m MEANING

m NATURE
m NEED
m KINDS OF DECISIONS
m TRADITIONAL METHOD: ARR
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Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to firm¶s future.

conceptually, capital budget process is identical to decision

process used by individuals making investment decisions
m The firm¶s decision to invest its current funds most
efficiently in the long term assets in anticipation of
an expected flow of benefits over a series of
years. Or
m Capital budgeting is the process of making
investment decisions in capital expenditures.
m Capital expenditure decisions are also called as
long term investment decisions.
m Capital budgeting is also known as investment
decision making, Capital Expenditure decisions,
Planning capital Expenditure and Analysis of
capital Expenditure.
m Is an expenditure incurred for acquiring or
improving the fixed assets, the benefits of which
are expected to be received over a number of
years in future.
m For example:
(1) Cost of acquisition of permanent assets as
land and building, plant and machinery, goodwill,
etc
(2) Cost of addition, expansion, improvement or
alteration in the fixed assets.
(3) Cost of replacement of permanent assets,
(4) Research and development project cost, etc.
m The exchange of current funds for future
benefits.
m The funds are invested in long-term assets.
m The future benefits will occur to the firm over a
series of years.
m They have a long term and significant effect on
the profitability of the concern.
m They involve, generally, huge funds.
m They are irreversible decisions.
m Growth
m Risk
m Funding
m Irreversibility
m Complexity
m Growth: Fixed assets are earning assets, since they
have decisive influence on the rate of return and
direction of firm¶s growth.
m More Risky: Investment in long-term assets increase
average profit but it may lead to fluctuations in its
earnings, then firm will become more risky. Hence,
investment decision decides the future of the business
concern.
m Huge Investments/ Funding: long-term assets involve
more initial cash out flows, which make the firm
imperative to plan its investment programs very
carefully and make an advance arrangement of funds
either from internal sources or external sources or
from both sources.
m Irreversibility: long-term investments decisions are
not easily reversible without much financial loss to
the firm; due to difficult to find out market for such
used capital items. Hence, firm will incur more loss
in that type of capital assets.
m Complexity: Capital budgeting decision is very
difficult due to
(a) the decision involves based on expected future
years cash inflows,
(b) the uncertainty of future and more risk.
m Measurement problem: evaluation of project requires
identifying and measuring its costs and benefits of that
project, which are difficult since they involve tedious
calculations and lengthy process.
m Uncertainty: Selection or Rejection of a capital
expenditure project depends on expected costs and
benefits that for in to the future.
m Temporal spread: the cost and benefits, which are
expected, to be associated with a particular capital
expenditure project spread out over a long period of
time, which is 10-20 years for industrial projects and 20-
50 years for infrastructure projects. The temporal
spread creates some problems in estimating discount
rates for conversation of future cash inflows in present
values and establishing equivalences.
m One classification is as follows:
- Expansion of existing business
- Expansion of new business
- Replacement and modernisation

m Det another useful way to classify investments

is as follows:
- Mutually exclusive investments
- Independent investments
- Contingent investments
!RIDGE vs. !OAT to get products across a river.

Projects are: mutually exclusive, if the cash flows of one can be adversely impacted by
the acceptance of the other.
Projects are: independent, if the cash flows of one are unaffected by the acceptance of
the other.
m It should maximise the shareholders¶ wealth.
m It should consider all cash flows to determine the true profitability of
the project.
m It should provide for an objective and unambiguous way of
separating good projects from bad projects.
m It should help ranking of projects according to their true profitability.
m It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.
m It should help to choose among mutually exclusive projects that
project which maximises the shareholders¶ wealth.
m It should be a criterion which is applicable to any conceivable
investment project independent of others.
m Three steps are involved in the evaluation of an
investment:
- Estimation of cash flows
- Estimation of the required rate of return (the
opportunity cost of capital)
- Application of a decision rule for making the choice
 Idea Review of the
generation Project

Evaluation or Execution or
analysis Implementation

Financing the
Selection selected
project
 Traditional or Modern or
Non-discounted Discounted
cash flow Cash Flow

Net
Pay !ack
Present
Period
Value

Accounting Internal
Rate of Rate Of
Return Return

Profitability
Index
m ARR method uses accounting information as
revealed by financial statements, to measure the
profitability of the investment proposals. It is also
known as the return on investment (ROI).
Sometimes it is called as average rate of
return(ARR). Average annual earnings after
depreciation and taxes are used to calculate ARR.
It is measured in terms of percentage. ARR may
be calculated in two ways.
m henever it is clearly mentioned as Accounting Rate of
Return
if accounting rate of return is given in the problem,
return on original investment method should be used to
calculate accounting rate of return.
ARR= Average Annual EAT or PAT ×100
Original Investment (OI)*
* OI = Original Investment+ Additional NC+ Installation
charges+ Transportation charge
m (ii) whenever it is clearly mentioned as Average Rate Of
Return
if the average rate of return is given in the problem,
return on average investment method should be used to
calculate average rate of return.
ARR= Average Annual EAT ×100
Average Investment(AI)*
*AI=(Original investment-Scrap Value)1/2+ Additional
NC + Scrap Value
m (iii) if ARR is given in the problem, any of the method
can be used to calculate ARR
(preferably return on average investment method).

DECISION RULE
Acceptance or Rejection of the project decided on the
based comparison of calculated ARR with the
predetermined rate or cut off rate.
Accept: Cal ARR> Predetermined ARR or Cut-off rate
Reject: Cal ARR< Predetermined ARR or Cut-off rate
The ARR method has some merits:
- It is very simple to understand and easy to
calculate.
- Information can easily be from accounting records.
- It takes into account all profits of the projects life
period.
- Cost involvement in calculating ARR is very less
with the comparison of modern methods, since it
saves analyst¶s time.
m It uses accounting profits instead of actual cash flows
after taxes in evaluating the projects.
m It ignores the concept of time value of money.
m It does not allow the fact that profit can be reinvested.
m It does not differentiate between the size of the
investment required for each project.
m It does not take into consideration any benefits, which
can accrue to the firm from the sale of the abundant of
equipment, which is replaced by the new investment.
m It feels that 10 percent rate of return for 10 years
is more beneficial tan 8 percent rate of return for
25 years.
m It is incompatible with the objective of wealth
maximization to the equity shareholders.
m It uses arbitrary cut-off as yardstick or standard for
acceptance or reject rule.