of various proposals regarding capital investments so as to

choose the best out of many alternative proposals.

The importance of capital budgeting can be well understood from the fact that an unsound
investment decision may prove to be fatal to the very existence of the concern.

The need, significance or importance of capital budgeting arises mainly due to the
following:

(1) Large Investments:

Capital budgeting decisions, generally, involve large investment of funds. But the funds
available with the firm are always limited and the demand for funds far exceeds the
resources. Hence, it is very important for a firm to plan and control its capital expenditure.

(2) Long-term Commitment of Funds:

Capital expenditure involves not only large amount of funds but also funds for long-term or
more or less on permanent basis. The long-term commitment of funds increases the financial
risk involved in the investment decision. Greater the risk involved, greater is the need for
careful planning of capital expenditure, i.e. Capital budgeting.

(3) Irreversible Nature:

The capital expenditure decisions are of irreversible nature. Once the decision for acquiring a
permanent asset is taken, it becomes very difficult to dispose of these assets without incurring
heavy losses.

(4) Long-Term Effect on Profitability:

Capital budgeting decisions have a long-term and significant effect on the profitability of a
concern. Not only the present earnings of the firm are affected by the investments in capital
assets but also the future growth and profitability of the firm depends upon the investment
decision taken today. An unwise decision may prove disastrous and fatal to the very existence
of the concern. Capital budgeting is of utmost importance to avoid over investment or under
investment in fixed assets.

(5) Difficulties of Investment Decisions:

The long term investment decisions are difficult to be taken because:

(i) Decision extends to a series of years beyond the current accounting period,

(ii) Uncertainties of future and

(iii) Higher degree of risk.

(6) National Importance:

Investment decision though taken by individual concern is of national importance because it

determines employment, economic activities and economic growth. Thus, we may say that
without using capital budgeting techniques a firm may involve itself in a losing project.
Proper timing of purchase, replacement, expansion and alternation of assets is essential.

Limitations of Capital Budgeting:

Capital budgeting techniques suffer from the following limitations:

(1) All the techniques of capital budgeting presume that various investment proposals under
consideration are mutually exclusive which may not practically be true in some particular
circumstances.

(2) The techniques of capital budgeting require estimation of future cash inflows and
outflows. The future is always uncertain and the data collected for future may not be exact.
Obliviously the results based upon wrong data may not be good.

(3) There are certain factors like morale of the employees, goodwill of the firm, etc., which
cannot be correctly quantified but which otherwise substantially influence the capital
decision.

(4) Urgency is another limitation in the evaluation of capital investment decisions.

(5) Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.
 METHODS OF CAPITAL BUDGETING OF EVALUATION

By matching the available resources and projects it can be invested. The funds available are
always living funds. There are many considerations taken for investment decision process
such as environment and economic conditions.
The methods of evaluations are classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Post Pay-back Methods
(iii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method

Pay-back Period

Pay-back period is the time required to recover the initial investment in a project

(It is one of the non-discounted cash flow methods of capital budgeting).

Merits of Pay-back method

The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.
Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.
Accept /Reject criteria
If the actual pay-back period is less than the predetermined pay-back period, the project
would be accepted. If not, it would be rejected.

Exercise 1
Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the project is
5 years. Calculate the pay-back period.

Exercise 2
A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after

depreciation @ 12½% but before tax at 50%. Calculate the pay-back period.
Uneven Cash Inflows
Normally the projects are not having uniform cash inflows. In those cases the pay-back
period is calculated, cumulative cash inflows will be calculated and then interpreted.
Exercise 3
Certain projects require an initial cash outflow of Rs. 25,000. The cash inflows for 6 years are
Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.
Solution
Accounting Rate of Return or Average Rate of Return

Average rate of return means the average rate of return or profit taken for considering
the project evaluation. This method is one of the traditional methods for evaluating
the project proposals:
Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties
in the calculation of the project.
Accept/Reject criteria
If the actual accounting rate of return is more than the predetermined required rate of
return, the project would be accepted. If not it would be rejected.

Exercise 5
A company has two alternative proposals. The details are as follows
 Net Present Value

Net present value method is one of the modern methods for evaluating the project proposals.
In this method cash inflows are considered with the time value of the money. Net present
value describes as the summation of the present value of cash inflow and present value of
cash outflow. Net present value is the difference between the total present value of future
cash inflows and the total present value of future cash outflows.
Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders’ wealth.
Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.
Accept/Reject criteria
If the present value of cash inflows is more than the present value of cash outflows, it would
be accepted. If not, it would be rejected.

Exercise 6
From the following information, calculate the net present value of the two project and suggest
which of the two projects should be accepted a discount rate of the two.
Internal Rate of Return

Internal rate of return is time adjusted technique and covers the disadvantages of the
traditional techniques. In other words it is a rate at which discount cash flows to zero. It is
expected by the following ratio: Cash inflow Investment

Base factor = Positive discount rate

DP = Difference in percentage
Merits
1. It consider the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the internal rate
of return.
Accept/Reject criteria
If the present value of the sum total of the compounded reinvested cash flows is greater than
the present value of the outflows, the proposed project is accepted. If not it would be rejected.

Capital Rationing
In the rationing the company has only limited investment the project are selected according to
the profitability. The project has selected the combination of proposal that will yield the
greatest portability.

Exercise 12 Let us assume that a firm has only Rs. 20 lakhs to invest and funds cannot be
provided. The various proposals along with the cost and profitability index are as follows.

Solution
In this example all proposals expect number 2 give profitability exceeding one and are profitable
investments. The total outlay required to be invested in all other (profitable) project is Rs.
25,00,000(1+2+3+4+5) but total funds available with the firm are Rs. 20 lakhs and hence the firm has
to do capital combination of project within a total which has the lowest profitability index along with
the profitable proposals cannot be taken.

Profitability Index method

The PI is calculated by dividing the present value of future expected cash flows by the
initial investment amount in the project. A PI greater than 1.0 is deemed as a good
investment, with higher values corresponding to more attractive projects.