Unit II: Introduction to Capital Budgeting, Importance of capital Budgeting, Capital

Budgeting Process, Techniques of Capital Budgeting – Accounting Rate of Return,

Pay Back Period, Net Present Value, Internal Rate of Return, and Profitability Index.

INVESTMENT DECISIONS
 Introduction to Capital Budgeting

Budget

An estimate of income and expenditure

for a set period.
Introduction to Capital Budgeting
• The term Capital Budgeting is a combination of two words ‘Capital’
and ‘budgeting.’

• The capital here refers to big expenditures that a firm makes, such as
buying assets, research and development expenses, and more.

• The term ‘Budgeting’ means setting targets to maximize profitability.

• Capital Budgeting refers to the process of analyzing big

expenditures to get maximum return on investments.

• Capital budgeting refers to the application of appropriate capital

budgeting techniques (one or more) to evaluate any capital budgeting
proposal and make a capital budgeting decision.
 Capital budgeting is a technique for
evaluating big investment projects.

Basics of It helps an entity decide whether or

Capital not a project would offer the
expected returns in the long term.
Budgeting
Also, it helps a company to choose
the best project when it faces a
choice between two or more
products.
 Capital budgeting is the process of evaluating long-range
investment proposals for the purpose of allocating limited
resources effectively and efficiently.

Basics of
Capital Budgeting techniques are employed to assess the financial
viability of the project.

Capital Suppose, for instance, a company wants to introduce a new soap

Budgeting and launching of the new product demands changes in the

manufacturing process, the company will have to purchase new
equipment in the form of fixed assets.

Capital budgeting is a technique used to evaluate the value of

investment and projects in fixed assets. It is also used to assess the
working capital requirements.
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
• For the growth & prosperity of any organization, a long term vision is necessary, because a wrong decision
may severely impact the survival of the firm, which may influence the capital budgeting in the long run.
• Not only this, but it also impacts the companies future cost & growth. In the long run, capital spending has
a significant impact on business profitability.
2 – Huge Investments
3 – Decision cannot be Undone
4 – Expenditure Control
5 – Information Flow
6 – Helps in Investment Decision
7 – Wealth Maximization
8 – Risk and Uncertainty
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
Any organization needs considerable investment to grow as the company has limited 
resources to grow while taking the investment decision; it has to make a wise decision. Because the
wrong decision may blow up the sustainability of the business, it may profoundly impact the purchase
of an asset, rebuilding or replacing existing equipment.
3 – Decision cannot be Undone
4 – Expenditure Control
5 – Information Flow
6 – Helps in Investment Decision
7 – Wealth Maximization
8 – Risk and Uncertainty
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
Most of the time, the capital investment decision are irreversible in nature; it caters to vast
investment, and it is difficult to find the market for it. The only way to remains with the
company is to scrap the asset and bear the losses.
4 – Expenditure Control
5 – Information Flow
6 – Helps in Investment Decision
7 – Wealth Maximization
8 – Risk and Uncertainty
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
4 – Expenditure Control:
Capital budgeting requires more attention to the expenditure and do R&D for an investment project
if needed. A good project turns into bad if the expenses were not done in a controlled manner and
not monitored carefully, While this step is quite crucial in the capital budgeting process.
5 – Information Flow
6 – Helps in Investment Decision
7 – Wealth Maximization
8 – Risk and Uncertainty
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
4 – Expenditure Control:
5 – Information Flow:
Capital budgeting process facilitates the transfer of information to appropriate
decision-makers so they can make a better decision in the growth of the organization.
6 – Helps in Investment Decision
7 – Wealth Maximization
8 – Risk and Uncertainty
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
4 – Expenditure Control:
5 – Information Flow:
6 – Helps in Investment Decision:
The long-term investment decisions are time-consuming as it takes several years for accomplishment
beyond the current period. Uncertainty defines the involvement of the risk in it. Management loses
his flexibility and liquidity of funds when making an investment decision. It must be considered
while accepting the proposal.
7 – Wealth Maximization
8 – Risk and Uncertainty
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
4 – Expenditure Control:
5 – Information Flow:
6 – Helps in Investment Decision:
7 – Wealth Maximization:
Motivate the organization to invest in long term investment to safeguard the interest of the shareholder in
the organization. If the organization invests in certain projects in a planned manner, the shareholder will
show their interest in the organization. It will help them to maximize the growth of the organization. Any
expansion of the organization is further related to the growth, sales, and future profitability of the firm and
assets based on capital budgeting.
8 – Risk and Uncertainty
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
4 – Expenditure Control:
5 – Information Flow:
6 – Helps in Investment Decision:
7 – Wealth Maximization:
8 – Risk and Uncertainty:
When we invest in certain project expects a certain return in the permanent commitment of funds. More
risk is involved because of the permanent commitment of funds. Capital budgeting decision is surrounded
by a great number of uncertainties whether the investment is in present or in future. Longer the period of
the project, more the risk and uncertainty involved. The estimates about the cost, revenues, and profits may
vary depending upon the time.
9 – Complicacies of Investment Decisions
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
4 – Expenditure Control:
5 – Information Flow:
6 – Helps in Investment Decision:
7 – Wealth Maximization:
8 – Risk and Uncertainty:
9 – Complicacies of Investment Decisions:
The investment in long term proposals is quite tedious and involves a lot of complicacy in
nature. While the purchase of fixed assets is a continuous process, so the management needs to
understand the complicacy of connected projects.
10 – National Importance
 Importance of Capital Budgeting
1 – Long Term Effect on Profitability:
2 – Huge Investments:
3 – Decision cannot be Undone:
4 – Expenditure Control:
5 – Information Flow:
6 – Helps in Investment Decision:
7 – Wealth Maximization:
8 – Risk and Uncertainty:
9 – Complicacies of Investment Decisions:
10 – National Importance:
Initiation of any project offers new job opportunities, helps in economic growth, which
increases per capita income. These are the contribution made by the company during the
selection of a new project.
TYPES OF CAPITAL BUDGETING DECISIONS
1. Accept / Reject Decision: This type of arrangement is fundamental
and mostly applies to the independent projects which are not affected
by the acceptance possibility of other projects. The projects which
generate a high rate of return or cost of capital are accepted, and the
plans which do not fulfil the criteria are rejected.

2. Mutually Exclusive Project Decision: These projects compete with

one another, i.e., the possibility of accepting one project excludes the
acceptance of the other.

3. Capital Rationing Decision: The term itself explains that the

limitation of capital dominates such decisions. In a situation where
the firm has multiple investment options demanding huge funds, the
management rank the projects on specific criteria; such as the rate of
return of each project. Then, the projects with the highest percentage
of profit or those which fulfil the requirements most can be selected.
 Capital budgeting is the evaluation and selection of
long-term investments on the basis of their costs
and potential returns.

The process provides a framework for formulating

and implementing the appropriate investment
Techniques of Capital strategies.

Budgeting
Cash flow estimates are used to determine the
economic viability of long-term investments.

The cash flows of a project are estimated using

discounted and non-discounted cash flow methods.
 Discounted Cash Flows

1.Discounted cash flow, or DCF, methods account for the time

value of money when determining the viability of projects.

2.This time value is the change in the purchasing power of the

Techniques of currency over time. The DCF methods also indicate the

Capital Budget opportunity cost -- that is, the consequences of forgoing

alternative investments to make the chosen investment.

3.The main types of DCF methods are Net Present Value,

Internal Rate of Returns and the profitability index.
 ESTIMATING CASH FLOWS FOR PROJECT APPRAISAL

Non-discounted Cash Flows

1.Non-DCF methods do not account for the time value of money; they assume the value of
the currency will remain constant over the economic life of a capital investment.

2.The Payback Period, or PBP, and accounting rate of return are the non-DCF method that
uses cash flow estimations. PBP is the duration it takes to recover the initial capital of an
investment.

3.Investments with short PBP are preferred over investments with longer PBP. However,
this method has major shortcomings, because it does not show the timing of cash flows
and the time value of money.
ESTIMATING CASH FLOWS FOR PROJECT APPRAISAL
TECHNIQUES OF CAPITAL BUDGETING DECISIONS
• The Delta company is planning to purchase a machine known as
machine X. Machine X would cost Rs.25,000 and would have a useful
life of 10 years with zero salvage value. The expected annual cash
inflow of the machine is Rs.10,000.

Payback period = 25,000/10,000

= 2.5 years

According to payback period analysis, the purchase of machine X is desirable because its payback period is
2.5 years.
• An investment of 2,00,000 is expected to generate the following cash
inflows in six years:
• Year 1: 70,000
Year 2: 60,000
Year 3: 55,000
Year 4: 40,000
Year 5: 30,000
Year 6: 25,000
Compute payback period of the investment. 
Payback period = 3 + (15,000*/40,000)
= 3 + 0.375
= 3.375 Years
• An investment of 2,20,000 is expected to
generate the following cash inflows in six
years:
• Year 1: 45,000
Year 2: 27,000
Year 3: 62,000
Year 4: 35,000
Year 5: 56,000
Year 6: 78,000
Compute payback period of the investment. 
 The Fine Clothing Factory wants to replace an old machine with a new one. The old
machine can be sold to a small factory for $10,000. The new machine would increase
annual revenue by $150,000 and annual operating expenses by $60,000. The new
machine would cost $360,000. The estimated useful life of the machine is 12 years with
zero salvage value.
1.Compute accounting rate of return (ARR) of the machine using above information.
2.Should Fine Clothing Factory purchase the machine if management wants an accounting
rate of return of 15% on all capital investments?
Solution:
(1):Computation of accounting rate of return:
= $60,000* / $350,000**
= 17.14%
*Incremental net operating income:
Incremental revenues – Incremental expenses including depreciation
$150,000 – ($60,000 cash operating expenses + $30,000 depreciation)
$150,000 – $90,000
$60,000
** The amount of initial investment has been reduced by the net realizable value of the old
machine ($360,000 – $10,000).

(2). Conclusion:
According to accounting rate of return method, the Fine Clothing Factory should purchases
the machine because its estimated accounting rate of return is 17.14% which is greater than
the management’s desired rate of return of 15%.
 The Chocolate factory wants to replace an old machine with a new one. The old machine
can be sold to a small factory for $15,000. The new machine would increase annual
revenue by $1,65,000 and annual operating expenses by $50,000. The new machine
would cost $2,80,000. The machine’s estimated useful life is 10 years with zero salvage
value.
1.Compute accounting rate of return (ARR) of the machine using above information.
2.Should Fine Clothing Factory purchase the machine if management wants an accounting
rate of return of 20% on all capital investments?
Solution:

Incremental net operating income:

Incremental revenues – Incremental expenses including
depreciation

The amount of initial investment has been reduced by the net

realizable value of the old machine
Net Present Value (NPV)
 A project requires an initial investment of 225,000 and is expected to generate the following net cash inflows:
Year 1: 95,000
Year 2: 80,000
Year 3: 60,000
Year 4: 55,000
Compute net present value of the project if the minimum desired rate of return is 12%.

Solution:
The cash inflow generated by the project is uneven. Therefore, the present value would be computed for each year
separately:

The project seems attractive because its net present value is positive.
 The Internal Rate of Return or IRR is a rate that makes the net present value of any project equal to zero. In
other words, the interest rate that equates the present value of cash inflow with the present value of cash outflow of
any project is called as Internal Rate of Return.

Merits of Internal Rate of Return

1.IRR takes into account the Time Value of Money.
2.It considers the cash flows over the entire life of the project.
3.IRR is consistent with the goal of wealth maximization.
4.While computing the NPV the discount rate taken is normally the cost of capital, but in the case of IRR, there
is no need for the cost of capital because the rate of return generated by the project itself is used to evaluate
the efficiency of the project. Thus, the rate is internal to the project.

Demerits of Internal Rate of Return

5.It is quite difficult and involves tedious calculations.
6.IRR produces multiple discount rates, which might be confusing.
7.While evaluating the mutually exclusive proposals, the project having the highest value is chosen over the
other that may not be necessarily the most profitable or be in line with the objectives of the firm of wealth
maximization.
8.It is assumed that the cash flows are reinvested at an internal rate of return.
The internal rate of return is usually the rate of return that a project earns. It is often called as the yield on
investment, the marginal efficiency of capital, the marginal productivity of capital, rate of return and time
adjusted rate of return.
Formula
Profitability Index
SP Limited company is having two projects, requiring a capital outflow of Rs. 150,000. The expected annual
incomes as follows

S.No. X Y
1 60000 40000
2 50000 45000
3 40000 50000
4 30000 25000
5 20000 15000
Taking the cutoff rate as 10%, Calculate Profitability Index (PI).
 Discount Discount
S.No. Cash factor Present S.No. Cash factor Present
Inflows @10% Value Inflows @10% Value
1 60000 0.909 54540 1 40000 0.909 36360
2 50000 0.826 41300 2 45000 0.826 37170
3 40000 0.751 30040 3 50000 0.751 37550
4 30000 0.683 20490 4 65000 0.683 44395
5 20000 0.621 12420 5 50000 0.621 31050
Present Value 158790 186525
Less Initial outlay 150000 150000
NPV 8790 36525
Profitability Index PV/IO PV/IO
PI 1.0586 1.2435