Unit -5:Capital Budgeting

Capital Budgeting
 Introduction:
Capital expenditure budget or capital budgeting is a process of
making decisions regarding investments in fixed assets which
are not meant for sale such as land, building, machinery or
furniture. The word investment refers to the expenditure which
is required to be made in connection with the acquisition and
the development of long-term facilities including fixed assets.
It refers to process by which management selects those
investment proposals which are worthwhile for investing
available funds. For this purpose, management is to decide
whether or not to acquire, or add to or replace fixed assets in
the light of overall objectives of the firm.

Capital Budgeting
 Meaning:
Capital budgeting is concerned with 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 immediate and subsequent streams
of expenditure for it.

Capital Budgeting
 Definition:
1. “Capital budgeting is long term planning for making and
financing proposed capital outlays”
2. “Capital budgeting consists of in planning development
of available capital for the purpose of maximizing the long
term profitability of the concern”.

Features /Nature/Needs
Capital Budgeting
 Capital expenditure plans involve a huge investment in fixed
assets.
 Capital expenditure once approved represents long-term
investment that cannot be reserved or withdrawn without
sustaining a loss.
 Preparation of budget plans involve forecasting of several years
profits in advance in order to judge the profitability of projects.

Cont.
 Capital budgeting decisions involve the exchange of current
funds for the benefits to be achieved in future.
 The future benefits are expected and are to be realized over a
series of years.
 The funds are invested in non-flexible long-term funds.
 They have a long terms and significant effect on the
profitability of the concern.
 They involve huge funds.
 They are irreversible decisions. They are strategic decisions
associated with high degree of risk.

Procedure of Capital
Budgeting
 In capital budgeting process, main points to be borne in mind
how much money will be needed of implementing immediate
plans, how much money is available for its completion and how
are the available funds going to be assigned tote various capital
projects under consideration.

Process
1. Organization of Investment Proposal.
2. Screening the Proposals
3. Evaluation of Projects
4. Establishing Priorities
5. Final Approval
6. Evaluation

Net Present Value (NPV)
The net present value decision tool is a more common and
more effective process of evaluating a project. Perform a net
present value calculation essentially requires calculating the
difference between the project cost (cash outflows) and cash
flows generated by that project (cash inflows). The NPV tool is
effective because it uses discounted cash flow analysis, where
future cash flows are discounted at a discount rate to
compensate for the uncertainty of those future cash flows. The
term "present value" in NPV refers to the fact that cash flows
earned in the future are not worth as much as cash flows today.
Discounting those future cash flows back to the present creates
an apples to apples comparison between the cash flows. The
difference provides you with the net present value.

Internal Rate of Return
(IRR)The internal rate of return is a discount rate that is commonly
used to determine how much of a return an investor can expect
to realize from a particular project. Strictly defined, the internal
rate of return is the discount rate that occurs when a project is
break even, or when the NPV equals 0. Here, the decision rule
is simple: choose the project where the IRR is higher than the
cost of financing. In other words, if your cost of capital is 5%,
you don't accept projects unless the IRR is greater than 5%.
The greater the difference between the financing cost and the
IRR, the more attractive the project becomes.

Payback Period
The payback period is the most basic and simple decision tool.
With this method, you are basically determining how long it
will take to pay back the initial investment that is required to
undergo a project. In order to calculate this, you would take the
total cost of the project and divide it by how much cash inflow
you expect to receive each year; this will give you the total
number of years or the payback period. For example, if you are
considering buying a gas station that is selling for $100,000 and
that gas station produces cash flows of $20,000 a year, the
payback period is five years.

Accounting Rate of Return
 This is a percentage value of the average rate at which a fixed
asset can generate benefits over its economic life. Management
is responsible for setting the ARR for accepting capital
investments. To compute the ARR, divide the average net
income of a fixed asset by its average book value, then multiply
the result by 100. For example, if the potential income of a six-
year fixed asset is $900, $1,000, $1,100, $1,050, $990 and
$900, its average net income would be $990. If the asset’s book
value in the six-year period is $12,000, $11,000, $10,000,
$9,000, $8,000 and $7,000, its average book value would be
$9,500. The asset’s ARR would be $990/9,500 x 100 = 10.4
percent. Accept the asset if the ARR exceeds the ARR set by
the management.

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.
 Capital rationing is a strategy used by organizations attempting
to limit the costs of their own investments. Typically, a
company engaging in capital rationing has made unsuccessful
investments of capital in the recent past and would like to raise
the return on those investments prior to engaging in new
business.

Cont.
 The main benefit of capital rationing is budgeting a company's
corporate resources. When a company issues stock or borrows
money, it can use these resources for new investments.
However, if the company does not see a good return on
investments, it is wasting these resources. By capital rationing,
which is the process of increasing the cost of capital, the
company can make sure it takes on fewer projects. Further, it
can take on only projects for which the anticipated return on
investment is high. This will prevent the company from over-
extending its finances, which would cause a decrease in stock
price and stability.