CAPITAL

BUDGETING
What is Capital Budgeting?

Capital Budgeting is defined as the process by which a business determines which fixed asset
purchases or project investments are acceptable and which are not.

Capital asset management requires a lot of money; therefore, before making such
investments, they must do capital budgeting to ensure that the investment will procure profits
for the company.
Techniques/ Methods of
Capital Budgeting
#1 Payback Period Method
It refers to the time taken by a proposed project to generate enough income to cover the initial investment. The
project with the quickest payback is chosen by the company.

Formula:

Payback period =

Example:

An enterprise plans to invest Rs.1,00,000 to enhance its manufacturing process. It has two mutually
independent options in front: Product A and Product B. Product A exhibits a contribution of Rs.25
and Product B of Rs.15. The expansion plan is projected to increase the output by 500 units for
Product A and 1,000 units for Product B.
#2 Net Present Value
Net present value is a tool of Capital budgeting to analyze the profitability of a project or
investment. It is calculated by taking the difference between the present value of cash inflows
and present value of cash outflows over a period of time.

Formula for NPV:

= FV FV= Future Value

r = rate of return
n = number of periods
Example:

Invest Rs.20,000 now and receive 3 yearly payments of Rs.5,000 each, plus
Rs.12,000 in the 3rd year. Use 10% discount Rate. Find NPV.

10% discount rate: DCF @ 10% Present Values

Year DCF
0 1.00
1 0.9091
2 0.8264
3 0.7513
#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the cash inflow rate equals the cash outflow rate. Although it considers the time value of money, it is one of the complicated methods.

It follows the rule that

if the IRR is more than the average cost of the capital, then the company accepts the project, or else it rejects the project.

Example:

Invest Rs. 9,000 now, receive 3 yearly payments of Rs. 2,500 each, plus Rs. 4,000 in the 3rd year. Find IRR.