Capital Budgeting

What is capital budgeting

1. Capital budgeting is the making of long-run planning decisions

for investments in projects and programs.

2. It is a decision-making and control tool that focuses primarily

on projects or programs that span multiple years.
 Capital Budgeting Example
1.One of the goals of Assisted Living is to improve the diagnostic
capabilities of its facility
2.Management identifies a need to consider the purchase of new
equipment.
3.The search stage yields several alternative models, but
management focuses on
one particular machine.`
 Net Present Value Example

Year in the Life of the Project

0 1 2 3

$(250,000) $125,000 $130,000 $115,000

Net initial Annual cash

investment inflows
 Net Present Value Example

Net Cash NPV of Net

Year 10% Col. Inflows Cash Inflows
1 0.909 $125,000 $113,625
2 0.826 130,000 107,380
3 0.751 115,000 86,365
Total PV of net cash inflows $307,370
Net initial investment 250,000
Net present value of project $ 57,370
 Profitability index

It is a ration of the pv of the cash inflow and the pv of the

outflow

Decision factor

If pv>1 accepted

If pv<1 rejected
Internal Rate of Return

Investment
= Expected annual net cash outflow
× PV annuity factor

Investment
÷ Expected annual net cash inflow
= PV annuity factor
Internal Rate of Return Example

Initial investment is $303,280.

Useful life is five years.
Net cash inflows is $80,000 per year.

What is the IRR of this project?

$303,280 ÷ $80,000 = 3.791 (PV annuity factor)

10% (from the table, five-period line)

 Payback period

It can be defined as the no of years required

for the proposal cumulative cash inflow to
cumulative cash inflow to be equal to cash
outflow. Pay back period is the length of time
required to recover initial cost of the project .
 Accounting rate of return (ARR)

It is based on accounting concept of return on

investment. ARR may be defined as annulaise
the net income on the average funds invested in
a firm

ARR =annual profit(after tax)/ average

investment