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Subject: Financial Management 
Chapter no. 11: Capital Budgeting 
Chapter No. 11 – Capital Budgeting 
Contents
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Capital budgets as opposed to revenue budgets
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Different kinds of capital budgets – non-productive assets, improving operating efficiency and capital projects
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Choosing capital projects – Conventional and Discounted Cash Flow techniques
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Payback period, Discounted payback period, Net Present Value, Internal Rate of Return, Profitability Index methods
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Assumptions underlying different methods
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Introduction to IRR vs. NPV
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Incremental cash flow principle for evaluation of replacement decisions
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Numerical exercises on incremental cash flows, NPV, IRR, Discounted payback periodand Profitability IndexAt the end of the chapter the student will be able to:
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Apply incremental cash flow principle to a replacement decision
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Apply conventional as well as DCF techniques to capital investment decisions
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Determine NPV for a given project and fix the range of rates between which IRR for agiven set of projections would lie
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Understand how IRR readily offers itself for fixing Equated installments on a loan at agiven rate of interest, duration and periodicity like monthly or quarterly
Capital budgets as opposed to revenue budgets
The assumption here is that the students understand the significance of the term “budgets”. To recap, “budgets” areessentially meant for:
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Allocation of scarce resources and
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Control and monitoring of expensesThe budgets are of various kinds, depending upon the objectives in the organisation. The two major finance budgetsthat a business enterprise usually prepare are:
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Revenue budget – prepared on an annual basis with monthly break-up. Purpose is to control revenue expensesrelated to different activities in an organisation. There is a review process. The frequency of break-up could beless say a quarter. The frequency of review process and the period for which break-up is given like month or
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Subject: Financial Management 
Chapter no. 11: Capital Budgeting 
quarter synchronise with each other. If there is a monthly break-up of expenses, the review is also done on amonthly basis.
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Capital budget – prepared on an annual basis with once in a year review process. This budget is more meant forcapital expenses for which the enterprise will be required to manage within its internal accruals and not dependupon external finance. External finance and shareholders’ capital are warranted only for major capitalexpenditure like expansion, diversification, modernisation etc. The students will appreciate that there is adifference between capital expenditure on routine items like say copier machine, furniture and fixtures, EPABX(telephone exchange) etc. which do not give any return unlike industrial projects. Industrial projects require a lotof funds and in turn, give positive cash flows (net cash flows being positive – difference between cash outflowsand cash inflows)In this chapter we are going to learn about capital budgeting, a process of selection of projects and decision onalternative investment opportunities available to a business enterprise.
Different kinds of capital budgets – non-productive assets, improving operating efficiency and capitalprojects
 Just to link this point with what we have seen in the previous paragraph, we may state that there could be differentkinds of capital budgets in an organisation like:1.Budgets for projects that involve huge capital outlays (cash outflows) but also bring in substantial net cashinflows2.Budgets for replacement of assets that bring in improved operating efficiency resulting in cost reduction that isindirectly cash inflow – this is different from the first one in requirement of funds also. Further this is done on anon going basis unlike industrial projects that happen once in a while3.Budgets for routine items that are fairly regular (examples given in the preceding paragraph) and involve onlycapital expenditure from internal accruals.We can see that the parameters for all the above three would be different for planning, resource mobilisation,resource allocation, monitoring and control. Let us see the differences in the following lines.1.Budgets for projects require in-depth and detailed planning like project report including report on marketingfeasibility, technical feasibility, technological feasibility, financial feasibility etc. Resource mobilisation will bepartly from equity of promoters and major portion will be in the form of debts like project loans, debentures etc.There will be a separate committee constituted in professionally run organisations called, “project committee”that takes the responsibility for the entire project. The committee is associated with the project right from theconception of the project till its completion and commercial production. One of the major functions of thecommittee is “project review, monitoring and control”. Lenders go in depth into the risks associated with theprojects and have a detailed appraisal before sanctioning the loans etc. The repayment of the external loans isspread over a fairly long period.2.Budgets for replacement may or may not be supported by external assistance. If the requirement is substantialdue to a number of machines being replaced, although in a phased manner, external assistance may be called forin the form of loans; otherwise the resources could be “internal accruals”. If external loan is warranted, theplanning process will be very much involved, although it will not be elaborate. The resource mobilisation will befairly easy, easier than in the case of projects. The repayment period will be shorter than for projects in point no.1 above. The resource allocation, monitoring and control will also be fairly simple.3.Budgets for routine items have to be met only from internal accruals. Rarely external assistance will be availablefor this as incremental income will be absent. Hence a lot of internal control is called for in this case. There willbe constant demand from various departments within the organisation for funds and budgetary process is verymuch indicated here. Budget is for resource allocation, monitoring and control. Not much of planning isrequired and resources are available internally.
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Subject: Financial Management 
Chapter no. 11: Capital Budgeting 
Choosing capital projects – Conventional and Discounted Cash Flow techniquesBasis for project cash flows and capital expenditure on projects
A project owner wants return from the project higher than the cost of debt (borrowing) and the cost of equity (hisown contribution). Please refer to the chapters on “time value of money” as well as “cost of capital”. He also wantsthe recovery of capital (total of equity and debt) within a period that he is comfortable with. This period is known as“pay back period”. Thus from the project owner’s point of view he has definite ideas on:
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The period for capital recovery and
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The rate of return from the projectThe finance manager or the consultant as the case may be proceeds to prepare the project cash flows based on certainassumptions that are central to the working of the project. Some of the assumptions are:
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The cost of the project and means of financing them
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The cost of all inputs like materials, power etc. and the selling prices of outputs
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The weighted average cost of capital
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The rates of depreciation on the fixed assets
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The requirement of working capital for the project
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The installed capacity (in terms of 100% production) of the plant
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The capacity utilisation in terms of % of the installed capacity
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The rate of corporate taxes that the business will be paying
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The repayment or redemption period for various loans, debentures or bonds
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The number of days working for the project
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The number of shifts on which the production will be done
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The cost of imported materials, components if any and the foreign exchange fluctuation if any etc.
Note: As usual, this list is not exhaustive. These are some of the better-known assumptions for the projectworking. The success of the project lies in the assumptions being as close to reality as possible.
Methods of financial evaluation of the project:
The methods take into account the following considerations from the project owners’ and project lenders’ points ofview:1.Whether the project is earning a return that is higher then its cost of capital?2.Whether the project’s earnings recover the capital investment in the desired period called “pay back period”?3.Whether the objective of the project in creating assets is achieved through “wealth maximisation” – by addingfurther wealth?
Broad classification of the methods of financial evaluation of projects –
Conventional methods – these methods do not consider the timing of the future cash flows. Let us see the followingexample to understand this.
Example no. 1
We invest in a project Rs. 300 lacs. The projected cash flows at the end of three years is as under:
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