Capital Budgeting

Meaning:- refers to long term planning for proposed capital outlays and their
financing
- raising of long term funds as well as their utilization
- “ the firm’s formal process for the acquisition and investment of
capital”
- involves firm’s decision to invest its current funds for addition,
disposition, modification and replacement of long term or fixed
assets

Importance:
-involvement of heavy funds
-long term implications ( purchase a new plant)
-Irreversible decisions- cannot be change
-Most difficulty to make future estimate

Techniques –
1. Payback Period Method
-refers to the period in which the project will generate the necessary cash to
recoup the initial investment
a) When the cash inflows are uniform every year
Payback period = Initial investment / Annual cash inflow*
• indicates before depreciation but after taxation.
b) When the cash inflows are not equal every year
Cumulative years + remaining amount needed to reach the initial
investment / that year cash inflows
2. Discounted Cash Flow Method or Time Adjusted Techniques:
a) Net Present Value Method –
- under this method cash inflow and outflows associated with the
project are first worked out
- then the cash inflows and outflows are then calculated at the rate of
return acceptable to the management
- this rate of return is considered as the cut off rate and is generally
determined on the basis of cost of capital suitably adjusted to allow
for the risk element involved in the project.
b) Internal Rate of Return.
- is that rate at which the sum of discounted cash inflows equals the
sum of discounted cash outflows. In other words it is the rate
which discounts the cash flows to zero.
Cash Inflows / Cash Outflows =1
i- When cash inflows are uniform
F= I / C
Where F= Factor to be located
I = Original investment
C= Cash inflow per year
 ii- when cash inflows are not uniform
then instead of cash inflow per year average cash inflow will
be considered.
c) Net Present Value method-= present value of future cash inflows /
present value of future cash outflows × 100

3. Accounting or Average Rate of Return Method (ARR)

The capital investment proposals are judged on the basis of their
relative profitability. For this purpose, capital employed and related income are
determined according to commonly accepted accounting principles and
practices over the entire economic life of the project and then the average yield
is calculated.
i) ARR = Annual average net earnings */ Original Investment × 100
ii) ARR = Annual average net earnings / Average Investment × 100
iii) ARR = Increase in expected future annual net earnings/ Initial
increase in required investment × 100

* is the average of the earnings ( after depreciation and tax)