CAPITAL BUDGETING

The management of any business enterprise has to make two type of decisions, short and long term. The long term decisions relates to capital budgeting which implies the budgeting of expenditure on capital assets. Definitions:- capital budgeting generally refers to acquiring inputs with long term returns. Definition:- capital budgeting is a long term planning for making and financing proposed capital outlays.

Types of decisions
Replacement Buy or lease Expansions Installation

Data for capital expenditure decisions

Initial investments Cash inflows

Treatment of depreciation
Treatment of salvage value Working capital requirement

Approaches to capital budgeting decisions

1. Accept-reject approach

2. Ranking approach

Methods of evaluating investment proposals

A. TRADITIONAL METHODS 1. first years performance method 2. pay back period method 3. Average Rate of Return B. DISCOUNTED CASH FLOW TECHNIQUE 1. Discounted pay back period 2. Net present value method 3. Profitability Index 4.Internal rate of return

Capital Rationing
Firms may have alternative and multiple projects to accept but limited amount of money to invest. The company under such circumstances, adopts policy of capital rationing. Capital rationing is a process of capital allocation or distribution of capital over capital projects according to rank and their profitability.

The objectives of capital rationing is to select the projects that will maximize the owners wealth.

IRR Approach
This approach involves plotting IRRs or yield, against total rupees on the basis of decreasing yields. Suppose there are 6 projects for a fixed budget of Rs.250000. The IRR and initial investment for each projects are given below: projects initial invest. IRR A 80000 12% B 70000 20% C 100000 18% D 40000 8% The firms Cost of Capital is 10%. Advise the management as regard to capital rationing.

Solution:
On the basis of internal rate of return the projects are ranked. Projects IRR Capital allocation Cumulative

B C E

20% 18%

70000 100000

70 000 1 70 000

15% 60000 2 30 000 A 12% 80000 -----So, on the basis of internal rate of return the projects are ranked because this is a rate which the companies earn on its investments. And it is also to be compared with cost of capital to make financial decisions.