3.

Capital Budgeting
• Capital budgeting is the process by which
investors determine the value of a potential
investment project.
• Capital budgeting is a process of evaluating
investments and huge expenses in order to
obtain the best returns on investment.  An
organization is often faced with the
challenges of selecting between two
projects/investments or the buy vs replace
decision. Ideally, an organization would like
to invest in all profitable projects but due to
the limitation on the availability of capital an
organization has to choose between different
projects/investments.
 Capital Investment Decisions
Capital investment decisions involve the judgments made by a management team in regard to
how funds will be spent to procure capital assets. There are a number of factors that management
must consider when making capital investment decisions, such as:
•How well an investment fits into the long-term strategy of the business.
•Whether a projected increase in sales for which capacity is being increased will actually occur.
•Whether a projected increase in fixed assets will increase the breakeven point of the business,
requiring the firm to generate more sales before it can earn a profit.
•Whether the cash flows from the investment will generate a positive return on investment.
•Whether the investment is required by regulatory requirements, irrespective of the return on
investment.
•Whether the firm has sufficient funding available to pay for the assets that it wishes to acquire.
•Whether the entity’s cost of capital is low enough to permit an investment that will yield a
positive return.
Capital investment decisions are also known as Capital Budgeting.
 Methods of Capital Budgeting

1. Payback period: It is defined as the number of years

required to recover the original cash outlay invested in a
project.
Payback period = Cash outlay (investment) / Annual cash
inflow 
2. Accounting Rate of Return method: It is used to
measure the profit abilities of the investment proposals.
ARR= Average income/Average Investment or original
investment .
3. Net present value method: It is a process of calculating
the present value of cash flows (inflows and outflows) of
an investment proposal, using the cost of capital as the
appropriate discounting rate, and finding out the net
profit value, by subtracting the present value of cash
outflows from the present value of cash inflows.
4. Internal Rate of Return Method : The internal rate of return (IRR) equates the
present value cash inflows with the present value of cash outflows of an investment. It
is called internal rate because it depends solely on the outlay and proceeds associated
with the project and not any rate determined outside the investment.

5. Profitability index: It is the ratio of the present value of future cash benefits, at the
required rate of return to the initial cash outflow of the investment . It is also called as
benefit cost (BC) ratio. It is calculated as
PI = PV cash inflows/Initial cash outlay 
• The process of determining the present
value of the amount to be received in the
future is known as Discounting. 
• Compounding uses compound  interest
rates while discount rates are used
in Discounting. 
• Compounding of a present amount means
what will we get tomorrow if we invest a
certain sum today.
• Discounting of future sum means, what
should we need to invest today to get the
specified amount tomorrow.
Risk & Uncertainty in Capital Budgeting:
Risk : defined as the chance that the actual outcome will differ from the expected
outcome.
Uncertainty : relates to the situation where a range of differing outcome is possible.
• RADR : The risk-adjusted discount rate is the total of the risk-free rate, i.e. the required 
return on risk-free investments, and the market premium, i.e. the required return of the
market. Financial analysts use the risk-adjusted discount rate to discount a firm’s cash
flows to their present value and determine the risk that investor should accept for a
particular investment. Risk-adjusted discount rate is the rate used in the calculation of
the present value of a risky investment, the risk-adjusted discount rate represents the
required return on investment.
RADR = Risk Free Rate + Risk Premium
k = Rf + Rp
Decision Rule : If NPV is +ve : Accept , if –ve : Reject and IRR > RADR : Accept , if IRR <
RADR : Reject.
• Certainty Equivalent approach in capital budgeting : Under this approach , the riskiness of
the project is taken into consideration by adjusting the expected cash flows and not the
discount rate as in case of Risk-adjusted discount rate approach.
α1 = Risk Free Cash Flow / Risky Cash Flow
• Sensitivity analysis : is widely used in capital budgeting decisions to assess how the
change in such inputs as sales, variable costs, fixed costs, cost of capital, and marginal tax
rate will affect such outputs as net present value (NPV) of a project, internal rate of return
(IRR), and discounted payback period. It also provides a better understanding of the risks
associated with a project.
• Probability Technique : The concept of probability is fundamental to the use of the risk
analysis techniques. It may be defined as the likelihood of occurrence of an event. If an
event is certain to occur, the probability of its occurrence is one but if an event is certain
not to occur, the probability of its occurrence is zero. Thus, probability of all events to
occur lies between zero and one. Probability distribution can be used to compute
expected values.
• Standard deviation is a statistical measure of dispersion. It measures the deviation from a
central number i.e. mean. By calculating standard deviation in capital budgeting, we can
measure in each case the extent of variation. Higher the standard deviation, higher is the
risk associated with the project. However, wherever returns are expressed in revenue
terms the co-efficient of variation gives better measurement for risk evaluation.
Coefficient of variation is calculated as follows: Coefficient of variation = σ/Expected value
• Decision tree technique is a method to evaluate risky proposals. A decision tree shows
the sequential outcome of a risky decision. A capital budgeting decision tree shows the
cash flows and net present value of the project under differing possible circumstances.