Capital Budgeti

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Capital Budgeting
Capital Budgeting
Introduction:
Firms continuously invest in assets, these assets produce income and cash flows
that the firm can than either reinvest in more asset or pay to the owners. This asset
represents firms capital. Capital is the firms total asset. It includes all tangible and
intangible assets. A firms capital investment decisions are compromised of distinct
decisions. The investment decision of the firm is known as capital budgeting decision.
A capital budgeting may be defined as the firms decision to invest its current fund
most efficiently in the long term asset in anticipation of expected flow of benefits
over a series of year. An efficient allocation of capital is the most important finance
function in modern times. Such decisions are of considerable importance to the firm
since they tend to determine its value size by influencing its growth, risk and
profitability.
Importance of Capital Budgeting because capital budgeting decisions impact the
firm
for several years, they must be carefully planned. A bad decision can have a significant
effect on the firms future operations. In addition, the timing of the decisions is
important. Many capital budgeting projects take years to implement.
If firms do not plan accordingly, they might find that the timing of the capital budgeting
decision is too late, thus costly with respect to competition. Decisions that are made too
early can also be problematic because capital budgeting projects generally are very large
investments, thus early decisions might generate unnecessary costs for the firm.
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Capital Budgeting
Generating Ideas for Capital Budgetingideas for capital budgeting projects usually
are generated by employees, customers, suppliers, and so forth, and are based on the
needs and experiences of the firm and of these groups. For example, a sales
representative might continue to hear from some of his or her customers that there is a
need for products with particular characteristics that the firms existing products do
not possess.
The sales representative presents the idea to management, who in turn evaluates the
viability of the idea. By consulting with engineers, production personnel, and perhaps
by conducting a feasibility study. After the idea is confirmed to be viable in the sense
it is saleable to customers, the financial manager must conduct a capital budgeting
analysis to ensure the project will be beneficial to the firm with respect to its value.
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Capital Budgeting
Capital is a limited resource

In the form of either debt or equity, capital is a very limited resource. There is a
limit to the volume of credit that the banking system can create in the economy.
Commercial banks and other lending institutions have limited deposits from which
they can lend money to individuals, Corporations, and governments.
In addition, the Federal Reserve System requires each bank to maintain part of
its deposits as reserves. Having limited resources to lend, lending institutions are
selective in extending loans to their customers. But even if a bank were to extend
unlimited loans to a company, the management of that company would need to
consider the impact that increasing loans would have on the overall cost of
financing.
In reality, any firm has limited borrowing resources that should be allocated
among the best investment alternatives. One might argue that a company can issue
an almost unlimited amount of common stock to raise capital. Increasing the number
of shares of company stock, however, will serve only to distribute the same amount
of equity among a greater number of shareholders.
In other words, as the number of shares of a company increases, the company
ownership of the individual stockholder may proportionally decrease. The argument
that capital is a limited resource is true of any form of capital, whether debt or equity
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Capital Budgeting
(short-term or long-term, common stock) or retained earnings, accounts payable or

notes payable, and so on.
Even the best-known firm in an industry or a community can
increase its the
company ownership of the individual stockholder may proportionally decrease. The

argument that capital is a limited resource is true of any form of capital, whether
debt or equity (short-term or long-term, common stock) or retained earnings,
accounts payable or notes payable, and so on.
Even the best-known firm in an industry or a community can increase its
borrowing up to a certain limit. Once this point has been reached, the firm will either
be denied more credit or be charged a higher interest rate, making borrowing a less
desirable way to raise capital. Faced with limited sources of capital, management
should carefully decide whether a particular project is economically acceptable.
In the case of more than one project, management must identify the projects that
will contribute most to profits and, consequently, to the value (or wealth) of the firm.
This, in essence, is the basis of capital budgeting.
GOAL OF THE FIRM
Maximize share holder wealth or value of the
firm
Financing
decisions
Dividend
decision
Investment
decision
Long term
investmen
t
Short
term
investmen
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Capital
NOTE:-This work is copyright () to its Authors. This is only
for Educational
budgeting
Purpose.
Capital Budgeting
As such capital budgeting decision have a major effect on the value of the firm and
its
shareholder wealth.
Features of capital budgeting
1. It involves the exchange of current funds for the
benefits to be achieved in
future.
2. The benefits are expected to be realized over a period of years.
3.
Funds are invested in long term activities.
4.
It involves generally huge funds.
5. They are irreversible decisions.

6.
It has significant effect on the profitability of the concern.
7. A suitable administrative framework capable of transferring required

information to the decision level.
8.
The controlling of expenditures and careful monitoring of crucial aspects

of project execution.
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9.
A set of decision rules which can differentiate acceptable from

unacceptable alternatives is required.
10. A suitable administrative framework capable of transferring required

information to the decision level.
11. The controlling of expenditures and careful monitoring of crucial aspects
of project execution.
12. A set of decision rules which can differentiate acceptable from
unacceptable alternatives is required.
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Evolution of capital budgeting
Budgeting for capital expenditure has evolved over the decades and its importance has
increased (or decreased) over time. Overall, six discernible stages of changes in
capital budgeting practices and systems can be identified.12 The first stage is the
Great Depression years during which efforts were mainly focused on designing ways
to ensure economic recovery.
At the time, public borrowing for financing capital outlays, except for
emergencies, was not favored. In a cautious approach, Sweden introduced a capital
budget that was to be funded by public borrowing and used to finance the creation of
durable and self-financing assets that would contribute to an expansion of net worth
equivalent to the amount of borrowing. This so-called investment budget found
extended application in other Nordic countries in following years.
The second stage took place during the late 1930s when the colonial government in
India introduced a capital budget to reduce the budget deficit by shifting some items
of expenditures from the current budget. It was believed that the introduction of this
dual budget system would provide a convenient way to reduce deficits while
justifying a rationale for borrowing.
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The third stage refers to the growing importance attached to capital budgets as a
vehicle for development plans. Partly influenced by the Soviet-style planning, many
low-income countries formulated comprehensive five-year plans and considered
capital budgets the main impetus for economic development. Where capital budgets
did not exist, a variant known as the development budget was introduced.
Capital Budgeting in the 1960s to 1990s

The fourth stage reflects the importance of economic policy choices on the allocation of
resources in government. Quantitative appraisal techniques were applied on a wider scale
during the 1960s leading to more rigorous application of investment appraisal and financial
planning.
In the 1960s and 1970s, it was widely believed that government budget allocation,
including investment expenditures, could be largely reduced to a scientific process by
systems such as PPBS (planning, programming and budgeting system) or even ZBB (zerobased budgeting). Spackman believed that this turned out not to be true, for three main
reasons. One reason was that, for most public policies, finding the best way forward depends
not only on analysis but very largely on pragmatism, political intuition and windows of
political opportunity.
Second, the information demands were equivalent to those required to run a centrally
controlled economy. Third, the implied power structure within government was that of
control in detail from the center, as opposed to delegated authority, incentive structures and
local initiative.
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Capital Budgeting
A fifth stage saw a revival of the debate about the need for a capital budget in government,
particularly in the United States. Along with the growing application of quantitative
techniques during the 1960s came the view that the introduction of a capital budget could be
advantageous. But this view did not gain much support. A presidents commission in 1999
investigating budget concepts in the United States concluded that a capital budget could lead
to greater outlays on bricks and mortar, and as a result, current outlays could suffer.
Having rejected the use of separate capital budgets, the commission advocated the
introduction of accrual accounting in government accounts. The introduction of accrual
accounting, which did not make any progress in the United States until the early 1990s,
would have meant the division of expenditures into current and investment outlays.
Meanwhile, however, a development cast more serious doubts on the need for capital
budgets. Sweden (and other Nordic countries), which had made pioneering efforts in the
1930s, undertook a review of its budget system in the early 1970s. They found that excessive
focus on capital budgets would need to be tempered by a recognition that the overall
credibility and creditworthiness of a government depend more on its macroeconomic policy
stance and less on a governments net worth. This shift in emphasis contributed to a decline in
the popularity of the use of the capital budget until the late 1980s, when it came to be revived
in a different form. By then, government officials recognized that the management of
government finances required a new approach, and this approach was the application of
accrual accounting.
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Capital Budgeting
Component of Capital Budget
Initial Investment Outlay:

It includes the cash required to acquire the new equipment or build the new plant less
any net cash proceeds from the disposal of the replaced equipment. The initial outlay
also includes any additional working capital related to the new equipment. Only
changes that occur at the beginning of the project are included as part of the initial
investment outlay. Any additional working capital needed or no longer needed in a
future period is accounted for as a cash outflow or cash inflow during that period.
Net Cash benefits or savings from the operations:

This component is calculated as follow: The incremental change in operating
revenues-The incremental change in the operating cost = Incremental net revenueTaxes Changes in the working capital and other adjustments
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Terminal Cash flow

It includes the net cash generated from the sale of the assets, tax effects from the
termination of the asset and the release of net working capital.
The Net Present Value technique

Although there are several methods used in Capital Budgeting, the Net Present Value
technique is more commonly used. Under this method a project with a positive NPV
implies that it is worth investing in.
Example:
A company is studying the feasibility of acquiring a new machine. This machine will
cost $350,000 and have a useful life of three years after which it will have no salvage
value. It is estimated that the machine will generate operating revenues of $300,000
and incur $75,000 in annual operating expenses over the useful life of three years. The
project requires an initial investment of $15,000 in working capital which will be
recovered at the end of the three years. The firms cost of capital is 16%. The firms
tax rate is 25%.
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Significance of capital budgeting
The key function of the financial management is the selection of the most
profitable assortment of capital investment and it is the most important area of
decision-making of the financial manger because any action taken by the manger in
this area affects the working and the profitability of the firm for many years to come.
The need of capital budgeting can be emphasized taking into consideration the
very nature of the capital expenditure such as heavy investment in capital projects,
long- term implications for the firm, irreversible decisions and complicates of the
decision making. Its importance can be illustrated well on the following other
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Indirect Forecast of Sales:

The investment in fixed assets is related to future sales of the
firm during the life
time of the assets purchased. It shows the possibility of expanding the production
facilities to cover additional sales shown in the sales budget. Any failure to make the
sales forecast accurately would result in over investment or under investment in fixed
assets and any erroneous forecast of asset needs may lead the firm to serious
economic results.
Comparative Study of Alternative Projects:

Capital budgeting makes a comparative study of the alternative projects for the
replacement of assets which are wearing out or are in danger of becoming obsolete so
as to make the best possible investment in the replacement of assets. For this purpose,
the profitability of each project is estimated.
Timing of Assets-Acquisition:
Proper capital budgeting leads to proper timing of assets-acquisition and improvement
in quality of assets purchased. It is due to the nature of demand and supply of capital
goods. The demand of capital goods does not arise until sales impinge on productive
capacity and such situations occur only intermittently. On the other hand, supply of
capital goods with their availability is one of the functions of capital budgeting.
Cash Forecast:
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Capital Budgeting
Capital investment requires substantial funds which can only be arranged by making
determined efforts to ensure their availability at the right time. Thus it facilitates cash
forecast.
Wealth-Maximization of Shareholders:
The impact of long-term capital Investment decisions are far reaching. It protects the
interests of the shareholders and of the enterprise because it avoids over-investment
and under-investment in fixed assets. By selecting the most profitable projects, the
management facilitates the wealth maximization of equity share-holders
Features which distinguish capital budgeting decisions from ordinary

day to day business
1. Calculation is based on cash flow as it is the cash in hand that is important for
immediate investment and not the profit which may not be entirely in cash (Cash
flow = Accounting profit before depreciation, interest and tax depreciation
interest tax + depreciation)
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2. It involves the exchange of current funds for the benefits to be achieved in future.
3. The future benefits are expected to be realized over a series of years.
4. A significant period of time (more than one year) elapses between the investment
outlay and the receipt of the benefits.
5. They influence the firms growth in the long run as the effects of investment
decision extend into the future.
6. They affect the risk of the firm as the investment is made now but the benefits
occur in future and the future is uncertain.
7. The funds are invested in non-flexible and long-term activities.
8. They involve commitment of large amount of funds and therefore requires a
careful planning to the taken beforehand.
9. It involves a long term and significant effect on the profitability of the concern.
10. They are irreversible, or reversible at substantial loss. Long term assets such as
machinery once acquired are not easy to resell (dispose off) them unless otherwise.
Capital budgeting process.
Identification of potential investment opportunities:
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Capital Budgeting
The capital budgeting process begins with the identification of potential

investment opportunities. Typically the planning body develops estimates of
future sales which serve as the basis for setting production target. This information
in turn is helpful in identifying required investment in plant and equipment.
Assembling of investment proposals:
Investment proposal identified by the
production department and other
department are usually submitted in the standardized capital investment proposal

firm. Generally most the proposal, before they reach the capital budgeting
committee or somebody which assembles them, are routed through several
persons. The purpose of routing a proposal through several persons is primarily
to ensure that the proposal is viewed from different angles. It also helped in
creating a climate for bringing about coordination of interrelated activities.
Investment proposals are usually classified into various categories for facilitating
decision making, budgeting, and controlling.
Evaluate Opportunities:
Once you have identified the reasonable opportunities, you need to determine
which ones are the best. Look at them in relation to your overall business strategy
and mission. See which opportunities are actually realistic at the present time and
which ones should be put off for later.
Cash Flow
Next, you need to determine how much cash flow it would take to implement a
given project. You also need to estimate how much cash would be brought in by
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such a project. This process is truly one of estimating--it takes a bit of guesswork.
You need to try to be as realistic as you can in this process. Do not use the best-case
scenario for your numbers. Most of the time, you need to use a fraction of that
number to be realistic. If the project takes off and the best-case scenario is reached,
that is great. However, the odds of that happening are not the best on new projects.
Select Projects
After you look at all of the possible projects, it is time to choose the right project
mix for your company. Evaluate all of the different projects separately on their own
merits. You need to come up with the right combination of projects that will work
for your company immediately. Choose only the projects that mesh with your
company goals.
Decision making:
A system of rupee gate ways usually characterizes capital investment decision
making. Under this system, executives are vested with the power to okay investment
proposal up to certain limit. For example, in one company the plant superintendent
can okay investment outlays up to Rs 2,000,000 the works manager up to Rs
5,000,000 and the managing director up to Rs 20,000,000. Investment requiring hire
outlays need the approval of the board of directors.
Preparation of capital budget and appropriation:
Project involving smaller outlays and which can be decided by executive at lower
levels are often covered by the blanket appropriation for expeditious action projects
involving larger outlays are included in the capital budget after necessary approvals.
Before undertaking such projects an appropriation order
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in usually required. The purpose of this check is mainly to ensure that the fund
position of firm is satisfactory at the time of implementation further, it provides an
opportunity to review the project at the time of implementation.
Implementation:
Translating an investment proposal into concrete project is complex, time

consuming, and risk fraught task. Delays in implementation, which are
common, can lead to substantial cost over runs.
Performance Review:
Performance review, post completion audit, is a feedback device. It is a
measure for comparing actual performance with project performance. It may
be conducted, most appropriately, when the operations of the project have
established. It is useful in several ways:
It throws the light on how realistic were the assumptions underlying the project.
It provides a documented log of experience that is highly valuable for

decision making.
It helps in uncovering judgmental biases.

It includes
a desired caution
among project
sponsors.
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Rationale of Capital Expenditure decisions

The rationale underlying the capital budgeting decision is efficiency. Thus, the firm must
replace worn and obsolete plants and machinery, acquire fixed asset for current and new
products and make strategic investment decisions. This will enable the firm to achieve its
objective of maximizing profits either by way of increased revenues or by cost reductions.
The quality of these decisions is improved by capital budgeting. Capital budgeting decisions
can be of two types: (i) those which expand revenue (ii) those which reduce costs.
Investment Decisions Affecting Revenue:

Such investment decisions are expected to bring in additional revenue, thereby raising the
size of the firms total revenue. They can be the result of either expansion of present
operations or the development of a new product line. Both types of investment decisions
involve acquisition of new fixed assets. Both types of investment decisions are income
expansionary in nature.(e.g. Tata steel acquisition of Corus, RIL setting Oil and Gas
exploration in K.G. basin etc.)
Investment Decisions Reducing Costs:
Such decisions by reducing costs, add to the total earnings of the firm. The classic example of
such investment decisions is the replacement proposals. When an asset wears out or becomes
outdated, the firm must decide whether to continue with the existing asset or replace it. The
firm evaluates the benefit from the new machine in term of lower operating cost and the
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outlay that would be needed to replace the machine. An expenditure on a new machine may
be quite justifiable in the light of the total cost savings that result.
Project Classifications
Replacement decision:
A decision concerning whether an existing asset should replaced
by a newer version
of the same machine or even a different type of machine that does the same thing as
the existing machine. Such replacements are generally made to maintain existing levels
of operations, although profitability might change due to changes in expenses (that is,
the new machine might be either more expensive or cheaper to operate than the
existing machine).
Expansion decision:
A decision concerning whether the firm should increase operations by adding new
products, additional machines, and so forth. Such decisions would expand operations
Independent project:
The acceptance of an independent project does not affect the acceptance of any other
project that is, the project does not affect other projects. For example, if you have a large
sum of money in the bank that you would like to spend on yourself, say, $150,000. You
decide you are going to buy a car that costs about $30,000 and a new stereo system for
your house that costs less than $5,000. The decision to buy the car does not affect the
decision to buy the stereothey are independent decisions.
Mutually exclusive projects:
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In this case, the decision to invest in one project
affects other projects because only
one project can be purchased. For example, if in the above example you decided you
were going to buy only one automobile, but you were looking at two different types of
cars, one is a Chevrolet and the other is a Ford. Once you make the decision to buy the
Chevrolet, you have also decided you are not going to buy the Ford.
Mandatory investment:
These are expenditure required to comply with statutory requirements. Examples of
such are pollution control equipment, medical dispensary, fire fitting equipment,
crche in factory premises and so on. These are often non revenue producing
investments. In analyzing such investments the focus is mainly on finding the most
cost effective way of fulfilling a given statutory need.
Diversification projects:
These investments are meant to increase capacity and widen the distribution network.
Such investment call for an explicit forecast of growth. Since this can be risky and
complex, expansion projects normally warrant more careful analysis than replacement
projects. Decisions relating to such projects are taken by the top management.
Miscellaneous projects:
This is catch all category that includes items like interior decoration, recreational
facilities, executive aircrafts, landscape garden, and so on. There is no standard
approach for evaluating these project and decision regarding them are based on
personal preferences of top management.
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Research and development project:

Traditionally, R&D projects absorbed a very small proportion of capital budget in
most Indian companies. Things however are changing. Companies are now allocating
more funds to R:&:D projects more so knowledge intensive industries. R&D are
characterized by numerous uncertainties and typically involve sequential decision on
the basis of managerial judgment.
Capital budgeting technique

The capital budgeting decision has been a very typical issue in the sustenance of a
company. Several companies have lost their identity or liquidated due to wrong
capital budgeting decision they made at one particular time or the other. Based on
these prevalent problems in industries and the effect of globalization on industries, it
is important to use effective method to analyze investment before decision is made.
Capital budgeting is extremely important because the decision made involve the
direction and opportunity for future growth of the organization. One of the
traditional methods commonly used for capital investment appraisal by some
organizations is the payback method, although this method has been criticized by
academicians that it does not include the future cash flow and do not measure
profitability. The wide acceptance of this method by practicing managers, has called
for investigation as why is the method is still popularly used in organization. Firms
operating in a dynamic environment must continuously make changes in different
areas of its operations in order to meet the needs of a challenging environment for
growth and survival. Continuous change assists in improving the operational
process, thereby putting the organization at an advantage over their competitors.
Most changes involve capital expenditure decisions, which can invariably involve
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large sums of money. The expenditure might involve expansion in the current line of
business, diversification or takeovers. Prior to the decision of appraising an
investment opportunity, the organization must identify a strategic need for
investment in the project. The need will determine aspects like, which of the many
investment opportunities before the entity will best help to meet their strategic
objectives, how much to commit to the project in terms of funds, human resource
and the time towards the investment. Most of the strategic decisions which
necessitate large investments require managers to undertake detailed project
analysis before a final decision is made on whether or not to invest money in such a
project. All investments will have one form of return or another and the investment
decision would be dependent on the potential returns and their adequacy to justify
the sacrifices,(opportunity cost) the investing entity would have to make.
Organizations justify large capital investments decisions using different capital
appraisal techniques. These techniques have been developed over the years from the
insight and analysis of many researchers and practitioners and have become a
standard practice in project appraisal. They can be broadly classified in traditional
methods and modern method.
Capital budgeting
technique
Traditional
method
Modern method
Traditional approach:
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Some of the traditional techniques that have been used over the decades by
practitioners are payback period and accounting rate of return. Academics have
argued that these techniques lack the sophistication for any conclusive analysis
and have unanimously rejected their use for project appraisal. The main
drawback in these techniques is
their inability to consider the cash flow
timing and its dependence on book profits. Although severely criticized as

theoretically unacceptable in valuing projects, surveys have found wide
acceptance of its use mainly as a rule of thumb by executives. Some of the
traditional approaches are as follows:
Payback period
AAR
Payback period:
The payback method of investment appraisal, used for evaluating capital projects,
calculates the annual returns from the initiation of the project until the accumulated
returns are equal to the cost of the investment, at which time the investment is said
to have been paid back. The time required to achieve this payback is termed the
payback period. Under the PB method the required payback period sets the hurdle
rate (threshold barrier) for project acceptance. (Lefley 1996) The PB method is
generally used as a comparison of two or more projects and has a wide acceptance
as a rule of thumb. In a survey in India, Cherukuri (1996) analyzed that payback
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was widely used as a supplementary decision criterion. In a similar study of 151

firms by Petry and Sprow (1993), he finds the most firms used payback as a
secondary measure of capital budgeting. The payback period is defined as the time
required recovering the initial investment in a project from operations. The payback
period method of financial appraisal is used to evaluate capital projects and to
calculate the return per year from the start of the project until the accumulated
returns are equal to the cost of the investment at which time the investment is said to
have been paid back and the time taken to achieve this payback is referred to as the
payback period. The payback decision rule states that acceptable projects must have
less than some maximum payback period designated by management. Payback is
said to emphasize the managements concern with liquidity and the need to
minimize risk through a rapid recovery of the initial investment. It is often used for
small expenditures that have obvious benefits that the use of more sophisticated
capital budgeting methods is not required or justified. The payback period answers
the question of how long does it takes the
project to pay back its initial
investment. One of the oldest and most widely used method to evaluate a capital
investment proposal is the Payback Period, as the name implies it refers to the time
required to recover the initial investment or the initial cash outlay as it is called in
financial terms.
What is the formula for Payback Period?
Payback Period Example

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Let us illustrate finding payback period with an example investment proposal. Let us
say you were offered a series of cash inflows at the end of each of the next four years
as $5000, $4000, $3000, and $1000. Say the initial cash outlay for this proposal is
$10,000.
Initial investment $10000
Year
1
2
3
4
Cash flows
5000
4000
3000
1000
Cumulative cash flow

5000
9000
12000
13000
Payback Period Step by Step

We add up the cash inflows beginning after the initial cash outlay in the cumulative
cash inflows column
We keep an eye on this last column and track the last year for which the cumulative
total does not exceed the initial cash outlay
We compute the part or fraction of the next year's cash inflow need to payback the
initial cash outlay by taking the initial cash outlay less the cumulative total in the last
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step
then
divide
this
amount
by
the
next
years
cash
inflow.
E.g., ( $10,000 - $9,000 ) / $3,000 = 0.334
To now obtain the payback period in years , we take the figure from the last step and
add it to the year from the step 2. Thus our payback period is 2 + .334 = 2.334 years
Instead of represent the years as decimal value we could represent the payback period
in years and months this way We take the fraction 0.334 and multiply it by 12 to get
the months which is 4.01 months. Thus our payback period is 2 years and 4 months
The earlier the investment is recovered, sooner the cash funds can be used for other
purpose. The risk from loss of obsolesces and changed economic condition is less in a
shorter payback period
Minimum acceptance criteria: Whatever may be set by management?
Arguments in favour of payback:
The payback method is popular because of its simplicity. Studies by McIntyre and
Coulthurst (1986) observe that the PB has shown a considerable capacity for survival
despite an indication in the literature of the growing acceptance of the more
sophisticated methods like the discounted cash flow. In another study, Fremgen
(1973) shows that the use of PB is positively related to capital budget size of the firm.
Firms with large budgets (i.e. over $100 million) made more use of PB than firms
with smaller budgets.
Secondly, in a business environment of rapid technological change, new plant and
machinery may need to be replaced sooner than in the past, so a quick payback on
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investment is essential in the appraisal of advanced manufacturing technology (AMT)

projects in both the UK and USA
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Arguments against payback
Academics have identified two main deficiencies in the pay back period.
1) Omits cash flow:
The PB method doesnt take into account cash flows after the project's payback
period. The method only takes into account project returns up to the payback period.
Certain projects are, by their very nature, long-term projects, the benefits of which
may not accrue until sometime in the future, usually well beyond the normal payback
period. With such a profit profile the PB is said to be biased against the acceptance
of such projects. These projects may, however, be vital for the long-term success of
the business. It is therefore important to use the PB method more as a measure of
project liquidity rather than project profitability.
2) Time value of money:

The method ignores the time value of money. Academics have severely criticized this
flaw in evaluating investment projects. However a solution to this deficiency has been
suggested through modification of the simple PB method into a discounted payback
period (DPB), thereby searching the payback period when the accumulated present
value of the cash flows covers the initial investment outlay. He further argues that the
PB method fails to reflect all the dimensions of profitability relevant to capital
expenditure decisions, and it is not inclusive for investment evaluation purposes.
seminar,
Purpose.
Capital Budgeting
ARR Accounting Rate Return Rule:

A measure of the return on an investment over a given period, equal to average
projected earnings minus taxes, divided by average book value over the duration of the
investment. This measure can also be calculated using average projected earnings
without excluding taxes, or average projected earnings less taxes and depreciation.
seminar,
Purpose.
Capital Budgeting
This ratio measures how well investment assets are being used to generate income.
The accounting rate of return (ARR), computed from the financial statements, is a
periodic and an ex post indicator. Vatter (1966) ascertains that ARR is a figure based
only on the data related to a given year, and is not referenced to other parts of the
project except the year to which it applies. It is commonly defined as the ratio of
accounting profit earned in a particular period to the book value of the capital
employed in the period. According to the different numerators and denominators
applied to calculate ARR, there are several kinds of definitions used in analysis. For
the numerator of ARR, it is usually financial annual accounting profit or income, while
the denominator is often determined by book value of assets or book value of equity.
Employing the clean surplus concept, Peasnell (1982) defines ARR as the ratio of the
accounting profit to the book value of assets at the beginning of the period.
AAR=
Average Net Income

Average Book Value of Investment
Case Example
Initial Investment =$8000
Life = 15 years
Cash inflows per year = $1,300

Calculation:
Depreciation = [Cost - Salvage Value]/Life = $8,000/15 = $533
ARR = [cash Inflows per year - Depreciation]/Initial Investment
= [$1,300 - $533]/$8,000 = $767/$8,000 = 9.6%
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Purpose.
Capital Budgeting
If you use average investment, ARR is:
ARR = $767/[$8,000/2] = $767/$4,000 = 19.2%
Note: When average investment is used, rather than the initial investment, accounting
rate of return is doubled
Arguments in favour of ARR:

1) Uses readily available information:
The advantage in ARR is the easy availability of information for the computation of
results. The accounting data can be readily obtained from annual reports.
2) Easily understood:
The method was favored by managers due to the ease in understanding the process
and results. It has also been preferred as it is easy to convey to non-financial
executives.
ARR is most often used internally when selecting projects. It can also be used to
measure the performance of projects and subsidiaries within an organization.
Arguments against ARR:

The ARR method lacks general acceptance as an investment criterion because:
1) When analyzing investment / projects the managers are interested in the cash flows
earning over the life of the project and since ARR is based on numbers that include
non-cash items, it doesnt give a true picture of project quality.
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Purpose.
Capital Budgeting
2) The ARR method does not take into account the time value of money. Unlike the
other modern techniques which account for the timing of the cash flows, ARR values
1 today as similar to 1 at the end of the year.
3) Although the ARR is simple to calculate the other methods of capital investment
valuation are not very difficult to calculate given the availability of computing power.
The data may also be unreliable due to problems of creative accounting.
Conclusion of traditional approach in capital budgeting

We can conclude on the basis of previous literature and criticism that since ARR and
PB method does not take into account the time value of money, and is wholly
unadjusted for non-cash items, any investment decision based on it is necessarily
seriously flawed. Its only advantage is that it is very easy to calculate. It only uses the
comparison of the cash inflow and cash out flow which is not an appropriate method
for long term investment therefore modern methods have been introduced and are
being used greatly for healthy decision for capital investment.
Modern method:
Modern methods have come up to be widely used for project appraisal purposes
in recent years. These techniques mainly classified as discounted cash flow (DCF)
Techniques have received support from academics due to its theoretical
completeness and accuracy. The DCF techniques covers up all the major
drawbacks of the payback and accounting rate of return and hence are considered
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Purpose.
Capital Budgeting
the best tools for value maximization. The two DCF techniques we will analyze in
detail are the Net present value (NPV) and the Internal Rate of return (IRR).
NPV
IRR
Discounted Cash Flow
Profitability Index
NPV:
The net present value method is the classic economic method of evaluating the
investment proposals. It is a DCF technique that explicitly recognizes the time
value of money. It correctly postulates that cash flows arising at different time
periods differ in value and are comparable only when their equivalents- present
value are found out. The primary capital budgeting method that uses discounted
cash flow techniques is called the Net Present Value (NPV). Under the NPV net
cash flows are discounted to their present value and then compared with the
capital outlay required by the investment. The difference between these two
amounts is referred to as the NPV. The interest rate used to discount the future
cash flow is the required rate of return. A project is accepted when the net present
value is zero or positive the key inputs of the calculation of NPV are the interest
rate or discount rate which is used to compute present values of future cash
flows. If the discount rate exceeds the shareholders required rate of return, and
the project has a positive NPV at this rate, then shareholders will expect an
additional profit that has a present value equal to the NPV. Thus if the goal of the
corporation is to maximize shareholder wealth, managers would undertake all
projects that have a positive NPV, or choose the higher NPV project if faced with
two or more mutually exclusive positive NPV projects. NPV analysis is sensitive
to the reliability of future cash inflows that an investment or project will yield.
Net Present Value =Total PV of the future CFs- Initial investment
seminar,
Purpose.
Capital Budgeting
Example1
Initial investment of Rs100
Years
Cash flows
1
2
3
4
5
40
30
30
20
15
Total
137
DCF
Present value
0.909
0.826
0.753
0.683
0.621
of cash flows
36
24
23
17
9
109
Net Present Value= Present value of Inflows Present value of investment Project
Steps involved in the calculation of NPV:
1. Cash flows of the investment project should before casted based on realistic
assumptions.
2. Appropriate discounted rate should be identified. This appropriate rate is the
opportunity cost of capital of a project which is equal to the required rate of return
expected by investors on investments of equivalent risk.
3. Present value of cash flows should be calculated using the opportunity cost of capital
as the discount rate.
4. Net present value should be found out by subtracting present value of cash outflows
from present value of cash inflows.
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Purpose.
Capital Budgeting
Arguments in favour of NPV Method:

1. Time Value:
It recognizes time value of money while evaluating an investment
proposal. A
rupee received today is worth more than a rupee received tomorrow. The NPV
technique recognizes the time value of an investment opportunity. The time value
states that a pound today is more valuable than a pound tomorrow. Techniques which
fail to consider this primary criterion must be flawed in their valuation.
2. Measure of true Profitability:

It uses all cash flows occurring over the entire
life of project in calculating its
worth. Hence, it is a measure of the projects true profitability. The NPV method
relies on estimated cash flows and the discount rate rather than any arbitrary
assumptions, or subjective consideration. the accounting practice like depreciation
and non-cash expenditures, managements taste and profits from existing business
dont affect the decision.
3. Value:
Additives: The discounting process facilitate measuring cash flows in terms of
present values; that is, in terms of equivalent, current rupees. Therefore, the NPVs of
projects can be added. Since the present values are a measure of future returns, they
can be easily added up. Hence incase of two projects even with different time
horizon, the present value of the combines investment is the sum of the parts. The
additivity property assists in recognizing suboptimal opportunities which are
packaged with good projects.
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Capital Budgeting
5. Shareholders value:
The NPV method is always consistent with the objective of the shareholder value
maximization. This is the greatest virtue of the method.
Arguments against NPV methods:

1. Changes in net annual flows:
If a project NPV exhibits inconsistent behavior of annual net benefits or net cash
flow
from a project due to change in sign more than once over the planning
horizon, the method becomes unsuitable for certain types of investment decisions.
This makes NPV technique less useful in valuing highly technical and risky projects.
2. Undervaluation:
NPV systematically undervalues all investment projects. This is due to the strong
implicit assumptions made that no decisions would be taken in the future after the
investment decision. The technique ignores the managerial flexibility and the
availability of options in the decision making process once the investments has been
made. Managers are known to undertake negative NPV projects in many cases
because they are armed with the options of expansion, delay, abandonment and
contracting (shrink) the project which has value.
3. Only mutually exclusive alternatives:

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Capital Budgeting
NPV technique treats some options as mutually exclusive from others. Consider a deferral
option where a project can be deferred for one or two years. NPV would value the two cases
separately to seek the option with higher value. It forces to conceive of false mutually
exclusive alternatives when confronted with decisions that could be made in the future.
The relationship between the advantages and disadvantages of

NPV and its use:
For the relationship between the degree of using NPV and its advantages, all
conducted tests produced coefficients that have positive sign and strong
relationship; no less than 0.50 and these results are statistically significant at
0.05 level. This means that the perception of respondents to the advantages of
the NPV positively and strongly affect its use. While for the relationship
between the degree of using NPV and its disadvantages, the results showed a
very small relationship; less than 0.10 and these result are statistically
insignificant at 0.05 level. We can say that the perception of the respondents
to the disadvantages of the NPV does not affect its use. This finding agrees
with the previous finding about the importance of the NPV techniques
advantages, agrees with the finding that NPV is the second most used
technique, and agrees with the finding that advantages of NPV techniques
were perceived to be important by the respondents. Also the finding agrees
with perception of the respondents to the disadvantages of the NPV, where the
respondents perceive them a less than moderately important
The Discounted Payback Period:

The payback method based on discounted cash flow figures was proposed by
Rappaport (1965) which related the opportunity investment rate notion to the
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Purpose.
Capital Budgeting
payback period measurement. This method attempted to overcome one of the

drawbacks of the conventional payback calculation which failed to take into
account a companys cost of capital. The discounted payback period method
proposed by Rappaport is an improved measure of liquidity and project time
risk over the conventional payback method and not a substitute for
profitability measurement because it still ignores the returns after the payback
period. He stated that, the proper role for the discounted payback period
analysis is as a supplement to profitability measures and thus highlighting the
supportive nature of the payback method, whether conventional or discounted
payback period How long does it take the project to Pay Back its initial
investment taking the time value of money into account? Payback Period does
not consider time value of money when providing an answer whereas with
Discounted Payback Period we get to see the real value of cash inflows when
they are measured in today's amount of money as these are discounted at an
interest rate called the Discount Rate. We get to see the number of years
required to recoup the initial cash outlay or our investment.
Discounted payback period=

year before recovery +unrecovered cost at
the start of the year
Cash flow during the year
Discounted Payback Period Example

seminar,
Purpose.
Capital Budgeting
Let us illustrate finding Discounted Payback Period with an example

investment proposal. Let us say you were offered a series of cash inflows at
the end of each of the next four years as Rs 6000, Rs2000, Rs1000, and
Rs5000 Say the Initial Cost Outlay for this proposal is Rs8000
Year
1
2
3
4
Cash flow
6000
2000
1000
5000
PV ratio @12
%
DCF
Cumulative
0.893
0.797
0.712
0.636
5358
1594
712
3180
flow
5385
6952
7664
10844
Discounted payback period = 3+336

3180
=3.105yrs.
Discounted Payback Period Step by Step
We add up the discounted cash inflows beginning after the initial cash outlay in the
cumulative cash inflows column
We keep an eye on this last column and track the last year for which the cumulative
total does not exceed the initial cash outlay.
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Purpose.
cash
Capital Budgeting
We compute the part or fraction of the next year's cash inflow need to payback the
initial cash outlay by taking the initial cash outlay less the cumulative total in the last
step then divide this amount by the next years cash inflow.
To know obtain the discounted payback period we take the figure from the last step
and add it to the year thus the discounted payback period is 3+.105=3.105yrs
Instead of represent the years as decimal value we could represent the Discounted
Payback Period in years and months this way. We take the fraction o105 and multiply
it by 12 to get the months which is 1.26 months.
Arguments in favour of Discounted cash flow:

1.
Theoretically, the DCF is arguably the most sound method of valuation.
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Capital Budgeting
2. The DCF method is forward-looking and depends more future expectations rather
than
historical results.
3. The DCF method is more inward-looking, relying on the fundamental expectations

of the business or asset, and is influenced to a lesser extent by volatile external
factors.
4. The DCF analysis is focused on cash flow generation and is less affected by
accounting practices and assumptions.
5. The DCF method allows expected (and different) operating strategies to be
factored into the valuation.
6. The DCF analysis also allows different components of a business or synergies
to be valued separately.
Arguments against Discounted cash flow:

1. The accuracy of the valuation determined using the DCF method is highly
dependent on the quality of the assumptions regarding FCF, TV, and discount
rate. As a result, DCF valuations are usually expressed as a range of values rather
than a single value by using a range of values for key inputs. It is also common to
run the DCF analysis for different scenarios, such as a base case, an optimistic
case, and a pessimistic case to gauge the sensitivity of the valuation to various
operating assumptions. While the inputs come from a variety of sources, they
must be viewed objectively in the aggregate before finalizing the DCF valuation.
2. The TV often represents a large percentage of the total DCF valuation. Valuation,
in such cases, is largely dependent on TV assumptions rather than operating
assumptions for the business or the asset.
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Purpose.
Capital Budgeting
The Internal Rate of Return rule:

IRR is the discount rate that sets NPV to zero. The IRR differs from the NPV in that
it results in finding the internal yield of the potential investment. The IRR is
calculated by discounting the net cash flows using different discount rates till it gives
a net present value of zero. However it may be easily calculated financial calculators
or excel program. Internal Rate of Return or IRR is the investor's required rate of
return which equates the initial cash outlay with the present value of series of
expected cash flows. In other words, IRR is the rate at which the difference between
initial cash outlay and present value of cash inflows in zero The internal rate of Return
(IRR) is the discount rate that equals the present value of a future steam of cash flows
to the initial investment. In simple terms, discount rate is the rate at which the Net
present value of a project equals zero. It can be thought of as the annualized rate of
return (in percent) of an investment using compound interest rate calculations.
Graphically
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Purpose.
Capital Budgeting
The IRR decision rule specifies that all independent projects with an IRR greater than
the cost of capital should be accepted. When choosing among mutually exclusive
projects, the project with the highest IRR should be selected (as long as the IRR is
greater than the cost of capital).
IRR Example
Let us illustrate finding Internal Rate of return with an example investment
proposal. Let us say you were offered a series of cash inflows at the end of each of
the next four years as $5000, $4000, $3000, and $1000. Say the initial cash outlay
for this proposal is $10,000.
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Purpose.
Capital Budgeting
Year
Net Cash Flows
PVIF @ 10%
Present Value
5000
0.909
$4,545
4000
0.826
$3,304
3000
0.751
$2,253
1000
0.683
$683
NPV = $785
$10,785
Minimum acceptance criteria:

Accept if the IRR exceeds the required rate.
Select the alternative with highest IRR.
Arguments in favor of IRR technique:

1) Present value method:
The IRR technique computes the present value of investment opportunities cash
flows and hence takes into account the time value of money. This value states that a
pound today is more valuable than a pound tomorrow. This is a primary condition in
the choice of investment of investment appraisal techniques.
2) Based on cash flows:

The IRR is based on the expected net cash flows from the project. These cash flows
are computed as total cash inflow less total cash outflow. Hence the accounting
practice like depreciation and profits from existing business dont affect the
decision making process.
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Purpose.
Capital Budgeting
3) Easy to understand:
Returns expressed in terms of percentage are easier to understand and communicate
for managers and shareholders compared to NPV, due to unfamiliarity with the
details of the appraisal techniques.
4) Maximum profitability of Shareholder
If there is only project which we have to select, if we check its IRR and it is higher
than its cut off rate, then it will give maximum profitability to shareholder
Arguments against IRR technique:

1) Reinvestment rate assumption:
The IRR assumes that the time value of money is the project specific IRR, as it
doesnt discount the cash flows at the opportunity cost of capital. The method
assumes that the intermediate cash flows can earn the same rate of returns as the
original project, and this creates unrealistic returns to the management and
shareholders. It can be very unreasonable to expect the returns to remain stable over
the life of the project and hence can give a misleading view of a proposed investment.
2) Not absolute size:

The IRR method is unsuccessful in measuring returns in terms of absolute amounts of
wealth changes. It only gives a percentage measure of returnsand this may cause
difficulties in ranking projects where there are conditions of mutual exclusivity.
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Purpose.
Capital Budgeting
3) Additivity not possible:

The IRR technique fails to supports the additivity principle when evaluating multiple
projects as the returns are expressed in percentage terms. The additivity principle is
particularly necessary when evaluating project of different time horizons.
NPV vs IRR Methods:
Key differences between the most popular methods, the NPV (Net Present Value)
Method
and
IRR
(Internal
Rate
of
Return)
Method,
include:
NPV is calculated in terms of currency while IRR is expressed in terms of the

percentage
return
firm
expects
the
capital
project
to
return;
Academic evidence suggests that the NPV Method is preferred over other methods
since
it
calculates
additional
wealth
and
the
IRR
Method
does
not;
The IRR Method cannot be used to evaluate projects where there are changing cash
flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may
be
required
in
the
case
of
land
reclamation
by
mining
firm);
However, the IRR Method does have one significant advantage -- managers tend to
better understand the concept of returns stated in percentages and find it easy to
compare
to
the
required
cost
of
capital;
and,
finally,
While both the NPV Method and the IRR Method are both DCF models and can
even reach similar conclusions about a single project, the use of the IRR Method can
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Purpose.
Capital Budgeting
lead to the belief that a smaller project with a shorter life and earlier cash inflows, is
preferable
to
larger
project
that
will
generate
more
cash.
Applying NPV using different discount rates will result in different

recommendations. The IRR method always gives the same recommendation.
The Profitability Index rule:

A Profitability index (PI), alternatively referred to as a profit investment ratio or a
value investment ratio, is a method for discerning the relationship between the costs
and benefits of investing in a possible project. It calculates the cost/benefit ratio of the
present value(PV) of a projects future cash flow over the price of the projects initial
investment. This formula is commonly written as PI = PV of future cash flows
initial investment. The figure this formula yields helps investors decide on whether or
not a project is financially attractive enough to pursue. The profitability index, also
known as the benefit-cost ratio, is another measure that uses a simple rule to evaluate
cash flow results for a given project. In this case, the profitability index rule would
tell managers and executives to accept all projects that have an index value that is
equal to or greater than 1.
Calculating Profitability Index
The calculation of profitability index is based on a simple relationship between a

project's costs and the discounted after tax cash flow it produces. The formula for
profitability index is as follows:
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Purpose.
Capital Budgeting
Profitability Index = Present Value of Cash Flows / Cost of Project

So the rule of thumb for profitability index would state that we accept all projects that
produce benefits (present value) that are in excess of the project's cost.
Profitability Index Example
We'll use the following discounted cash flows to illustrate how profitability index is
calculated:
Based on the above information we know:

Present Value of Cash Flows = 459 + 421 + 387 = 1,267
Cost of Project = 1,000
So the profitability index in this example would be 1,267 / 1,000 or 1.267 which is greater than one. Therefore we would accept this project as a good
Arguments in the favour of profitability index:

One of the strengths of profitability index is that it will provide us with the same result as the
net present value method. If the NPV of cash flows is positive, then Profitability Index will
be greater than one
May be useful when available investment funds are limited.
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Purpose.
Capital Budgeting
Easy to understand and communicate.
Correct decision when evaluating independent projects.
Arguments against profitability index:
Problems with mutually exclusive investment.
Minimum acceptance criteria: Accept if PI >1
NPV V/S PI
The NPV method and PI yield same accept or reject rules, because PI can be greater
than one only when the project net present value is positive. In case of marginal
project, NPV will be zero and PI will be equal to one. But a conflict may arise
between the two methods if a choice between mutually exclusive projects has to be
made.
Consider the following illustration.
PV cash inflow
Initially cash outflow
NPV
PI
Project c
100000
50000
50000
100000 =2.0
Project d
50000
20000
30000
50000 =2.5
500000
20000
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Purpose.
Capital Budgeting
Project c should be accepted if we use NPV method, but project d is preferable

according to PI method.
The NPV method should be preferred expect under capital rationing, because the net
present value represent the net increase in the firms wealth. In our illustration, project
c contributes all that project d contributes plus additional net present value of Rs
20000 (Rs50000-Rs30000) at an incremental cost of Rs 50000 (Rs100000-Rs50000).
As the net present value of project c incremental outlay is positive, it should be
accepted. Project c is also applicable if we calculate the incremental profitability
index.
PV of cash inflows
Initial cash outflow
NPV
Project c
100000
(50000)
50000
Project d
50000
(20000)
30000
Incremental flow
50000
(30000)
20000
PI
100000=2.0
50000=2.5
50000=1.67
50000
20000
30000
Because the incremental investment has positive net present value, Rs 20000 and a PI
greater than one, project c should be accepted.
If we consider a different situation where two mutually exclusive projects return Rs
100000 each in terms of net present value and one project costs twice as much as
another, the profitability index will obviously give a logical answer. The net present
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Purpose.
Capital Budgeting
value method will indicate that both are equally desirable in absolute terms. However
the profitability index will evaluate these two projects relatively and will give correct
answers. Between two mutually exclusive projects with same NPV, the one with
lower initial cost will be selected.
Capital budgeting analysis:

Capital Budgeting Analysis is a process of evaluating how we invest in capital
assets,i.e. assets that provide cash flow benefits for more than one year. It has been
said that how we spend our money today determines what our value
will be
tomorrow. Therefore, we will focus much of our attention on present values so that
we can understand how expenditures today influence values in the future. A very
popular approach to looking at present values of projects is discounted cash flows or
DCF. However, we will learn that this approach is too narrow for properly
evaluating a project.
There are three types of analysis done:
Decision analysis.
Option pricing.
Discounted cash flow
Decision analysis:
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Purpose.
Capital Budgeting
Decision-making is increasingly more complex today because of uncertainty.

Additionally, most capital projects will involve numerous variables and possible
outcome. For example, estimating cash flows associated with a project involves
working capital requirements, project risk, tax considerations, expected rates of
inflation, and disposal values. We have to understand existing markets to forecast
project revenues, assess competitive impacts of the project, and determine the life
cycle of the project. If our capital project involves production, we have to
understand operating costs, additional overheads, capacity utilization, and startup
costs. Consequently, we cannot manage capital projects by simply looking at the
numbers; i.e. discounted cash flows. We must look at the entire decision and
assess all relevant variables and outcomes within an analytical hierarchy. In
financial management, we refer to this analytical hierarchy as the Multiple
Attribute Decision Model (MADM).
Multiple attributes are involved in capital projects and each attribute in the decision
needs to be weighed differently. Therefore analytical hierarchy is used to structure
the decision derive the importance of attributes in relation to one another. We can
think of MADM as a decision tree which breaks down a complex decision into
component parts. This decision tree approach offers several advantages.
Both financial and non financial criteria are systematically considered.
Judgments and assumptions are included within the decision based on

expected values.
The opinions and ideas of others into the decision. Group or team decision
making is usually much better than one person analyzing the decision.
Therefore, our first real step in capital budgeting is to obtain knowledge

about the project and organize this knowledge into a decision tree.
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Purpose.
Capital Budgeting
Option price:
The second stage in this process is to consider all options or choices we have
or should have for the project. Therefore, before proceeding to discounted
cash flows we need to build a set of options into our project for managing
unexpected changes.
In financial management, consideration of options
within capital budgeting is called contingent claims analysis or option pricing.

For example, suppose you have a choice between two boiler units for your
factory. Boiler A uses oil and Boiler B can use either oil or natural gas. Based
on traditional approaches to capital budgeting, the least costs boiler was
selected for purchase, namely Boiler A. However, if we consider option
pricing Boiler B may be the best choice because we have a choice or option
on what fuel we can use.
Suppose we expect rising oil prices in the next five years. This will result in
higher operating costs for Boiler A, but Boiler B can switch to a second fuel
to better control operating costs. Consequently, we want to assess the options
of capital projects.
Options can take many forms; ability to delay, defer, postpone, alter, change,
etc. These options give us more opportunities for creating value within
capital projects. Capital need to thought as a bundle of option. Three
common source of option are:
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Purpose.
Capital Budgeting
Timing Options:
The ability to delay our investment in the project.
Abandonment Options:
The ability to abandon or get out of a project that has gone bad.
Growth Options:
The ability of a project to provide long-term growth despite
negative
values. For example, a new research program may appear negative, but it
might lead to new product innovations and market growth. We need to
consider the growth options of projects.
Option pricing is the additional value that we recognize within a project
because it has flexibilities over similar projects. These flexibilities help us
manage capital projects and therefore, failure to recognize option values can
result in an under-valuation of a project.

Discounting refers to taking a future amount and finding its value today.
Future values differ from present values because of the time value of money.
Financial management recognizes the time value of money because:
Inflation reduces values over time; i.e. Rs 1,000 today will have less value
five years from now due to rising prices (inflation).
Uncertainty in the future; i.e. we think we will receive Rs1, 000 five years
from now, but a lot can happen over the next five years.
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Purpose.
Capital Budgeting
Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000

five years from now because we can invest $ 1,000 today and earn a return.
The Discounted cash flow uses the Time Value of Money to discount the Total
project cash flow with the assumed Discount Rate. Total project cash flow is
calculated as follows:
Total project cash flow = Operating cash flow + Net Working Capital
flow + Net Capital Spending
Risk analysis in capital budgeting
ST
o
tt
a
m
R
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seminar,
Purpose.
cash
Capital Budgeting
Systematic risk:
Systematic risk refers to the variation in return of the company due to systematic
factors
like industrial production, GDP, inflation, forex rate, interest rate. Impact of
systematic risk cannot be diversified.
Unsystematic risk:
Unsystematic risk refer to the variation in return of the company due to company
specific factor like dividend, capital structure, management etc.
Risk exists because of the inability of the decision maker to make perfect
forecasts.
Forecasts cannot be made with perfection or certainty since the future events on
which they depend are uncertain. An investment is not risky if, we can specify a
unique sequence of cash flows for it. But whole trouble is that cash flows cannot be
forecast accurately, and alternative sequences of cash flows can occur depending on
the future events. Thus, risk arises in investment evaluation because we cannot
anticipate the occurrence of the possible future events with certainty and
consequently, cannot, make are correct prediction about the cash flow sequence. To
illustrate, let us suppose that a firm is considering a proposal to commit its funds in a
machine, which will help to produce a new product. The demand for this product may
be very sensitive to the general economic conditions. It may be very high under
favorable economic conditions and very low under unfavorable economic conditions.
Thus, the investment would be profitable in the former situation and unprofitable in
the later case. But, it is quite difficult to predict the future state of economic
conditions, uncertainty about the cash flows associated with the investment derives.
A number of techniques to handle risk are used by managers in practice. They range
from simple rules of thumb to sophisticated statistical techniques. The following are
the popular, not-conventional techniques of handling risk in capital budgeting.
seminar,
Purpose.
Capital Budgeting
Payback
Risk-adjusted
discount
rate
Certainty equivalent
Payback period:
Payback is one of the oldest and commonly used methods or explicitly
recognizing risk associated with an investment project. This method, as applied
in practice, is more an attempt to allow for risk in capital budgeting decision
rather than a method to measure profitability. Business firms using this method
usually prefer short payback to longer ones, and often establish guidelines that a
firm should accept investments with some maximum payback period, say three
or five years. The merit of payback is its simplicity. Also payback makes an
allowance for risk by focusing attention on the near term future and thereby
emphasizing the liquidity of the firm through recovery of capital, and by
favoring short term projects over what may be riskier, longer term projects. It
should be realized, however, that the payback period, as a method of risk
seminar,
Purpose.
Capital Budgeting
analysis, is useful only in allowing for a special type of risk, the risk that a
project will go exactly as planned for a certain period and will then suddenly
cease altogether and be worth nothing. It is essentially suited to the assessment of
risks of time nature. Once a payback period has been calculated, the decisionmaker would compare it with his own assessment of the projects likely, and if the
letter exceeds the former, he would accept the project. This is a useful procedure,
economic only if the forecasts of cash flows associated with the project are likely
to be unimpaired for a certain period. The risk that a project will suddenly cease
altogether after a certain period life may arise due to reasons such as civil war in
a country, closure of the business due to an indefinite strike by the workers,
introduction of a new product b a competitor which captures the whole market
and nature disasters such as flood or fire. Such risks undoubtedly exist but they,
by no means, constitute a large proportion of the commonly encountered
business risks. The usual risk in business is not that a project will go as forecast
for a period and then collapse altogether; rather the normal business risk is that
the forecasts of cash flows will go wrong due to lower sales, higher cost.
Risk adjusted discount rate:

For a long time, economic theorists have assumed that, to allow for risk, the
businessman required a premium over and above an alternative, which was riskfree. Accordingly, the more uncertain the returns in the future, the greater the risk
and grater the premium required. Based on this reasoning, it is proposed that the
risk premium be incorporated into the capital budgeting analysis through the
discount rate. That is, if the time preference for money is to be recognized by
seminar,
Purpose.
Capital Budgeting
discounting estimated future cash flows, at some risk free rate, to their present
value, then, to allow for the riskiness, of those future cash flows a risk premium
rate may be added to risk-free discount rate. Such a composite discount rate,
called the risk-adjusted discount rate, will allow for both time preference and risk
preference and will be a sum of the risk-free rate and risk-premium rate reflecting
the investors attitude towards risk. The risk-adjusted discount rate method can be
formally expressed as follows:
Risk-adjusted discount rate = Risk free rate + Risk premium
Under capital asset pricing model, the risk premium is the difference between the
market rate of return and the risk free rate multiplied by the beta of the project. The
risk adjusted discount rate accounts for risk by varying the discount rate depending
on the degree of risk of investment projects. A higher rate will be used for riskier
projects and a lower rate for less risky projects. The net present value will decrease
with increasing risk adjusted rate, indicating that the riskier a project is perceived,
the less likely it will be accepted. If the risk free rate is assumed to be 10%, some
rate would be added to it, say 5%, as compensation for the risk of the investment,
and the composite 15% rate would be used to discount the cash flows.
Advantages of risk adjusted discount rate

seminar,
Purpose.
Capital Budgeting
It is simple and can be easily understood.
It has a great deal of intuitive appeal for risk-averse businessman.
It incorporates an attitude towards uncertainty
Disadvantages
There is no easy way deriving a risk adjusted discount rate. Capital asset
pricing model provides a basis of calculating the risk adjusted discount rate.
Its use has yet to pick up in practice.
It does not make any risk adjusted in the numerator for the cash flows that are
forecast over the future years.
It is based on the assumption that investor are risk-averse. Through it is

generally true, there exists a category of risk seekers who do not demand
premium for assuming risks; they are willing to pay premium to take risks.
Accordingly, the composite discount rate would be reduced, not increased, as
the level of risk increases.
Steps of risk adjusted discounted rate:
Simply adjust the discount rate to reflect higher risk.

Riskier project will use higher risk adjusted discounted rates.
Calculate NPV using the new risk adjusted discounted rate.
Certainty equivalent:
seminar,
Purpose.
Capital Budgeting
Yet another common procedure for dealing with risk in capital budgeting is to
reduce the forecasts of cash flows to some conservative levels. For example, if an
investor, according to his best estimate expects a cash flow of Rs.60000 next
year, he will apply an intuitive correction factor and may work with Rs.40000 to
be on safe side. There is a certainty-equivalent cash flow. In formal way, the
certainty equivalent approach may be expressed as
Net present value = (the risk adjusted factor X the forecasts of net cash
flow) / (1 + Risk free rate)
The certainty equivalent coefficient, the risk adjustment factor assumes a value
between zero and one, and varies inversely with risk. A lower risk adjustment rate
will be used if lower risk is anticipated. The decision maker subjectively or
objectively establishes the coefficients. These coefficients reflect the decision
makers confidence in obtaining a particular cash flow in period. For example, a
cash flow of 20000$ may be estimated in the next year, but if the investor feels
that only 80% of it is a certain amount, then the certainty-equivalent coefficient
will be 0.8. That is, he consider only 16000$ as the certain cash flow. Thus, to
obtain certain cash flows, we will multiply estimated cash flows by the certaintyequivalent coefficients.
The certainty equivalent approach explicitly recognizes risk, but the procedure for
reducing the forecasts of cash flows is implicit and is likely to be inconsistent from
one investment to another. Further, this method suffers from many dangers in a
large enterprise. First, the forecaster, expecting the reduction that will be made in
his forecasts, may inflate them in anticipation. This will no longer give forecasts
according to best estimate. Second, if forecasts have to pass through several
layers of management, the effect may be to greatly exaggerate the original forecast
or to make it ultra conservative. Third, by focusing explicit attention only on the
gloomy outcomes, chances are increased for passing by some good investments
seminar,
Purpose.
Capital Budgeting
Steps of certainty equivalent:
Adjust all after cash flows by certainty equivalent factors to get certain cash
flows.
Discount the certain cash flows by risk free rate of interest.
Sensitivity analysis:
To conduct a sensitivity analysis, hold all projections constant except one, alter
that one, and see how sensitive cash flow is to that one when it changes - the
point is to get a fix on where forecasting risk may be especially severe.
In the evaluation of an investment project, we work with the forecast of cash
flows. Forecasted cash flow depend on the expected revenue and cost. Further,
expected revenue is the function of sales volume and unit selling price. Similarly
sales volume will depend upon the market size and the firms market are. Costs
include variable cost which depend upon sales volume and unit variable cost and
fixed cost. The net present value and the internal rate of return of the project are
determined by analyzing the after tax cash flow arrived at combining forecast of
various variable. It is difficult to arrive at arrive at an accurate and unbiased
forecast of each variable. We cant be certain about the outcome of any of these
variables. The reliability of the NPV or IRR of the project will depend on the
reliability of the forecast of variables underlying the estimates of net cash flows.
To determine the reliability of the project NPV or IRR we can work out how much
difference it makes if any of the forecasts goes wrong. The NPV of the project is
recalculated under these different assumptions. This method of recalculating NPV
and IRR by changing each forecast is called sensitivity analysis
Scenario Analysis:
seminar,
Purpose.
Capital Budgeting
Estimating the cash flow of a project is typically very difficult and requires many
carefully thought of assumptions. A wrong assumption on the number of units sold
or the fixed costs might result in an entirely different decision made. It is thus
prudent and useful to perform a Scenario Analysis during Capital Budgeting.
Scenario Analysis basically involves estimating the cash flows on a Base
Case,
Worst Case and Best Case scenario. The Project Cash Flow Scenario Analysis
worksheet allows Scenario Analysis to be performed easily. It allows the inputs of
the Base Case scenario, Worst Case scenario and Best Case scenario to be entered
into the same worksheet. After which, the cash flow is automatically projected
based on the scenario selected and the Net Present Value and Internal Rate of
Return is calculated for the selected scenario.
Determinants of capital budgeting:

seminar,
Purpose.
Capital Budgeting
Companies tax exposure:

Debt payments are tax deductible. As such, if a company's tax rate is high, using
debt as a means of financing a project is attractive because the tax deductibility
of the debt payments protects some income from taxes.
Financial Flexibility:
This is essentially the firm's ability to raise capital in bad times. It should come
as no surprise that companies typically have no problem raising capital when
sales are growing and earnings are strong. However, given a company's strong
cash flow in the good times, raising capital is not as hard. Companies should
make an effort to be prudent when raising capital in the good times, not
stretching its capabilities too far. The lower a company's debt level, the more
financial flexibility a company has.
The airline industry is a good example. In good times, the industry generate
significant amounts of sales and thus cash flow. However, in bad times, that
situation is reversed and the industry is in a position where it needs to borrow
funds. If an airline becomes too debt ridden, it may have a decreased ability to
raise debt capital during these bad times because investors may doubt the
airline's ability to service its existing debt when it has new debt loaded on the
top.
Management Style :
Management styles range from aggressive to conservative. The more
conservative a management's approach is, the less inclined it is to use debt to
increase profits. An aggressive management may try to grow the firm quickly,
using significant amounts of debt to ramp up the growth of the company's
earnings per share (EPS)
seminar,
Purpose.
Capital Budgeting
Growth Rate:
Firms that are in the growth stage of their cycle typically finance that
growth
through debt, borrowing money to grow faster. The conflict that arises with this
method is that the revenues of growth firms are typically unstable and unproven.
As such, a high debt load is usually not appropriate. More stable and mature
firms typically need less debt to finance growth as its revenues are stable and
proven. These firms also generate cash flow, which can be used to finance
projects when they arise.
Market Conditions:
Market conditions can have a significant impact on a company's capital-structure
condition. Suppose a firm needs to borrow funds for a new plant. If the market is
struggling, meaning investors are limiting companies' access to capital because of
market concerns, the interest rate to borrow may be higher than a company would
want to pay. In that situation, it may be prudent for a company to wait until
market conditions return to a more normal state before the company tries to
access funds for the plant.
Sales Stability
A firm whose sales are relatively stable can safely take on more debt and incur
higher fixed charges than a company with unstable stables; this factor has
generally been observed in terms of sales or earning variability as capital
budgeting is concern.
Factors influencing capital budgeting practices:

seminar,
Purpose.
Capital Budgeting
Project ranking
Size disparity
Project ranking:
If a company imposes capital rationing on investmen projects, the appropriate cision
criterion is to select those projects with the highest net present value. This may
prevent
the acceptance of those projects that ranked highest in terms of their
internal rate of return.
Size disparity:
The size disparity problem occurs when mutually exclusive projects of unequal size
are being considered. If there is no capital rationing then the project, which provides
for the largest net present value will be selected. When capital rationing exists, the
company should select the set of projects with the largest net present value.
Time disparity:
The time disparity problem results from the differing reinvestment assumptions made
by the net present value and internal rate of return decision criteria. The NPV criterion
implicitly assumes that cash flows over the life of the project can be reinvested at the
required rate of return or cost of capital. The IRR method assumes that the cash flows
over the life of the project can be reinvested at the internal rate of return.
Capital budgeting and inflation

Doesn't inflation have an impact in a capital budgeting analysis? The answer is
qualified yes in that inflation does have an impact on the numbers that are used in
capital budgeting analysis. But it does not have impact on the results of the analysis if
seminar,
Purpose.
Capital Budgeting
certain conditions are satisfied. To show what we mean by this statement, we will use
the following data.
Example:
Martin company wants to purchase a new machine that costs $36,000. The machine
would provide annual cost savings of $20,000, and it would have a three-year life
with no salvage value. For each of the next three years, the company expects a 10%
inflation rate in the cash flows associated with the new machine. If the company's cost
of capital is 23.2%, should the new machine be purchased?
To answer this question, it is important to know how the cost of capital was derived.
Ordinarily, it is based on the market rates of return on the company's various sources
of financing - both debt and equity. This market rate of return includes expected
inflation; the higher the expected rate of inflation, the higher the market rate of return
on debt and equity. When the inflationary effect is removed from the market rate of
return, the result is called a real rate of return. For example if the inflation rate of 10%
is removed from the Martin's cost of capital of 23.2% the real cost of capital is only
12% as shown below:
seminar,
Purpose.
Capital Budgeting
Capital budgeting and inflation:
Reconciliation of the Market-Based and Real Costs of Capital

The real cost of capital
12.0%
The inflation factor
10.0
The combined effect (12% 10% = 1.2%)
1.2
The market based cost of capital
23.2%
========
Solution A: Inflation Not Considered:
Amount of Cash
Item
Initial investment
Annual cost savings
Year(s)
Now
1-3
Flows
$(36,000)
20,000
Present Value of Cash

12% Factor
1.000
2.402
Net present value
Flows
$(36,000)
48,040
$12040*
=========
Solution B: Inflation Considered:

Amount
ofPrice
IndexPrice
Adjusted23.2%
Year(s)
Cash Flows
Number**
Cash Flows
Initial investment
Now
$(36,000)
1.000
$(36,000)
1.000
$(36,000)
Annual cost savings
20,000
1.100
22,000
0.812
17,864
20,000
1.210
24,200
0.659
15,948
20,000
1.331
26,620
0.535
14,242
Net present value
Factor***
Present Value of Cash
Item
Flows
$12,054*
=========
*These amounts are different only because of rounding errors

**Computation of the price index numbers, assuming a 10% inflation rate each year: Year 1, (1.10) = 1.10; Year 2, (1.10) 2 = 1.21; Year 3, (1.10)3 =
1.331
***Discount formulas are computed using the formula 1/(1 + r) n, where r is the discount factor and n is the number of years. The computations are
1/1.232 = 0.812 for year 1; 1/(1.232)2 = 0.659 for year 2; and 1/(1.232)3 = 0.535 for year 3.
seminar,
Purpose.
Capital Budgeting
You cannot simply subtract the inflation rate from the market cost of capital to obtain
the real cost of capital. The computations are bit more complex than that.
When performing a net present value analysis, one must be consistentThe market based
cost of capital reflects inflation. Therefore, if a market based cost of capital is used to
discount cash flows, then the cash flows should be adjusted upwards to reflect the
effects of inflation in forthcoming periods. Computations of Martin Company under this
approach are given in solution B Above.
On the other hand, there is no need to adjust the cash flows upward if the "real cost of
capital" is used in the analysis (Since the inflationary effects have been taken out of the
discount rate). Computation of the martin under this approach are given in solution A
above. Note that under solution A and B that the answer will be the same (within
rounding error) regardless of which approach is used, so long as one is consistent and all
of the cash flows associated with the project are effected in the same way by inflation.
Several points should be noted about solution B, where the effects of inflation are
explicitly taken into account, First, not that the annual cost savings are adjusted for the
effects of inflation by multiplying each year's cash savings by a price index number that
reflects a 10% inflation rate. (observe from the foot notes to the solution how the index
number is computed for each year.) Second, note that the net present value obtained in
solution B, where inflation is explicitly taken into account, is the same, within rounding
error, to that obtained in solution A, where the inflation effects are ignored. This result
may seem surprising, but it is logical. The reason is that we have adjusted both the cash
flows and the discount rate so that they are consistent, and these adjustments cancel each
other out across the two solutions.
Throughout this section of the website (Capital Budgeting Decisions) we assume for
simplicity that there is no inflation. In that case, the market-based and real costs of capital
are the same, and there is no reason to adjust the cash flow for inflation since there is
none. When there is inflation, the unadjusted cash flows can be used in the analysis if all
seminar,
Purpose.
Capital Budgeting
of the cash flows are affected identically by inflation and the real cost of capital is used to
discount the cash flows. Otherwise, the cash flows should be adjusted for inflation and the
market-based cost of capital should be used in the analysis.
Utility Theory and Capital Budgeting:
On the basis of figures of the expected values and standard deviations, it is difficult
to say whether a decision maker should choose a project with a high expected value
and a high standard deviation or a project with a comparatively low expected value
and a low standard deviation. The decision makers choice would depend upon his
risk preference. Individuals and firms differ in their attitudes towards risk. In contrast
to the approaches for handling risk, utility theory aims at incorporation of decision
makers risk preference explicitly into the decision procedure. In fact, a rational
decision maker would maximize his utility. Thus, he would accept the investment
project, which yields maximum utility to him.
Risk adverse:
Risk adverse investors attach lower utility for increasing wealth. For them the value of
the potential increasing wealth is less than the possible loss from the decreasing
wealth. In other words, for a given wealth they prefer less risk to more risk.
Risk neutral:
Risk neutral attaches same utility to increasing or decreasing wealth they are
indifferent to less or more risk for a given wealth.
Benefits and limitation of utility theory

Utility approach to risk analysis in capital budgeting has certain advantages
seminar,
Purpose.
Capital Budgeting
1. The risk preferences of the decision maker are directly incorporated in capital
budgeting analysis.
2. It facilitates the process of delegating the authority for decision. If it is possible to
specify the utility function of the superior-the decision maker, the subordinate can b
asked to take risk consistent with the risk preference of the superior.
Utility approach to risk analysis in capital budgeting has certain

disadvantages:
1. In practice difficulty is encountered in specifying a utility function. Whose utility
function should be used as a guide in making decision? For small firms the utility
function of the owner or one dominant shareholder may be used to guide the decision
making process of the firm.
2. Even if the owner or a dominant shareholder utility function is being used as a guide,
the derived utility function at a point of time is valid only for that one point of time.
3. It is quite difficult to specify the utility function if the decisions are taken by group of
persons. Individual differ in their risk preferences. As a result, it is very difficult to
derive a consistent utility function of group.
Probability Distribution Approaches:

seminar,
Purpose.
Capital Budgeting
In this situation, the decision maker faces several states of nature. But he is supposed
to have believable evidential information, knowledge, experience or judgment to
enable him to assign probability values to the likelihood of occurrence of each state of
nature. Probabilities could be assigned to future events by reference to similar
previous experience and information. Sometimes past experience, or past records
often enable the decision-maker to assign probability values to the likely possible
occurrence of each state of nature. Knowing the probability distribution of the states
of nature, the best decision is to select that course of action that has the largest
expected payoff value.
Probability theory is the rational way to think about uncertainty. It is the branch of
mathematics devoted to measuring quantitatively the likelihood that a given event will
occur. These two definitions derive from two different approaches to the concept of
probability: subjective versus objective.
Independence of cash flows overtime:

The independence of cash flows overtime means that the probability distributions for
future periods are not dependent on each other.
Example on Expected Cash Flows
Example
Suppose there is a project which involves initial cost of Rs 20,000 (cost at t = 0). It is expected to
generate net cash flows during the first 3 years with the probability as shown in Table.
TABLE:
Expected
Net
Probability Cash
Net
Probability Cash
Flows
Flows
0.10
Rs.
Probability
0.10
Rs.
0.10
Cash
Net Cash
Flows
Rs.
6000
4000 | www.troubleshoot4free.com/fyp/
2000
0.25
6000 0.25
4000
seminar,8000 0.25
Summer 10,000
training
report and
more. 6000
0.30
0.30
8000lot 0.30
0.25
12,000 0.25
10,000 0.25
8000
Purpose.
0.10
14,000 0.10
12,000 0.10
10,000
Flows
Capital Budgeting
Solution
(i)
Expected Values: For the calculation of standard deviation for different periods, the expected
values are to be calculated first. These are calculated in Table.

(ii)
The
standard
deviation
of
possible
net
cash
flows
is:
Thus, the standard deviation for period 1 is:
When calculated on similar lines the standard deviations for periods 2 and 3 (cr2 and (T3) also work
out to Rs 2,280.
(iii) NPV = Rs 10,000(0.0909) + Rs8, 000(0.826) +Rs6, 000(0.751)-Rs20, 000= Rs204
TABLE Calculations of Expected Values of Each Period

Year 1
seminar,
Purpose.
Capital Budgeting
Probability
Net cash flow
(1)
0.10
0.25
0.30
0.25
0.10
(2)
6000
8000
10000
12000
14000
Expected value (1x2)

(3)
600
2000
3000
3000
14000
CF1=10000
Year2
Probability
Net cash flow
(1)
0.10
0.25
0.30
0.25
0.10
(2)
4000
6000
8000
10000
12000

(3)
400
1500
2400
2500
1200
CF2=8000
Year 3
Probability
Net cash flow
(1)
0.10
0.25
0.30
0.25
0.10
(2)
4000
6000
8000
10000
12000

(3)
200
1000
1800
2000
1000
CF3=6000
The standard deviation under the assumption of independence of cash flows over time:
seminar,
Purpose.
Capital Budgeting
Normal Probability Distribution:

The normal probability distribution can be used to further analysis the risk element in capital
budgeting. The normal probability distribution is a smooth, symmetric, continues bell shaped
curve. In probability theory and statistics, the normal distribution or Gaussian distribution is
a continuous probability distribution that describes data that clusters around a mean or
average. The graph of the associated probability density function is bell-shaped, with a peak
at the mean, and is known as the Gaussian function or bell curve. The normal distribution can
be used to describe, at least approximately, any variable that tends to cluster around the mean.
For example, the heights of adult males in the United States are roughly normally distributed,
with a mean of about 70 inches. Most men have a height close to the mean, though a small
number of outliers have a height significantly above or below the mean. A histogram of male
heights will appear similar to a bell curve, with the correspondence becoming closer if more
data is used.
seminar,
Purpose.
Capital Budgeting
Capital budgeting in small and large firm

Capital budgeting is one of the most important areas of finance literature. The decision of
capital budgeting, or the allocation of fund in assets for a long term, is obvious for both the
large and small business. Existing theory of capital budgeting explains the investment
decision-making pattern of large businesses very well. This paper discusses whether the
capital budgeting theory of large business is well applicable for the small ones or not. If it is
not, further development of theory becomes necessary. Followed by the analysis of some
theoretical and empirical studies, this paper suggests specific factors to consider in future
researches on capital budgeting theory for small businesses.
Understanding the pattern of capital budgeting in small businesses is important. Small
business is a significant portion of total businesses in an economy. Also, small business
constitutes the starting point for the entrepreneurs. According to Deek (1973), small business
is an important asset within an advanced industrial economy. But they cannot make possible
contribution for the economy if they are held back by managerial and entrepreneurial
limitations. According to FitzRoy (1989), evidences are there to support that small firms are
more innovative. Furthermore, it is observed that the overall demand for customized goods
and services increase than the increase of mass-produced goods (Carlsson, 1989). Thus,
worldwide experience shows that equitable development from economic and social context is
enhanced by the contribution of small businesses (Jeppesen, 2005). All these studies indicate
that successful small business is important for an economy. And, the success of small
business depends on optimal capital budgeting decision. This is why small business capital
budgeting demands special attention for complete theoretical development
The theory of capital budgeting supports Net Present Value (NPV) method most, which
involves discounting all relevant cash flows at a market determined discount rate such as the
cost of capital. Determination of cost of capital requires the separation principle that requires
seminar,
Purpose.
Capital Budgeting
that the investment decision can be made independent of shareholders (owners) tastes and
preferences. Since the ownership is not readily marketable, separation principle, and thus the
market- determined discount rate are inappropriate for closely held and small businesses
Therefore, there is some degree of complexity and inappropriateness employing existing
capital budgeting theory for small business investment decisions.
In case of small businesses, the owner will have to make decisions concerning production,
sales, finance and administration without any specialist management support or advice which
is not the same at all for large incorporated firms. Danielson and Scott (2007) have worked
on the agency problem in small firm investments. Their result shows that agency conflicts
affect a firms investment decisions in different ways before and after the separation
of ownership and control.
Therefore, there is a need to address the problem of decision-making in small business, and
some scholars have been working in this field. For example, McMahon and Stanger (1995)
suggest that small business financial objective function is sympathetic to existing financial
thought, but capture complexities arising in small business. They also argue that the small
business financial objective function should reflect the kinds of enterprise-specific risk that
typically exist in small businesses arising from liquidity, diversification, transferability,
flexibility, control, and accountability considerations
In other words, the capital budgeting process of small business is likely to be different from
that of a large business. The size and availability of capital, investment opportunities, and the
nature of the decision makers being different for small businesses may partially explain this
difference.
There are several reasons small and large firms might use different criteria to evaluate
projects. First, small business owners may balance wealth maximization (the goal of a firm in
capital budgeting theory) against other objectivessuch as maintaining the independence of
the business when making investment decisions. Second, small firms lack the personnel
resources of larger firms, and therefore may not have the time or the expertise to analyze
seminar,
Purpose.
Capital Budgeting
projects in the same depth as larger firms. Finally, some small firms face capital constraints,
making project liquidity a prime concern.
While large firms tend to rely on the discounted cash flow calculations favored by capital budgeting
theory small firms most often cite gut feel and the payback period as their primary project
evaluation tools.
Many small-business owners have limited formal education, and their firms may have
incomplete management teams. Therefore, a lack of financial sophistication is an important
reason why the capital budgeting practices of small firms differ so dramatically from the
recommendations of theory. Small staff sizes also constrain the amount of capital budgeting
analyses the firms can perform. Beyond this, there are also substantive reasons a small firm
might choose to use methods other than discounted cash flow analysis to evaluate projects.
The primary reason is that many small businesses do not operate in the perfect capital
markets that capital budgeting theory assumes. Most of the firms in our sample are very small
they have short operating histories and their owners do not have college education These
characteristics may limit their bank credit, posing credit constraints. If so, these firms may be
required to finance some future investments using internally generated funds, and it would
not be surprising for the owners to consider measures of project liquidity (such as the
payback period) when making investment decisions
FIRM A: RELOCATING A PRODUCTION FACILITY
Firm A produces sisal matting for sale as floor coverings. It has two production facilities one in Johannesburg, Gauteng; and the other in Polokwane, which is approximately 330
kilometers further north. The latter facility is the larger of the two. The focus of this analysis
is the decision to relocate this plant. Figure 1 provides an overview of the decision-making
process followed by this firm. Throughout the decision-making process, the management of
seminar,
Purpose.
Capital Budgeting
Firm A expressed a commitment to two (sometimes conflicting) strategies4: export promotion

and cost minimization.
The first strategy reflected the firms belief that the export market represented a better
opportunity for sustained growth than the domestic market. The current proportion of
domestic to international sales was 70:30. The stated commitment was to reverse this
proportion within 10 years. Given the perceived limited potential for product diversification
in the sisal carpeting market, the other strategic commitment was that of maintaining
competitiveness through minimizing costs.
Step 1: Recognition of the need to move
Management reported three reasons for the consideration of a move from the Polokwane
production facility: the loss of relative cost advantages, the low levels of productivity at
Polokwane and the increasing importance of export sales. The original decision to locate the
factory in Polokwane was in response to government incentives both direct (e.g. rent) and
indirect (production of sisal in the area was subsidised). These have since been discontinued.
The existence of significant negative productivity differentials between the Polokwane and
Johannesburg factories is a continued management challenge. Finally, export sales, once nonexistent, now comprise thirty percent of the firms total sales. As both the raw materials and
the finished product are relatively bulky and raw materials need to be imported and the final
product exported (both by sea) Polokwanes inland position counts heavily against it.
These reasons clearly reflect the firms strategic considerations.
seminar,
Purpose.
Capital Budgeting
Overview of firm As decision-making process
1. Recognition of the need to move.
2. Identify the possible location
3. Identify preferred location

1. Best inland location (Johannesburg)
2. Best costal location (Durban /pine town)
3. Best foreign location
(Mauritius)
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seminar,
Purpose.
4. Identify optimal location (Mauritius)
5. Final decision (set up plant in Mauritius)
Capital Budgeting
Step 2: Identify possible locations

The first step in the decision-making process was to identify a list of possible alternative
locations. This list was composed in terms of the following criteria:
1. Access to reliable, flexible and cheap transport networks closely linked to a port
(for the imports of sisal and exports of finished goods);
2. Availability of adequate production premises;
3. Presence of supporting infrastructure of sufficient quality, such as engineering
facilities, and access to other vital inputs, and
4. Access to staff (preferably experienced/skilled in manufacturing).
Step 3: Identify preferred locations

The company felt that a complete analysis of the list of possible locations identified was
not cost-effective. The second step in the decision-making process consisted of
selecting three sites from the initial list (the eventual choices made are in brackets):
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Purpose.
Capital Budgeting
1. The best domestic inland location (Gauteng/Johannesburg);

2. The best domestic coastal location (Durban/Pinetown); and
3. The best foreign location (Mauritius).
It was felt that these three categories captured the essential strategic choices. An inland
centre would be closer to the existing market (mainly Gauteng) which would be better
as domestic sales remained dominant in the short to medium term. A coastal venue
would be superior in terms of reducing transport costs for the export market the long
term strategic goal. Finally it was believed that a foreign location might be even more
attractive in terms of achieving the long-term strategy of increased export promotion.
Throughout the evaluation exercise, it was decided to retain Polokwane as a benchmark
case. The influence of the two strategic goals can be clearly seen at this point.
The destinations on the short list were selected on the basis of a series of comparative, nonformal analyses concentrating on qualitative differences: two locations were compared and
the lack of a particular factor in one of the two locations, ceteris paribus, was deemed enough
to warrant its exclusion. For example, Port Elizabeth was excluded (when compared to
Durban) on the grounds of:
It was further to Johannesburg than Durban. This would lead to higher transport
cost.
There were fewer road transport companies on the route as compared to Durban.
There would be less flexibility in terms of the number of alternatives available and
(probably) higher costs per kilometer.
Shipping lines stopped less often in Port Elizabeth than Durban. This would again
limit the flexibility and increase cost of the transport in, of raw materials, and out,
of finished products
Step 4: Identify optimal location

seminar,
Purpose.
Capital Budgeting
For each of the three locations a comparison of estimated direct costs for each location
to current direct costs at Polokwane was completed as was an estimated profit/loss statement.
Two scenarios, based on differing assumptions regarding the rates of growth of the domestic
and foreign components of their current demand, were used in these exercises. The first
assumed an annual (compounded) rate of growth (in real terms) of the export market of 15
percent and the second, a growth in export demand of 7 percent5. In both cases, demand in
the domestic market was assumed to grow by 5 percent (also in real terms). These rates of
growth were identified as being the two most likely scenarios representing good or bad
future outcomes.
These exercises indicated that the Mauritius option clearly represented a superior choice to all
the domestic alternatives in terms of both relative costs and expected profits. The quantified
benefits of significantly lower wages, the absence of any company taxation, and significantly
reduced internal transport costs outweighed the quantified negatives of higher rental costs,
higher transport costs to the South African market; and the unquantified problems of
managing across borders and over such a distance.
The Polokwane region presented the most profitable domestic site due to the significantly
cheaper current rental charge used. Two qualifications to this result were immediately raised
by management. Firstly, the low rental charge used for Polokwane in the calculations was not
likely to last for the period covered by the model. Secondly, the exercise assumed that the
increases in output were to be produced with the existing labour and capital stocks which
would
be
extremely
difficult
to
achieve
in
Polokwane.
Consequently
the
Gauteng/Johannesburg site was considered to be the best domestic alternative.

This penultimate stage of the decision-making process provides the first application of a
formal evaluation technique. Identification of relative cost differences is consistent (in part)
with the traditional model of decision-making and the choice of the final location was
determined by the results of this technique.
seminar,
Purpose.
Capital Budgeting
The formal evaluation exercise allowed management to identify what the probable relative
production costs would be (in present terms) at the various locations not the expected value
of the alternative sites. This was sufficient as it dealt with what the decision makers believed
was their key strategic objective minimizing production costs.
Step 5: The final decision

In spite of Mauritius overwhelming advantage over the domestic locations in terms of
relative costs and expected profit, the potential risks of doing business in a completely new
cultural and economic environment were perceived to be very large. Consequently,
management decided to keep the production facility in Polokwane running for another year at
least to allow for a pilot plant to be set up in Mauritius to make products forexport to the
European market. This deferred the decision to move the entire production facility from
Polokwane for a year. Moreover, the experience of running the pilot plant would give
management the experience to more accurately evaluate the viability of running a production
plant in Mauritius.
The nature of the final decision suggests that that management recognised the limitations of
the formal evaluation exercise. It allowed them to identify Mauritius as their first choice for a
future production facility. However, they decided to limit their exposure by setting up a pilot
plant in Mauritius and deferring the decision to move for a year. While the results of the
formal evaluation exercise were seen to be directionally correct, they were deemed not to be
sufficiently accurate to allow management to commit to the choice suggested by the
evaluation exercise. This suggests that the formal evaluation exercise had a limited impact on
the eventual decision. However their to invest in a pilot plant only is entirely consistent with
the conclusions of Real Options theory which recognizes that delaying an investment
decision until key uncertainties have been resolved is a valuable source of flexibility.
In summary, this case study highlights a role for the formal (financial) evaluation exercise
different to that proposed by the traditional model. Rather than being the basis for this entire
decision-making process, it can be seen as a mechanism which enabled the firm to identify
the lowest cost alternative site from a pre-selected group. It is an important step in the overall
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Purpose.
Capital Budgeting
process but the importance of the strategic factors was far greater especially in terms of
defining the need for the capital investment decision and the criteria by which alternatives
should be chosen for further analysis. They determined which locations should be
(imperfectly) formally evaluated. Moreover, whilst guided by the results of the formal
evaluation exercise the final decision taken was directly affected by the uncertainty regarding
the accuracy of the formal evaluation exercise and thus its conclusions. Even at this late stage
in the decision-making process, the results of the valuation exercise did not provide the
managers of Firm A with a sufficiently strong foundation for them to commit to their
final choice of location as was evidenced by the choice to build a pilot plant.
In terms of process, decision makers seemed to follow a filtering process rather than a onceoff comparison of estimates of value. Initially, a broad mesh or filter is applied to eliminate
unwanted choices and then finer and finer filters are applied as the process continues. The
(truncated) value-related estimation exercise was effectively the final mesh used to identify
the optimal location.
FIRM BS DECISION TO EXPAND ITS CAPACITY

Firm B is a large South African paper manufacturing company and the decision analysed in
this section was taken by the Tissue Paper Division. Capital expenditure proposals are
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Purpose.
Capital Budgeting
motivated at the divisional level but permission has to be obtained at the group level if the
amount to be spent is above R1 million. This is formally done through a presentation to Firm
Bs Board of Directors.
1. Recognition of the need for additional

capital.
2. Identify first list option: Option A Selected
3. Identify revised list of option: Option H

selected
4. Pre-engineering study: Option H rejected,

Option E selected
5. Board presentation: Option E accepted
An overview of firm Bs capital expenditure decision-making process

Firm Bs Tissue Division held the largest market share of 37 percent. Management viewed the
market as essentially a commodity market with little room for product differentiation.
Consequently they believed that long term profitability could only be achieved through high
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Purpose.
Capital Budgeting
operating efficiencies and continued market dominance. This implied that, firstly, the division
must produce at the lowest possible overall cost (i.e. it must not over-capitalize itself); and
secondly, it must maintain a level of excess capacity to block potential entrants. A key
challenge for management was seen to be one of balancing the two competing aims and this
conflict becomes apparent at almost every stage of the process.
Step 1: Recognition of the need for additional capacity

Two reasons were given by the divisions management for the need to consider additional
production capacity. Firstly, the rate of growth of market demand was expected to increase;
and secondly, they believed it to be a strategic necessity to continue to maintain sufficient
excess capacity to protect the firms dominant market position from potential new entrants.
The change (increase) to the expected rate of growth of market demand (sales) for tissue
products was largely the result of the personal input of the group managing director. In July
1995 he indicated to the Division that they should base their capital expenditure planning on
three scenarios: five, ten and fifteen percent annual growth in levels of market demand
(sales). Prior to this the Tissue Division had considered three alternative
scenarios of five, seven and a half and ten percent. It was estimated that the divisions
capacity constraints would be reached in 1998, 1997 and 1996, under the three new scenarios
respectively. The division thus proceeded to look for alternative ways to supply the perceived
need for an increase in productive capacity.
Step 2: Identify first list of options

Option C was rejected as only offering a short-term solution. It was then argued that the lack
of in-house technical resources meant that it could only manage one of the remaining three
alternatives at a time. The required level (and timing) of the additional capacity required was
very sensitive to the accuracy of the expectation regarding the rates of growth in future
demand. It was felt that the highly significant increase in demand (50 percent or greater)
which would necessitate the consideration of a new plant was not certain enough to take the
risk of over-capitalizing the division. Options A and B could provide sufficient breathing
seminar,
Purpose.
Capital Budgeting
space (in terms of additional capacity) to confirm accuracy of these expectations. The
upgrading options (A and B) should thus be considered first as they would provide
incremental tonnage at the lowest cost (and risk). Moreover these options would allow the
Division to correct for the lack of adequate investment in the past which was constraining its
current and future operating efficiency levels.
The first set of option considered by the division
Option
Action
Additional capacity
(000s tons p.a)

Rebuilding of paper machine 3(PM3)at the 2000
site K factory
Upgrading of paper machine four (PM4) 9000
at the site B factory

Renegotiate the supply contract with 4000
SAPPL
Build a new paper machine
27000
Further consideration of Option D building a new paper machine was effectively stopped
at this stage on the basis that the risk of over-capitalisation was too great due to both the
higher cost of investment in a new machine and the significant additional capacity it would
bring. However, there was no formal analysis of the risk of the rate of growth in reaching the
levels necessary to justify this investment.
The reasons given for the decision taken to focus on options A and B were that it would allow
the Division to use its existing assets more efficiently and avoid over capitalizing the
division. The decision to exclude Options C and D was thus made on their inability to meet
the Divisions strategic goals not through a comparison of the expected value of the range
of alternatives.
Outside consultants were briefed with the aim of identifying whether options A and B were
feasible and what the potential associated costs might be. This led to the next set of
alternatives considered in November.
seminar,
Purpose.
Capital Budgeting
Step 3. Identify revised list of options

The outside consultants advised that further consideration of option A was not required as
option B provided clearly superior output and cost advantages. Five alternative forms of
option B were presented for consideration (see options E, F, G, H and I in Table 2 these are
mutually exclusive alternatives). At this stage, the technical director, again on the advice of
the consultants, introduced two additional proposals for expenditure on projects of a
replacement/upgrade nature (Options One and Two in Table 2). Of these alternatives, Option
H, One and Two were selected for further analysis. The total expected increase in capacity
would be approximately 6 000 tons per annum.
The process for deciding between these options is seemingly based on criteria similar to those
proposed by the traditional value based approach discussed above. As shown in Table Two,
each option was presented with its expected benefit (additional output added), its relative
(estimated) capital costs, and finally, its Internal Rate of Return (IRR) measure. Furthermore,
the option with the highest IRR was the one selected (Option H).
seminar,
Purpose.
Capital Budgeting
Option
Action
Additional
capacity
Upgrading PM4s stock 5700tons
preparation using latest
Estimated
IRR (%)
Payback
cost
45million
23.45
period
4yrs 6months
p.a
technology
Option E
with 5300tons
35million
28.06
3yrs
essential equipment only

p.a
Upgrade
&combine 5000tons
33million
28.06
11months
3yrs
but
PM3 & PM 4 stock

H
separation
Utilize existing
PM3 4000tons
stock preparation with

upgrade
PM4
preparation
Start up
One
machine
Implementation
of
p.a
11months
15million
46.59
2yrs6month
8million
24.05
4yrs5 months
10million
21.55
4yrs
p.a
stock
PM3 4700tons
p.a
of 817tons
distributed control
p.a
system
Two
1170tons
Fittings of gas fired
p.a
10months
drying hood
The IRR and Payback Period calculated for options F and G were identical. When questioned
about this highly unlikely outcome the Technical Director for the Division (who prepared the
document) said that these results were correct and any similarity was simply a coincidence.
There are two problems with this conclusion, however. Firstly, the results of the supposedly
redundant payback period (PP) measure were presented for all of the options considered.
When interviewed, management regularly referred to the PP results when explaining the
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Purpose.
Capital Budgeting
relative attractiveness of that alternative. This indicates that decision-makers do not agree
with the theoretical redundancy of the PP measure and do not feel comfortable with the use of
DCF techniques in isolation10. Secondly, while the choice of Option H is justified (as it had
the highest IRR), options One and Two were also selected for further analysis even with
their very ordinary IRR (and PP) figures. This suggests that the IRR (or even PP) measures
were not the primary basis for the decision at this point. When asked about this choice, the
Divisional Managing Director indicated that because of his (personally) pessimistic outlook
regarding future demand, he had wanted the smallest possible investment of additional assets
into the production process. He felt that anything more would have been unnecessary and
would have led to the division over-capitalizing itself. Option H, One and Two offered this
combination. The importance of the divisions strategic aims in this decision-making process
reemphasized at this point as the inclusion of options One and Two only makes sense as they
maximizing managements ability to implement their strategy of sweating the
Assets
The next stage of the capital expenditure process was a pre-engineering study to determine a
more accurate estimation of the costs of options H, One and Two for budgeting purposes.
Step 4: Pre-engineering study

The significant results of this study were that the chosen option (H) was discarded on the
advice of the consultants11. Option G was also excluded on the same basis while option I was
rejected on the basis that it did not present a long term solution. The choice was thus between
Options E and F. Option F, while offering a higher IRR, suffered from the problems of
technology obsolescence in the future which would negatively affect the productivity of all
the associated machinery and lead to lower quality levels. On the other hand, option E would
allow PM4 to run at its designed capacity. It would correct for the original lack of support
processes and thus would increase both levels of output and improve the efficiency of the
existing capital stock. While significantly more expensive (R45 million as compared to R15
million), its use of new technology would mean that it would require replacement much later
than any other alternative. The importance of these efficiency gains would be multiplied by
their relative longevity.
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Purpose.
Capital Budgeting
In spite of it having a lower IRR (and a longer PP) than option F, option E was selected. The
basis for this decision was that it would supply sufficient additional capacity for the
(downgraded) expected needs of the Division as well as prolong the life of the PM4 machine
and improve its operating efficiency measures over this period. This suggests that either these
benefits either not fully reflected in the IRR calculations completed in
the previous stage, or alternatively, that the IRR measures, if accurate, are not important in
the decision-making process. Management indicated that these benefits were not initially
included because they were judged to be unquantifiable and it was only after the preengineering study that this data was available. However it is important to remember that the
choice of focus of the pre-engineering study was option H. Consequently it was effectively
only an accident this data on Option E became available. Furthermore, new IRR estimates
were not estimated and presented in support of this choice.
This stage of the process highlights a significant problem with the implementation of a model
of decision-making based on the comparison of estimates of value. The data required to
accurately estimate the value of the competing alternatives is very expensive either in terms
of management time (or consultants fees). As a result, managers need to priorities options for
further consideration and in this case, they did it on qualitative and strategic grounds (the
ability of Option E to minimize additional investment while leveraging the unused production
capacity of the existing assets).
The process of elimination outlined in this step clearly highlights the continued importance of
qualitative variables in the decision-making process in spite of the apparent use of DCF
techniques. Each alternative was carefully evaluated judged in terms of its alignment with the
strategic goals in spite of there being estimates of the projects IRRs. The estimate of value
produced by a DCF evaluation technique depends on the accuracy of their assumptions
regarding the future values of all relevant factors. The above example suggests that these
techniques produce estimates that are not accurate enough to provide decision makers with an
adequate basis for deciding between alternatives. The DCF evaluation techniques are either
somehow incapable of accurately capturing the value of the alternatives alignment with these
goals, or, alternatively, it may be that the costs of acquiring information required for the use
of the traditional decision-making approach are too great to allow for its use in comparing
alternative courses of action. The fact that this type of analysis is completed for the
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Purpose.
Capital Budgeting
presentation to the board suggests that the latter reason is correct in this case.
The final stage of the decision-making process was to present the results to the Capital
Expenditure Committee of the Groups Board of Directors in August 1996.
Step 5: Board presentation

The proposal to upgrade PM4 consisted of the Divisions request for permission to carry out
their planned course of action (Options E, One and Two). The upgrading of PM4 was
presented as a viable short-term alternative until the installation of a new machine could be
seen to be strategically appropriate. The divisions management clearly communicated this
choice as an opportunity to improve the efficiency of its capital stock and reduce the need for
additional future non-productive investment expenditure. This alternative allowed it
revitalized the capital stock of its existing production facility and avoided the gradual decline
in its long term capacity. The board approved the application and the changes to PM4 took
place.
Some formal evaluations of the proposed alternatives (IRR; PP) were included but these
results were not used to justify the course of action selected by indicating how these were the
best results available. The only other course of action mentioned in this presentation was to
bring the installation of a new paper machine forward. No analysis of the expected value of
this alternative was presented. This suggests that the only role of the formal evaluation
included in this presentation was to confirm the viability of the proposed plan of action to the
board rather than its necessary superiority over competing alternatives.
In
summary, the decision that Firm B took was initially prompted by a change of
expectations, modified by the divisions existing competitive strategies and then justified by
the formal analysis of a limited number of alternative solutions. The key choices throughout
the process were made with the aim of balancing the competing strategic aim. These choices
made were justified on the grounds of qualitative, and not quantitative, criteria. When used
the DCF techniques provided support for the decision taken on other grounds.
seminar,
Purpose.
Capital Budgeting
Financial Performance of Vizag Steel Plan

VSP had to bear the brunt of huge project cost right from the day of its inception. This has
affected the companys balance sheet due to very high interest burden. The company, in spite
of making operating profit every year had to report net loss during all financial years. This on
the other hand had resulted in making VSP to take great care in planning the financial
resources.
Financial Performance (In crores)
Year
2000-2001
2001-2002
2002-2003
2003-2004
2004-2005
2005-2006
2006-2007
2007-2008
2008-2009
Gross margin
504
690
1049
2073
3271
2383
2633
3515
2356
Cash profit
153
400
915
2024
3260
2383
2548
3483
2267
Net profit
-291
-75
521
1547
2008
1252
1363
1943
1336
seminar,
Purpose.
Capital Budgeting
An efficient allocation of capital is the most important finance function in the modern times.
It involves decisions to commit the firms funds to the long - term assets. Capital budgeting
for investment decisions is of considerable importance to the firm since they tend to
determine its value by influencing its growth, evaluation of capital budgeting decisions
Capital Budgeting Process of Vizag Steel Plant

1. Identification of investment proposal.
2. Screening the proposal.
3. Evaluation of various proposals.
4. Fixing priorities.
5.
Final approval & preparation of capital expenditure

budget.
6. Implementing proposal.
7. Performance review
Identification of investment proposal
The capital budgeting process begins with the identification of investment proposal. The
proposal or idea about potential investment opportunities may originate from the top of
management or may come from the rank and file workers of any department or from any
officers of the organization. The departmental head analyses the various proposals in the
light of the corporate strategies and submits the suitable proposals to the capital expenditures
planning committee in case of large organization or to the officers a concerned with the
corporate strategies and submits the suitable proposals to the capital expenditures. Capital
seminar,
Purpose.
Capital Budgeting
expenditures planning committee in the case of large organization or the officers concerned
with the process of long-term investment decision.
Screening the proposal
The expenditures planning committee screens the various proposals received from different
departments. The committee view these proposals form various angles to ensure that these are
in accordance with the corporate strategies or selection criterion of the firm and also do not
lead to the department imbalances.
Evaluation of various proposals:The next step in the capital budgeting process is to evaluate the profitability of various
proposals. There are many method which may be used for this purpose such as pay back
period method, rate of return method, net present value method, internal rate of return, etc.
All these method of evaluating profitability of capital investment proposals have been
classified as below.
i. Independent proposals.
ii. Contingent or dependent proposals and
iii. Mutually exclusive proposals.
Fixing priorities:After evaluating various proposals, the unprofitable proposals may be rejected straight away.
But it may not be possible for the firm to invest immediately in the all the acceptable
proposals due to limitation of funds. Hence, it is very essentials to rank the various proposals
and to establish priorities after considering urgency, risk and profitability involved there in.
Final approval & preparation of capital expenditure budget
Proposals meeting the evaluation and other criteria are finally approved to be included in the
capital expenditure budget. However, a proposal involving smaller investment may be
decides at the lower levels for expenditure action. The capital expenditures a budget lays
down the amount of the estimation expenditures to be incurred on fixed assets during the
budget period.
seminar,
Purpose.
Capital Budgeting
Implementing proposals
Translating an investment proposal into a concrete project is a complex, time consuming, and
risk- fraught task.
1. Adequate formulation of projects
The major reason for delay is insinuate formulation of projects put differently, if necessary
homework in terms of preliminary comprehensive and detailed formulation of the project.
2. Use of the principle of responsibility accounting
Assigning specific responsibility to project managers for completing the project within the
defined time-frame and cost limits is helpful for expeditious execution and cost control.
4. Use of Network Techniques
For project planning and control several network techniques like PERT (Programme
Evaluation Review Techniques) and CPM (Critical Path Method)are available.
Performance Review:Performance review, or post completion audit, is a feedback device. It is

a means for comparing actual performance with projected performance. It
may be conducted, most appropriately. When the operations of the project
have stabilized.
It is useful several ways.
I. It throws light on how realistic were the assumptions underlying the
project.
II. It provided a documented log of experience that is highly valuable for
decision making.
seminar,
Purpose.
Capital Budgeting
Conclusion
Capital budgeting is one of the important techniques of Financial Management to
evaluate the project efficiency. So that purchasing of new machinery, starting business,
expansion, replacement of old machinery with new etc. Comparatively modern method is
more effective over the traditional method because the modern method is considering the
time value of money. Capital budgeting has its own disadvantage but its advantages
overshadow its
disadvantages with its usage. But in India capital budgeting technique is
not properly utilized in corporate as well as government administrative level.

seminar,
Purpose.
Capital Budgeting
After studying this topic, I realize the importance of capital budgeting. I feel this that capital
technique can be utilized in corporate as well as government administration project such as
public utility service, public transportation service etc. Local authority services such as
MAHDA, BMC can use this technique to evaluate the prospective project.
I personally feel that due to lack of knowledge public is not willing to utilize this technique
in the prospective way. Capital budgeting can be utilize from domestic level to MNCs and
this sentence can express the importance of capital budgeting.
Glossary
Short forms
NPV
IRR
ARR
PI
DCF
Full forms
Net present value
Internal rate of return
Accounting rate of return
Profitability index
seminar,
Purpose.
Capital Budgeting
PB
Pay back
Bibliography
Financial management I.M.Pandey
Financial management-Prasanna Chandra
www.google.com
www.scribd.com
www.docstock.com
www.wisemind.com
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Purpose.
Capital Budgeting
www.thinkinghats.com
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Purpose.

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Capital is a limited resource

(short-term or long-term, common stock) or retained earnings, accounts payable or

increase its the

company ownership of the individual stockholder may proportionally decrease. The

Features of capital budgeting

1. It involves the exchange of current funds for the

Funds are invested in long term activities.

It involves generally huge funds.

5. They are irreversible decisions.

It has significant effect on the profitability of the concern.

7. A suitable administrative framework capable of transferring required

The controlling of expenditures and careful monitoring of crucial aspects

A set of decision rules which can differentiate acceptable from

10. A suitable administrative framework capable of transferring required

Evolution of capital budgeting

Capital Budgeting in the 1960s to 1990s

Component of Capital Budget

Initial Investment Outlay:

Net Cash benefits or savings from the operations:

Terminal Cash flow

The Net Present Value technique

Significance of capital budgeting

Indirect Forecast of Sales:

firm during the life

Comparative Study of Alternative Projects:

Features which distinguish capital budgeting decisions from ordinary

Capital budgeting process.

Identification of potential investment opportunities:

The capital budgeting process begins with the identification of potential

Assembling of investment proposals:

Investment proposal identified by the

production department and other

department are usually submitted in the standardized capital investment proposal

Preparation of capital budget and appropriation:

Translating an investment proposal into concrete project is complex, time

It provides a documented log of experience that is highly valuable for

It helps in uncovering judgmental biases.

Rationale of Capital Expenditure decisions

Investment Decisions Affecting Revenue:

Investment Decisions Reducing Costs:

A decision concerning whether an existing asset should replaced

Mutually exclusive projects:

In this case, the decision to invest in one project

affects other projects because only

Research and development project:

Capital budgeting technique

their inability to consider the cash flow

timing and its dependence on book profits. Although severely criticized as

was widely used as a supplementary decision criterion. In a similar study of 151

project to pay back its initial

What is the formula for Payback Period?

Payback Period Example

Initial investment $10000

Cumulative cash flow

Payback Period Step by Step

E.g., ( $10,000 - $9,000 ) / $3,000 = 0.334

investment is essential in the appraisal of advanced manufacturing technology (AMT)

2) Time value of money:

ARR Accounting Rate Return Rule:

Average Net Income

Cash inflows per year = $1,300

If you use average investment, ARR is:

ARR = $767/[$8,000/2] = $767/$4,000 = 19.2%