Principles of Capital Budget:

An Analytical Study

Research Project submitted to

Dr. Y. Papa Rao
(Faculty: Corporate Regulation)

Project submitted by
Sudarshini Nath
(Roll no.-170)
(Semester-IX)

HIDAYATULLAH NATIONAL LAW UNIVERSITY

RAIPUR, C.G.

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 ACKNOWLEDGEMENTS

I feel highly elated to work on the topic “Principles of Capital Budget: An Analytical
Study”.

The practical realization of this project has obligated the assistance of many persons. I
express my deepest regard and gratitude for Dr. Y Papa Rao, Faculty of Corporate
Regulations. His consistent supervision, constant inspiration and invaluable guidance have
been of immense help in understanding and carrying out the nuances of the project report.

I would like to thank my family and friends without whose support and encouragement, this
project would not have been a reality.

I take this opportunity to also thank the University for providing extensive database resources
in the Library and through Internet.

Some printing errors might have crept in, which are deeply regretted. I would be grateful to
receive comments and suggestions to further improve this project report.

Sudarshini Nath

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 TABLE OF CONTENTS
Introduction .......................................................................................................................................... 4

Scope and Objectives ........................................................................................................................... 6

Research Methodology ........................................................................................................................ 6

Meaning of Capital Budget ................................................................................................................. 7

Essentials of Capital Budget ............................................................................................................... 9

Characteristics of Capital Budget ..................................................................................................... 10

Role of Financial Manager ................................................................................................................. 11

Principles of Capital Budget .............................................................................................................. 14

Process of Capital Budget .................................................................................................................. 17

Identification of Potential Investment Opportunities .................................................................. 17

Assembling of investment Proposals ............................................................................................. 17

Decision Making .............................................................................................................................. 18

Preparation of capital Budget and Appropriations ..................................................................... 18

Implementation ............................................................................................................................... 18

Post-implementation audit ............................................................................................................. 19

Capital Budgeting Decisions .............................................................................................................. 21

Types of Capital Budgeting Decisions ........................................................................................... 21

Guidelines for taking Capital Budgeting Decisions ......................................................................... 24

Significance Of Capital Budgeting .................................................................................................... 25

Conclusion ........................................................................................................................................... 27

Reference ............................................................................................................................................. 28

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 INTRODUCTION

“To understand uncertainty and risk is to understand the key business problem- and the key
business opportunity”.
- David B. Hertz, 1972

In the form of either debt or equity, capital is a very limited resource. 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 (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.1

Capital Budget is a required managerial tool. The duty of the financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore a financial manager
must be able to decide whether an investment is worth understanding and be able to choose
intelligently between two or more alternative. To do this a sound procedure to evaluate,
compare and select projects is needed, this procedure is called Capital Budgeting. The
primary goals of capital budgeting investment decisions is to increase the value of the firm to
the shareholders i.e. Wealth maximization of the firm.2

1
What is Capital Budgeting?, http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/CapitalBudget/Capital
BudgetingTraining.pdf (last updated Oct 2, 2014).
2
http://dept.harpercollege.edu/tutoring/documents/ACC102-Chapter11new.pdf(last updated sep 27, 2014)

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Capital budgeting is investment decision-making as to whether a project is worth
undertaking. Capital budgeting is basically concerned with the justification of capital
expenditures.3

3
Id.

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 SCOPE AND OBJECTIVES

1. To understand the concept and importance of Capital Budget.

2. To discuss the role of Financial Manager with regard to capital budget and its relation
with goals of corporation.
3. To study the principles of Capital Budget.
4. To analyze the various methods applied for Capital Budgeting.

RESEARCH METHODOLOGY

Nature of research work: This project “Principles of Capital Budget: An Analytical Study” is
a ‘Doctrinal’ work. Doctrinal research includes studying books and established literature and
not actually going to the field and doing empirical research.

Source of research work: The sources of this project are both primary (bare acts, statutes, etc)
and secondary sources (books given by different authors, journals, internet, etc).

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 MEANING OF CAPITAL BUDGET

A budget is a coordinating and comprehensive plan used in finance and operations but
expressed in financial terms within a definite time period. Budget means annual allocations
of fund based on preplanned activity.

Capital Budget is a required managerial tool. The duty of the financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore a financial manager
must be able to decide whether an investment is worth understanding and be able to choose
intelligently between two or more alternative. To do this a sound procedure to evaluate,
compare and select projects is needed, this procedure is called Capital Budgeting.

Capital budgeting is a process of making decisions regarding investments in fixed assets

which are not meant for sale such as land, building, machinery or furniture. The word
investment refers to the expenditure which is required to be made in connection with the
acquisition and the development of long-term facilities including fixed assets. 4

It refers to process by which management selects those investment proposals which are
worthwhile for investing available funds. For this purpose, management is to decide whether
or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm.

What is capital expenditure is a very difficult question to answer. The term capital
expenditure is associated with accounting. Normally capital expenditure is one which is
intended to benefit future period i.e., in more than one year as opposed to revenue
expenditure, the benefit of which is supposed to be exhausted within the year concerned.

Capital budgeting is the planning process used to determine whether an organization’s long
term investments such as new machinery, replacement machinery, new plants, new products,
and research development projects are worth the funding of cash through the firm’s
capitalization structure (debt, equity or retained earnings). It is the process of allocating
resources for major capital, or investment, expenditures. One of the primary goals of capital

4
“Behavioral Finance: Capital Budgeting and Other Investment Decisions”,
https://faculty.fuqua.duke.edu/~sgervais/Research/Papers/BookChapter.OvCapitalBudgeting.pdf(last updated
sep 27, 2014)

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budgeting investments is to increase the value of the firm to the shareholders i.e. Wealth
maximization of the firm.5

Often times a prospective project’s lifetime cash inflows and outflows are assessed in order
to determine whether the returns generated meet a sufficient target benchmarks (investment
appraisal).

In order to manage the process several factors must be taken into consideration, including the
current value of House Assets, the average cash flow over the course of business year, the
level of debt carried by the business and any expansion goals or projects that are currently
under consideration.

The goal is to ensure that revenue coming from all sources including customer payments,
dividends from investments and that means is sufficient to sustain the operations. When
evaluating investment, we consider only the cash flows which change due to the decision.

Risk is a measure of surprise. High risk investment can be large flops or big hits. Investors
choose a balance of risk. It only makes sense to compare investment after returns which have
about the same risk.

5
ARTHUR SULLIVAN & STEVEN M. SHEFFRIN, ECONOMICS: PRINCIPLES IN ACTION 375 (2003) ISBN 0-13-
063085-3.

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 ESSENTIALS OF CAPITAL BUDGET

The estimation of any investment proposal using such methods like Average Rate of Return,
Net Present Value, Payback Period, Internal Rate of Return, Investment Appraisal, etc is also
the essential part of the Capital Budget.

It is the process of identifying, analyzing and selecting investment projects whose return
(cash flows) is expected to extend beyond one year.

It is worthwhile to mention here that long term funds, raised in first stage, are invested in
procuring fixed assets so Capital Budget decision is usually financed in long term funds.

The term Capital Budget is used interchangeably with Capital Expenditure decision, capital
expenditure management, long term investment decision, and management of fixed assets
and so on.6

In brief Capital Budget decisions can be broken down into:

1. Allocation of long term funds among fixed assets/long term assets.

2. Risk analysis of these investment decisions.

3. Measurement of the cost of capital.

The following are the basic features of Capital Budgeting:

1. It has the potentiality of making large anticipated profits.

2. It involves a high degree of risk,

3. It involves a relatively long-term period between the initial outlay and the anticipated
return.7

6
“ The goals of Capital Budgeting”, https://www.boundless.com/finance/textbooks/boundless-finance-
textbook/capital-budgeting-11/introduction-to-capital-budgeting-91/the-goals-of-capital-budgeting-391-
1444/(Last updated on Oct 5 2014)
7
Id

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 CHARACTERISTICS OF CAPITAL BUDGET

1. Creative Search for Profitable Opportunities

The concept of the profit-making idea must be embodied in the capital facility. Profitable
opportunities for the company’s invested capital must be turned up. A corporation’s
future profitability and growth are linked to the soundness of its capital expenditure
policy.

2. Long-Range Capital Planning

To provide consistent benchmarks for proposals originating in all parts of the

organisation, it is necessary to have some kind of a plan sketched and for the future even
though it is a tentative plan.8

3. Short-Range Capital Planning:

The purpose of preparing a short-range capital budget is to force the operating

management to submit the bulk of its capital proposals early enough to give the top
management an indication of the company’s credit demands for funds.

4. Measurement of Project Worth:

In order to permit an objective of the projects, the productivity of the proposed outlay will
have to be measured properly.

5. Screening and Selection:

A screening standard should be set in the light of the supply of cash available for capital
expenditures, the cost of money to the company, and the attractiveness of alternative
investment opportunities.

6. Control of authorized Outlays;

Control has to be exercised by the top management in order to ensure that the facility
conforms to the specifications and that the outlay expenditure is incurred, it is most
difficult to change the course of expenditure.9

8 “Characteristics of Capital Budget”, http://lessonsfrommba.blogspot.in/2011/06/characteristics-of-

capital-budgeting.html(last updated on Sep. 26 2014)

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 ROLE OF FINANCIAL MANAGER

It is generally assumed that management’s primary goal is to maximize the wealth of the
firm’s shareholders. Capital budgeting theory prescribes decision rules in keeping with this
objective.10

Financial management involves systematic efforts of management devoted to the

management of finance which is needed for all activities of a firm. It involves:

- Procuring money for the firm.

- Employment of the money in various assets and their proper management.
- Generating surplus (making money) and its distribution.

There may be several competing alternatives and constraints for each of the above functions
because of the complexity of business these days. Hence the decision function of financial
management has become complex and challenging. Financial decisions involves: Investment
Decisions, Financing Decisions, Dividend Decisions and Liquidity Decisions.

The first decisions i.e. Investment Decision is very important with regard to our present
discussion of Capital Budget. It involves identifying the assets or projects in which the firm’s
limited resources should be invested. Such assets may be land and buildings, plant and
machinery, furniture and fixtures, equipment such as computer laptop- generally referred to
as tangible or long-lived assets. Decision making relating to long-lived assets is referred as
Capital Expenditure Decision or Capital Budgeting.

Since these decisions normally deal with a longer period of time and comparatively large
amount of money, the risk element is high. ‘Risk’ is the probability of actual outcome
differing from expected outcome, say, profit or cash flow. In theory, there should be risk-
return trade-off i.e. the relation between risk and return. In other words, the higher the
perceived risk of an investment, the higher should be the return required by the investor and
vice-versa.

9
Id
10
Tarun K. Mukherjee & Glenn V. Henderson, The Capital Budgeting Process: Theory and Practice,
Interfaces, Vol. 17, No. 2 (Mar. - Apr., 1987), pp. 78-90, http://www.jstor.org/stable/25060944 (last updated
Oct. 8, 2013).

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The relationship between the firm’s overall goal, financial management and capital budgeting
is depicted in following figure11:

This self-explanatory chart helps to easily visualize and retain a picture of the capital
budgeting function within the broader perspective of corporate finance.

Funds are invested in both short-term and long-term assets. Capital budgeting is primarily
concerned with sizable investments in long-term assets. These assets may be tangible items
such as property, plant or equipment or intangible ones such as new technology, patents or
trademarks.

Investments in processes such as research, design, development and testing – through which
new technology and new products are created – may also be viewed as investments in
intangible assets.

Irrespective of whether the investments are in tangible or intangible assets, a capital

investment project can be distinguished from recurrent expenditures by two features. One is
that such projects are significantly large. The other is that they are generally long-lived

11
Don Dayananda & Richard Irons, Capital Budgeting: An Overview, Cambridge University Press,
http://assets.cambridge.org/97805218/17820/excerpt/9780521817820_excerpt.pdf (last updated Sep 29, 2014).

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projects with their benefits or cash flows spreading over many years. Sizable, long-term
investments in tangible or intangible assets have long-term consequences.

An investment today will determine the firm’s strategic position many years hence. These
investments also have a considerable impact on the organization’s future cash flows and the
risk associated with those cash flows. Capital budgeting decisions thus have a long-range
impact on the firm’s performance and they are critical to the firm’s success or failure.

Further it is the Director (Finance and Accounts), or the Chief Financial Officer, who is
vested with overall responsibility for matters concerning financial management, accounting
and audit. He has to ensure that accounts are prepared in compliance with generally accepted
accounting policies and provisions of Companies Act, and that they are audited and presented
before the shareholders in the annual general meeting for approval. He or she has also to
ensure that funds of the company are managed appropriately. Financial management being
the key to success of an organization, the financial manager has to ensure its effective
management.

It is also to be emphasized that financial management is an integral part of management

process in most companies. So the practice of financial management cannot be carried on
independently of, or in isolation from, the general management of the company. The financial
management process and, consequently, the financial manager have to operate in tandem
with the general management function in achieving the goals or objectives of the company.12

12
Supra note 10

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 PRINCIPLES OF CAPITAL BUDGET

Capital budgeting is the process of evaluating and implementing a firm’s investment

opportunities, by virtue of properly identifying such investments that are likely to enhance a
firm’s competitive advantage and increase shareholder wealth. A typical capital budgeting
decision involves a large up-front investment followed by a series of smaller cash inflows. A
typical capital budgeting process is focused around following basic principles:13

1. Decisions are based on potential cash flows and not accounting income:

If a project is undertaken and subsequently some relevant incremental cash flows are to
flow out by virtue of such a capital budgeting plan, the relevant cash flows are to be
considered as a part of the budgeting process, and the decisions on capital budgeting have
to take such incremental cash flows into consideration, before properly evaluating such a
capital budgeting plan. However, the sunk costs, which can’t be avoided, even by
overlooking or avoiding such a capital budgeting plan, should not be considered for
acceptance or rejection of the project.

However, while finalizing a capital budgeting decision, one needs to examine the impact
of implementing such a plan on the cash flows of related activities undertaken by the
same group, which has some synergy with the proposal for which the capital budgeting is
being undertaken. 14

If the sales of some related company within the same group are likely to face shrinkage
following the implementation of such a plan, the capital budgeting plan should take such
potential cash inflow loss into account, before going for the proposed plan.

In other words, if potential cash flows are likely to have a detrimental effect on the cash
flows emerging out of existing business, both of them need to be examined carefully
before finalizing the capital budgeting plan. Such a typical case, where an existing cash
flow may suffer due to potential cash flow of the new/ improved facility is called
cannibalization or externality.15

13
Manish, Basic Principles of Capital Budgeting, Corporate Finance, http://financetrain.com/basic-principles-
of-capital-budgeting/ (last updated Sep.30, 2013)
14 Id
15
Supra note 3

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 For example, if a day-care center decides to open another branch within a distance of 10
km from existing one, the impact of customers who decide to move from one facility to
the new facility that is now closer to their work place must be considered.

A project could have a conventional cash flow pattern, which typically means a cash flow
at the time of undertaking such a capital budgeting plan, to be followed a series of cash
inflows over the years to follow.

However, at times, there could be cases where the project may also have more than one
cash outflows, like the one at the start, which could follow at the time of retirement of the
project. Such cases are called non conventional cash flow patterns.

2. Cash flows are based on opportunity costs:

Any firm that undertakes an analysis of taking up a project may end up finding up that
there may be alternate plans available to boost its potential cash flows out of the funds it
is applying in the capital budgeting. Such cash flows which need to be foregone, for
undertaking the capital budgeting plan, are typically considered as the opportunity costs
for the firm and are key parameter before making a choice on whether to implement the
project, or forego it. Such opportunity costs should be duly considered while making a
final choice on whether or not to implement the new project.

3. Timing of Cash Flow:

It should be kept in mind that the timing of cash flows subsequent to the capital budgeting
(when the cash outflows move out of system), are important for undertaking a project.
Typically, the earlier the cash inflows start to plough back into the business, the higher is
its value.

The timing of cash flow is crucial because it is dependent on the time value of money.
Cash flow that is received now will be worth more in the future if it were to be received
later.16

4. Post tax analysis:

16
Id

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 It is important to note that all cash flows accruing into the business should be considered
only after taking into account the tax implication of such cash inflows or only on a post
tax basis.

It is useless to measure cash flow before taxes because it is not its present value. Firm’s
value is based on cash flow that a firm gets to keep, not the money that is sent to the
government.

5. Financing costs reflected in project’s required rate of return:

Rate of return is an aspect of financing that has potential risks. Project’s that are expected
to have a higher rate of return than their cost of capital will increase the value of the firm.

Once the opportunity costs are considered to evaluate the project, it is widely accepted
that the project no longer requires considering the financing costs, which get built into the
system automatically, once the entire project is examined with a perspective from the
required rate of return.17

17
Valuation Academy, Principles of Capital Budgeting, http://valuationacademy.com/principles-of-capital-
budgeting/ (last updated Sep. 24, 2014).

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 PROCESS OF CAPITAL BUDGET

Capital budgeting is process of selecting best long term investment project. Capital budgeting
is long term planning for making and financing proposed capital outlaying.

The following are the steps for capital budgeting process: 18

1. Identification involved in capital budgeting proposals
2. Screening the proposal
3. Evaluation of various proposals
4. Fixing the priorities
5. Final approval and planning the capital expenditure
6. Implementing the proposal
7. Performance review

Identification of Potential Investment Opportunities

The capital budgeting process begins with the identification of potential investment
opportunities. Usually, the planning body (it can be an individual or a committee, formal or
informal) develops estimates for future sales which serve as the basis of setting production
targets. This information, in turn, helps one to identify required investments in plant and
equipment.

For imaginative identification of investment ideas, it is helpful to:

a) monitor external environment regularly to scout for investment opportunities;

b) formulate a well defined corporate strategy based on a thorough analysis of strengths,
weakness, opportunities, and threats;
c) share corporate strategy and perspectives with persons who are involved in the
process of capital budgeting; and
d) motivate employees to make suggestion.

Assembling of investment Proposals

18 “The Basic Steps of Capital Budgeting”, http://www.finweb.com/financial-planning/the-basic-steps-

of-capital-budgeting.html#axzz3EvHfDFnA (Last updated on Oct 3,2014)

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Investment proposals identified by the production department and other departments are
usually submitted on a standardized capital investment proposal form. Generally, most of the
proposals are routed through several persons before they reach the capital budgeting
committee or some other body which assembles them. The purpose of this is primarily to
ensure that the proposal is viewed from different angles. It also helps in creating a climate for
the coordination of interrelated activities.19

Investment proposals are usually classified into various categories for facilitating decision
making budgeting and control. An illustrative classification is given below:

a) Replacement investments
b) Expansion investments
c) New product investments
d) Obligatory and welfare investments.

Decision Making

A system of rupee gateway usually characterizes the capital investment decision making in
practice. Under this system, executives are vested with the power to okay investment
proposals up to certain limits. For example, in one company the plant superintendent can
okay investment outlay up to Rs 1,00,000 the works manager up to Rs 5,00,000 and the
managing director up to Rs 20,00,000. Investments requiring higher outlays need the
approval of the board of directors.

Preparation of capital Budget and Appropriations

Projects involving smaller outlays and those can be decided by executives at lower levels are
often covered by a blanket appropriation for expeditious action. Projects which need larger
outlays are included in the capital budget after necessary approvals. Before undertaking such
projects, an appropriate order is usually required. The purpose of this check is mainly to
ensure that the funds position of the firm is satisfactory at the time of implementation of the
project. Further it provides an opportunity to review the project before implementation.20

Implementation

19
Agnė Keršytė,” CAPITAL BUDGETING PROCESS: THEORETICAL ASPECTS
“,http://www.ktu.lt/lt/mokslas/zurnalai/ekovad/16/1822-6515-2011-1130.pdf (last updated on Oct 4,2014)
20
Supra note 18

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Translating an investment proposal into a concrete project is a complex, risky and time
consuming task. Delays in implementation, which are common, may lead to substantial cost
overruns. For expeditious implementation at reasonable cost, the following are helpful:

a) Adequate formulation of projects:

The major reason for delay is inadequate formulation of projects. In other words, if
necessary homework in terms of preliminary studies and comprehensive detailed
formulation of the project has not been done, many surprises and shocks are likely to
spring on the way. Hence, the need for adequate formulation of the project cannot be
over emphasized.

b) Use of the principle of responsibility accounting:

Assigning specific responsibilities to project managers for completing the project
within the defined time frame and cost limits is helpful for expeditious execution and
cost control.

c) Use of network techniques:

For project planning and control several network techniques such as PERT (Program
Evaluation Review Techniques) and CPM (Critical Path Method) are available. With
the help of these techniques monitoring of a project becomes easier.21

Post-implementation audit

Post-implementation audit does not relate to the current decision support process of the
project; it deals with a post-mortem of the performance of already implemented projects. An
evaluation of the performance of past decisions, however, can contribute greatly to the
improvement of current investment decision-making by analyzing the past ‘rights’ and
‘wrongs’.

The post-implementation audit can provide useful feedback to project appraisal or strategy
formulation. For example, ex post assessment of the strengths (or accuracies) and weaknesses
(or inaccuracies) of cash flow forecasting of past projects can indicate the level of confidence
(or otherwise) that can be attached to cash flow forecasting of current investment projects. If
projects undertaken in the past within the framework of the firm’s current strategic plan do

21
Supra note 19

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not prove to be as lucrative as predicted, such information can prompt management to
consider a thorough review of the firm’s current strategic plan.22

22
Id

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 CAPITAL BUDGETING DECISIONS

Capital budgeting decisions fall into two broad categories:

1. Screening decisions.

2. Preference decisions.

Screening Decisions

Screening decisions relate to whether a proposed project meets some preset standard of
acceptance. For example, a firm may have a policy of accepting projects only if they promise
a retune of, say, 20% on the investment. The required rate of return is the minimum rate of
return a project must yield to be acceptable.

Preference Decisions

Preference decisions relate to selecting from among several competing courses of action. To
illustrate, a firm may be considering several different machines to replace an existing
machine on the assembly line. The choice of which machine to purchase is a preference
decisions.

Types of Capital Budgeting Decisions

Types of Capital Budgeting Decisions Capital budgeting refers to the total process of
generating, evaluating, selecting and following up on capital expenditure alternatives. The
firm allocates or budgets financial resources to new Investment proposals. Basically, the firm
may be confronted with three types of capital budgeting decisions: 23

1. Accept-Reject Decision.

2. Mutually Exclusive Project Decision

3. Capital Rationing Decision

23 Types of Capital Budgeting Decisions , http://www.caclubindia.com/forum/types-of-capital-budgeting-

decisions-57631.asp#.VCxWPfmSyvw(Last updated on Oct 2 2014)

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 1. Accept-Reject Decision:

This is a fundamental decision in capital budgeting. If the project is accepted, the firm
would invest in it; if the proposal is rejected, the firm does not invest in it. In general,
all those proposals which yield a rate of return greater than a certain required rate of
return or cost of capital are accepted and the rest are rejected. By applying this
criterion, all independent projects are accepted. Independent projects are the projects
that do not compete with one another in such a way that the acceptance of one
precludes the possibility of acceptance of another. Under the accept-reject decision,
all independent projects that satisfy the minimum investment criterion should be
implemented.

2. Mutually Exclusive Project Decision:

Mutually Exclusive Projects are those which compete with other projects in such a
way that the acceptance of one will exclude the acceptance of the other projects. The
alternatives are mutually exclusive and only one may be chosen. Suppose a company
is intending to buy a new folding machine, there are three competing brands, each
with a different initial investment and operating costs. The three machines represent
mutually exclusive alternatives, as only one of these can be selected. Moreover, the
mutually exclusive project decisions are not independent of the accept-reject

decisions.24 The project should also be acceptable under the latter decision. Thus,
mutually exclusive projects acquire significance when more than one proposal is
acceptable under the accept-reject decision.

3. Capital Rationing Decision:

In a situation where the firm has unlimited funds, all independent investment
proposals yielding returns greater than some pre-determined level are accepted.
However, this situation does not prevail in most of the business forms in actual
practice. They have a fixed capital budget. A large number of investment proposals
compete for these limited funds. The firm must, therefore, ration them. The firm
allocates funds to projects in a manner that it maximizes long-run returns.

24 “3 types of capital budgeting decisions”, http://managementation.com/3-types-or-kinds-of-

capital-budgeting/(Last updated on Oct 4,2014)

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 Thus, capital rationing refers to a situation in which a firm has more acceptable
investments than it can finance. It is concerned with the selection of a group of
Investment proposals out of many investment proposals acceptable under the accept-
reject decision. Capital rationing employs ranking of acceptable Investment projects.
These projects can be ranked on the basis of a pre-determined criterion such as the
rate of return. The projects are ranked in descending order of the rate of return.

Other than this it can be futher divided into the following-25

(1) Capital expenditure that increases revenue.

(2) Capital expenditure that reduces costs.

(1) Capital Expenditure Increases Revenue: It is the expenditure which brings more
revenue to the firm either by expanding the existing production facilities or
development of new production line.

(2) Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost
of present product and thereby increases the profitability of existing operations. It can
be done by replacement of old machine by a new one. 26

25
Supra note 23
26
http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-29-Capital-Budgeting.pdf as visited on
Oct.4 2014

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 GUIDELINES FOR TAKING CAPITAL BUDGETING DECISIONS

Virtually all general managers face capital-budgeting decisions in the course of their careers.
The most common of these is the simple ‘yes’ versus ‘no’ choice about a capital investment.
The following are some general guidelines to orient the decision maker in these situations:27

1. Focus on cash flows, not profits

One wants to get as close as possible to the economic reality of the project.
Accounting profits contain many kinds of economic fiction. Flows of cash, on the
other hand, are economic facts.

2. Focus on incremental cash flows

The point of the whole analytical exercise is to judge whether the firm will be better
off or worse off if it undertakes the project. Thus one wants to focus on the changes in
cash flows as a result of undertaking the project. The analysis may require some
careful thought: a project decision identified as a simple go/no-go question may hide a
subtle substitution or choice among alternatives.

For instance, a proposal to invest in an automated machine should trigger many

questions: Will the machine expand capacity (and thus permit us to exploit demand
beyond our current limits)? Will the machine reduce costs (at the current level of
demand) and thus permit us to operate more efficiently than before we had the
machine? Will the machine create other benefits (e.g., higher quality, more
operational flexibility)? The key economic question asked of project proposals should
be, “How will things change (i.e., be better or worse) if we undertake the project?”

3. Account for time. Time is money.

We prefer to receive cash sooner rather than later. Use NPV (Net Present Value)28 as
the technique to summarize the quantitative attractiveness of the project. Quite
simply, NPV can be interpreted as the amount by which the market value of the firm’s
equity will change as a result of undertaking the project.

27
What is Capital Budgeting?, http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/CapitalBudget/Capital
BudgetingTraining.pdf (last updated Sep 28, 2014).
28
Infra page 27.

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 4. Account for risk.
Not all projects present the same level or risk. One wants to be compensated with a
higher return for taking more risk. The way to control for variations in risk from
project to project is to use a discount rate to value a flow of cash that is consistent
with the risk of that flow.

These 4 precepts summarize a great amount of economic theory that has stood the test of
time. Organizations using these precepts make better investment decisions than organizations
that do not use these precepts.29

SIGNIFICANCE OF CAPITAL BUDGETING

29
What is Capital Budgeting?, http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/CapitalBudget/Capital
BudgetingTraining.pdf (last updated Oct 3, 2014).

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Capital budgeting is Significant for the following reasons:30

1. The decision maker loses some of his flexibility, for the results continue over an
extended period of time. He has to make a commitment for the future.

2. Asset expansion is related to future sales.

3. The availability of capital assets has to be phased properly.

4. Asset expansion typically involves the allocation of substantial amounts of funds.

5. Many firms fail because they have too much or too little capital equipment.

6. Decisions relating to capital investment are among the difficult and at the same time,
the most critical because the effect of such decisions will have a far reaching
influence on the firm’s profitability for many years to come.

30
Supra note 14

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 CONCLUSION
Capital budgeting is the planning process used to determine whether an organization’s long
term investments such as new machinery, replacement machinery, new plants, new products,
and research development projects are worth funding of cash through the firm’s capital
structure (debt, equity or retained earnings).

It is the process of allocating resources for major capital, or investment, expenditures. One of
the primary goals of capital budgeting investments is to increase the value of the firm to the
shareholders.

As a firm is 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.

Capital Budget is a required managerial tool. The duty of the financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore a financial manager
must be able to decide whether an investment is worth understanding and be able to choose
intelligently between two or more alternative. To do this a sound procedure to evaluate,
compare and select projects is needed, this procedure is called Capital Budgeting.

Capital budgeting is the process of evaluating and implementing a firm’s investment

opportunities, by virtue of properly identifying such investments that are likely to enhance a
firm’s competitive advantage and increase shareholder wealth. A typical capital budgeting
process is focused around following basic principles: Decisions are based on potential cash
flows and not accounting income:, Cash flows are based on opportunity costs, Timing of
Cash Flow, Post tax analysis, Financing costs reflected in project’s required rate of return.

Capital Budgeting is a project selection exercise performed by the business enterprise. It uses
tools such as payback period, accounting rate of return, net present value, internal rate of
return, profitability index to select projects.

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 REFERENCE
BOOKS

 ARTHUR SULLIVAN & STEVEN M. SHEFFRIN, ECONOMICS: PRINCIPLES IN ACTION (2003)

ISBN 0-13-063085-3.

 EILIS FERRAN, COMPANY LAW AND CORPORATE FINANCE (1999).

ARTICLES

 What is Capital Budgeting?, http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/

CapitalBudget/Capital BudgetingTraining.pdf (last updated Oct. 3, 2014).

 Tarun K. Mukherjee & Glenn V. Henderson, The Capital Budgeting Process: Theory and
Practice, Interfaces, Vol. 17, No. 2 (Mar. - Apr., 1987), pp. 78-90,
http://www.jstor.org/stable/25060944 (last updated Oct 2, 2014).

 Don Dayananda & Richard Irons, Capital Budgeting: An Overview, Cambridge
University Press, http://assets.cambridge.org/97805218/17820/excerpt/9780521817820_
excerpt.pdf (last updated Sep 30, 2014).

 Manish, Basic Principles of Capital Budgeting, Corporate Finance,
http://financetrain.com/basic-principles-of-capital-budgeting/ (last updated Sep. 20,
2013).

 Valuation Academy, Principles of Capital Budgeting, http://valuationacademy.com/
principles-of-capital-budgeting/ (last updated sep 29, 2014).

 Prof. R. Madumathi, Capital Budgeting, http://www.nptel.iitm.ac.in/courses/IIT-
MADRAS/Management_ Science_II/Pdf/2_4.pdf (last updated sep 30, 2014).

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