Capital Budget

1. CAPITAL BUDGETING

2. CAPITAL BUDGETING
Meaning of Capital Budgeting
The process of decisions to invest a sum of money when the expected results
will flow after the lapse of a period of more than one year is called Capital
Budgeting. Capital Budgeting is the process of making investment decision
in fixed assets or capital expenditure. Capital Budgeting is also known as
investment, decision making, planning of capital acquisition, planning and
analysis of capital expenditure etc. It is the process of deciding whether or
not to invest in a particular project as all the investment possibilities may
not be rewarding. Capital Budgeting or investment decisions play a vital
role in the future profitability of a concern.
• Capital budgeting is used by companies to evaluate major projects and
investments, such as new plants or equipment.
• The process involves analyzing a project’s cash inflows and outflows to
determine whether the expected return meets a set benchmark.

3. Objectives of Capital Budgeting
1. To find out the profitable capital expenditure.
2. To know whether the replacement of any existing fixed
assets gives more return than earlier.
3. To decide whether a specified project is to be selected
or not.
4. To find out the quantum of finance required for the
capital expenditure.
5. To assess the various sources of finance for capital
expenditure.
6. To evaluate the merits of each proposal to decide
which project is best.

4. Features of Capital Budgeting
1. Capital budgeting involves the investment of funds
currently for getting benefits in the future.
2. Generally, the future benefits are spread over several years.
3. The long term investment is fixed.
4. The investments made in the project is determining
the financial condition of business organization in future.
5. Each project involves huge amount of funds.
6. Capital expenditure decisions are irreversible.
7. The profitability of the business concern is based on the
quantum of investments made in the project

5. Importance of Capital Budgeting
Capital budgeting has long-term implications:
The most significant reason for which capital budgeting decisions are taken is that it
has long-term implications, i.e. its effects will extend into the future, and will have
to be endured for a longer period than the consequences of current operating
expenditure. Because, a proper investment decision can yield spectacular returns,
whereas a wrong investment decision can endanger the very survival of the firm.
That is why, it may be stated that the capital budgeting decisions determine the
future destiny of the firm. Moreover, it also changes the risk complexion of the
enterprise. When the average benefits of the firm increase as a result of an
investment proposal which may cause frequent fluctuations in its earnings that will
become a risky situation
Capital budgeting requires large amount of funds:
Capital investment decisions require large amount of funds which the majority of the
firms cannot provide since they have scarce capital resources. As a result, the
investment decisions must be thoughtful, wise and correct. Because, a
wrong/incorrect decision would result in losses and the same prevents the firm
from earning profits from other investments as well due to scarcity of resources

6. Importance of Capital Budgeting
CONTD……
Capital budgeting is not reversible:
Once the capital budgeting decisions are taken, they are not easily
reversible. The reason is that there may neither be any market for
such second-hand capital goods nor there is any possibility of
conversion of such capital assets into other usable assets, i.e., the
only remedy is to dispose-off the same sustaining a heavy loss to
the firm.
They are actually the most difficult decisions:
Capital investment decisions are, no doubt, the most significant since
they are very difficult to make. It is because of the fact that their
assessment depends on the future uncertain events and activities
of the firm. Similarly, it is practically a difficult task to estimate the
accurate future benefits and costs in terms of money as there are
economical, political and technological forces which affect the said
benefits and costs.

7. Limitations of Capital Budgeting
1. The economic life of the project and annual cash inflows are only
estimation. The actual economic life of the project is either increased or
decreased. Likewise, the actual annual cash inflows may be either more or
less than the estimation. Hence, control over capital expenditure can not
be exercised.
2. The application of capital budgeting technique is based on the presumed
cash inflows and cash outflows. Since the future is uncertain, the
presumed cash inflows and cash outflows may not be true. Therefore, the
selection of profitable project may be wrong.
3. Capital budgeting process does not take into consideration of various non-
financial aspects of the projects while they play an important role in
successful and profitable implementation of them. Hence, true
profitability of the project cannot be highlighted.
4. It is also not correct to assume that mathematically exact techniques
always produce highly accurate results. All the techniques of capital
budgeting presume that various investment proposals under consideration
are mutually exclusive which may not be practically true in some particular

8. 6. The morale of the employee, goodwill of the company etc.
cannot be quantified accurately. Hence, these can
substantially influence capital budgeting decision.
7. Risk of any project cannot be presumed accurately. The
project risk is varying according to the changes made in the
business world.
8. In case of urgency, the capital budgeting technique cannot
be applied.
9. Only known factors are considered while applying capital
budgeting decisions. There are so many unknown factors
which are also affecting capital budgeting decisions. The
unknown factors cannot be avoided or controlled

9. Process of Capital Budgeting
• Idea Generation
The most important step of the capital budgeting process is generating good investment ideas.
These investment ideas can come from a number of sources like the senior management, any
department or functional area, employees, or sources outside the company.
• Analyzing Individual Proposals
A manager must gather information to forecast cash flows for each project in order to determine its
expected profitability. This is because the decision to accept or reject a capital investment is based
on such an investment’s future expected cash flows.
• Planning Capital Budget
An entity must give priority to profitable projects as per the timing of the project’s cash flows,
available company resources, and a company’s overall strategies. The projects that look promising
individually may be undesirable strategically. Thus, prioritizing and scheduling projects is important
because of the financial and other resource issues.
• Monitoring and Conducting a Post Audit
It is important for a manager to follow up or track all the capital budgeting decisions. He should
compare actual with projected results and give reasons as to why projections did not match with
actual performance. Therefore, a systematic post-audit is essential in order to find out systematic
errors in the forecasting process and hence enhance company operations

10. Techniques of Capital Budgeting
Capital budgeting techniques are the methods to evaluate an investment
proposal in order to help the company decide upon the desirability of such
a proposal. These techniques are categorized into two heads: traditional
methods and discounted cash flow methods.
I Traditional Methods Traditional methods determine the desirability of an
investment project based on its useful life and expected returns.
Furthermore, these methods do not take into account the concept of time
value of money.
I) Pay Back Period Method
ii) Average Rate of Return Method (ARR)
II Discounted Cash Flow Methods
I) Net Present Value Method (NPV)
II) Internal Rate of Return (IRR)
III) Profitability Index

11. Pay Back Period Method
As the name suggests, 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. With simple calculations, selection or rejection of the project can be done, with
results that will help gauge the risks involved. However, as the method is based on thumb
rule, it does not consider the importance of time value of money and so the relevant
dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow
Decision Rule
The longer the payback period of a project, the higher the risk. Between mutually exclusive
projects having similar return, the decision should be to invest in the project having the
shortest payback period.
When deciding whether to invest in a project or when comparing projects having different returns,
a decision based on payback period is relatively complex. The decision whether to accept or
reject a project based on its payback period depends upon the risk appetite of the
management.

12. Example

13. Advantages of PBP
.
However, this method is quite popular because
(a) It is simple to calculate.
(b) It brings out a very important fact that unless the project is able to function for a
number of years equal to the pay-back period at least, there will be no profit on the
projects. Profit can arise only if the project runs for a period longer than the pay-back
period.
(c) This method is useful for those concerns which suffer from rather a shortage of funds so
that they want to use the same funds for many projects. They would like to invest the
funds with short pay-back period so that, when they receive the funds back, they use it
for the next project.
(d) A new concern will know from the pay-back period the initial period during which it
should absolutely refuse to pay dividends even though the Profit and Loss Account will
be prepared every year and even though that may reveal profit.
(e) It is very useful for industries where the technological development, and therefore
obsolescence, is very fast.

14. Disadvantages of PBP
1. Only Focuses on Payback Period.
There are some very big issues to observe with a payback period method, the first being that it only looks at cash
flow for a certain time frame. If a business is just looking to see how quickly they can break even on their
investment, this is fine, but that is certainly not always the case. The return on investment, after the initial
investment is paid back, will not be a factor in these scores, and that can be very short-sighted.
2. Time Value of Money Is Ignored.
When talking about the time value of money, it assumes that money coming in sooner is going to be more
valuable as it can be used to make more. The payback period method completely ignores the time value of
money, whether that is a positive or a negative thing for the project and business. If a business only looks at one
factor, then potentially promising investments can be missed.
3. Payback Period Is Not Realistic as the Only Measurement.
There is some usefulness to this method, especially in quick-moving industries with a lot of rapid change. The
problem for most businesses is that they need to have a better balance of projects and investments so that their
short, mid, and long-term needs are all taken care of. No business is going to be able to rely on this method for
their investment opportunities if they want to have a stable future ahead. It is always better to use a variety of
methods to make important decisions.
4. Doesn’t Look at Overall Profit.
This can be a major red flag for a lot of managers looking to improve their business. The profitability of a
project, either short-term or long-term, is not considered at all, and this cannot be ignored by a good manager.
You must be able to show profitability on a project, and the payback period method does not consider this
important metric.

15. The Accounting Rate of Return (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. This method takes into
account the entire economic life of a project providing a better
means of comparison. It also ensures compensation of expected
profitability of projects through the concept of net earnings.
However, this method also ignores time value of money and
doesn’t consider the length of life of the projects. Also it is not
consistent with the firm’s objective of maximizing the market value
of shares.
• ARR= Average income/Average Investment

16. How to calculate ARR
• First off, work out the annual net profit of investment. This
will be the revenue remaining after all operating expenses,
taxes, and interest associated with implementing the
investment or project have been deducted.
• If the investment is a fixed asset, such as property, then
deduct depreciation expense.
• Then, to arrive at the final figure for annual net profit,
simply subtract the depreciation expense from annual
revenue figure.
• Finally, simply divide the annual net profit by the initial cost
of the asset or investment.
• The calculation will show a decimal, so multiply the result
by 100 to see the percentage return.

18. Decision Rule under ARR method
Accept/Reject/Ranking Rule:
Company specifies a desirable rate of return on its investment. If the
rate of return calculated for the project is more than the pre-decided
rate, then the project will be accepted and if the ARR of the project is
less than the pre-specified rate of return, the project will be rejected.
Hence, If ARR > Pre-specified/Desirable rate of return ⇒ Accept the
project
If ARR < Pre-specified/Desirable rate of return ⇒ Reject the project
The ARR can also be used for ranking the projects. Projects will be
ranked in the descending order of their average rate of return i.e. the
project with the highest ARR will be ranked first.

19. Advantages and Disadvantages of the
Accounting Rate of Return (ARR)
Advantages
• The accounting rate of return is a simple calculation that does not require complex math and is
helpful in determining a project's annual percentage rate of return.
• Through this, it allows managers to easily compare ARR to the minimum required return. For
example, if the minimum required return of a project is 12% and ARR is 9%, a manager will know
not to proceed with the project.
• ARR comes in handy when investors or managers need to quickly compare the return of a project
without needing to consider the time frame or payment schedule but rather just the profitability or
lack thereof.
Disadvantages
• Despite its advantages, ARR has its limitations. It doesn't consider the time value of money. The
time value of money is the concept that money available at the present time is worth more than an
identical sum in the future because of its potential earning capacity.
• In other words, two investments might yield uneven annual revenue streams. If one project returns
more revenue in the early years and the other project returns revenue in the later years, ARR does
not assign a higher value to the project that returns profits sooner, which could be reinvested to
earn more money.
• Does not factor in long-term risk

20. Net Present Value Method(NPV)
• Net present value (NPV) is the difference between the present value of cash inflows
and the present value of cash outflows over a period of time. NPV is used in capital
budgeting and investment planning to analyze the profitability of a projected
investment or project. The Net Present Value (NPV) method involves discounting a
stream of future cash flows back to present value. The cash flows can be either
positive (cash received) or negative (cash paid). The present value of the initial
investment is its full face value because the investment is made at the beginning of
the time period. The ending cash flow includes any monetary sale value or
remaining value of the capital asset at the end of the analysis period, if any. The
cash inflows and outflows over the life of the investment are then discounted back
to their present values. The Net Present Value is the amount by which the present
value of the cash inflows exceeds the present value of the cash outflows.
Conversely, if the present value of the cash outflows exceeds the present value of
the cash inflows, the Net Present Value is negative. From a different perspective, a
positive (negative) Net Present Value means that the rate of return on the capital
investment is greater (less) than the discount rate used in the analysis.

21. Process of NPV Method
1. Determine initial investment.
2. Determine a time period to analyze
3. Estimate cash inflow for each time period
4. Determine the appropriate discount rate
5. Discount cash inflows
6. Sum discounted cash flows and subtract initial investment
To get the total NPV for the project, purchase, or investment, add up all
of discounted cash flows and subtract initial investment
7. Determine whether or not to make the investment.
In general, if the NPV for investment is a positive number, then
investment will be more profitable than putting the money in alternate
investment and accept it. If the NPV is negative, your money is better
invested elsewhere, and your proposed investment should be rejected.

22. ILLUSTRATION NPV

23. NPV Decision Rule
NPV Decision Rule
The following NPV signs explain whether the investment is good or
bad.
NPV > 0 - The present value of cash inflows is more than the present
value of cash outflows. The money earned on the investment is
more than the money invested. Hence, it is a good investment.
NPV = 0 - The present value of cash flows is more than the present
value of cash outflows. The money earned on the investment is
equal to the money invested. Therefore, there is no difference
between cash inflows and cash outflows.
NPV < 0 - The present value of cash inflows is less than the present
value of cash outflows. The money earned on the investment is less
than the money invested. Hence, it is not a fruitful investment.

24. Advantages and limitations of NPV
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its
calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firm’s cost of
capital is known. But in practice, to understand cost of capital is quite a
difficult concept.
3. It may not give satisfactory answer when the projects being compared
involve different amounts of investment.

25. Internal Rate of Return
The internal rate of return is a method used to estimate the
profitability of the potential investment. It is the discount rate that
makes the net present value of an investment equals zero. The Internal
rate of return method is widely used in discounting cash flow analysis,
and also used for analyzing capital budgeting method.
While calculating the IRR, the present value of future cash flows equals
the initial investment of the project, and thus makes the NPV = 0.
After calculating the IRR, it should be compared with the minimum
required rate of return or cost of capital of the project. For example, If
the calculated IRR is found greater than the minimum required rate of
return, then the project should be accepted whereas If the calculated
IRR is found lesser than the minimum required rate of return, then the
project should be rejected.

26. The internal rate of return or IRR is a
discounting cash flow method to determine
the rate of return earned by the project
excluding the external factor. By IRR
definition, it is the discounting rate at which
the present value of all future cash flows is
equal to the initial investment, that is the rate
at which the company investments break
even.

27. Features of IRR Method
• The internal rate of return (IRR) is the annual rate of growth that an
investment is expected to generate.
• IRR is calculated using the same concept as net present value (NPV),
except it sets the NPV equal to zero.
• The ultimate goal of IRR is to identify the rate of discount, which
makes the present value of the sum of annual nominal cash inflows
equal to the initial net cash outlay for the investment.
• IRR is ideal for analyzing capital budgeting projects to understand
and compare potential rates of annual return over time.
• In addition to being used by companies to determine which capital
projects to use, IRR can help investors determine the investment
return of various assets.

28. Calculation of Internal Rate of Return
(IRR)
I When Annual Net Cash Inflows are Equal:
(a) Calculate the discount factor of the project
INITIAL INVESTMENT/CASH INFLOW
The interest rate corresponding to the discount rate value (annuity) is a good
approximation of the IRR. To calculate the exact IRR go to the next step.
(b) Find the discount factors closest to payback period value against the life
period row of the project and the interest rate thereof.
Looking at the present value of an annuity table (A-4), find two values, one
smaller and other greater than the discount factor calculated in step (a).
(c) Find the interest rates corresponding to these two values.

29. II When Annual Net Cash Inflows are Unequal:
(a) Calculate the average annual cash flow to determine then annuity and
then the tentative discount rate
(b) Find the discount factors closest to value against tentative discount rate
the life period row of the project and the interest rates thereof.
Looking at the present value of an annuity table, find two values, one smaller
and other greater
(c) Find the interest rates corresponding to these two values.
(d) If cash inflows in the initial years are lower than the average annual cash
inflow, then a subjective decrease in the interest rates are made. On the
other hand, if cash inflows are higher than average cash inflows in initial years
of the project, a subjective increase in the interest rates are made.
Through trial and error method, two interest rates are to be calculated a
lower interest rate , where the NPV of the project is positive and a higher
interest rate where NPV of the project is negative. The IRR of the project
where NPV is zero lies between these two interest rates.

30. Illustration IRR cost of the project is 680

31. Decision Rule
• IRR is compared with the cost of capital or required rate of
return. If IRR is greater than cost of capital (k) or required
rate of return then the project is selected. If IRR is less than
cost of capital (k) then the project is rejected.
• Hence, If IRR > required rate of return or cost of capital ⇒
Accept the project.
• If IRR < required rate of return or cost of capital ⇒ Reject
the project.
• Ranking of the projects is done on the basis of IRR. Projects
with higher IRR will be given higher ranking.

32. Similarities of the IRR Method with
the NPV Method
• Conceptually both NPV method and internal rate of return method
are the same. Under the NPV method cash flows are discounted at
a discount rate i.e., cost of capital to find net present value of a
project.
• Under IRR method, a discount rate which makes NPV of an
investment proposal zero is calculated and is compared with cost of
capital to find the acceptability of the project. Both these methods
use a discounted cash flow approach.
• Both recognise the time value of money concept. Both of them
measure the cost and benefits of the projects in terms of cash flows
and consider all cash flows occurring during the life of the project.
These methods are also consistent with the objective of wealth
maximization.

33. Difference between NPV and IRR
Outcome. The NPV method results in net return that a project will produce, while IRR
generates the percentage return that the project is expected to create.
Purpose. The NPV method focuses on project surpluses, while IRR is focused on the
breakeven cash flow level of a project.
Decision support. The NPV method presents an outcome that forms the foundation for
an investment decision, since it presents a net return. The IRR method does not help
in making this decision, since its percentage return does not tell the investor how
much money will be made.
Discount rate issues. The NPV method requires the use of a discount rate, which can
be difficult to derive, since management might want to adjust it based on perceived
risk levels. The IRR method does not have this difficulty, since the rate of return is
simply derived from the underlying cash flows.
Generally, NPV is the more heavily-used method. IRR tends to be calculated as part of
the capital budgeting process and supplied as additional information.

34. Advantages of IRR Method:
(a) The IRR technique is based on the time value of money concept.
The cash flows occurring at different points of time are made
comparable by adjusting them for time value of money.
(b) It is based on Cash flows rather than the accounting profit. Further
it considers all cash flows occurring during the economic life of the
project.
(c) The project is qualified if IRR is more than the required rate of
return. It means all the investments would yield more than the
required rate of return.
(d) Because the investment earns more than the required rate of
return, hence it increases the value of the firm. IRR is therefore
consistent with the overall objective of wealth maximisation.

35. Limitations of the IRR Method
1. IRR may not provide accurate estimate cost as while calculating IRR, the cost of
capital is not considered in the equation. The cost of capital is the required rate
of return also known as hurdle rate is required returns to fund the project.
2. When using IRR to compare multiple projects, it does not look at the size or
scope of the project for comparison, it only compares the cash flows to the
amount of capital being injected to generate those cash flows.
3. The aim of the IRR method is to determine the projected cash flow form the
capital injected. It does not consider the potential costs such as fuel and
maintenance cost, that are variable over time. This may affect the profit in
future.
4. The biggest limitation of IRR is that it makes assumptions that future cash flows
can be invested at the same internal rate of return. In reality, the numbers
obtained by IRR can be quite high.
5. It required calculations that are quite long and tedious.

36. Profitability Index (PI) Method
Profitability index (PI) is the ratio of present values of all cash inflows associated with a project to the present
value of its cash outflows. It is a variation of the NPV method. While NPV method is an absolute measure of
project evaluation, PI is a relative measure.
It is a better method than NPV for evaluating projects requiring different cash outflows. It is also known as
Benefit Cost Ratio (B/C ratio).
Accept-Reject/Ranking Rule:
Accept/Reject rule of profitability index suggest that the project should be accepted if PI is more than 1 and
reject the project if PI is less than 1.
Hence, If PI > 1 ⇒ Accept the project
If PI < 1 ⇒ Reject the project
While ranking the proposals, the project with highest PI will be ranked as No. 1, with next highest PI as No. 2
and so on, provided the project is having PI more than 1. Projects having PI less than 1 will be straight away
rejected.
Advantages and Limitations of Profitability Index Method:
Advantages and disadvantages of PI method are the same as those of NPV method. This is because of the fact
that this method is also based on the same data i.e., PV of both cash inflows and outflows. Hence this method
is just an extension of NPV.
However, being a relative measure it is superior to NPV for evaluating those projects having different initial
investment. It is the best method to evaluate various investment proposals under capital rationing situations.

37. Profitability Index Illustration