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Which capital budgeting technique is best and why?

Submitted to

CHITKARA BUSINESS SCHOOL [B.COM (HONS)

DEPARTMENT]

Internal Evaluation for

Fundamentals of Financial Management

Module

Submitted by: Supervised by:

Aadheesh Sood (2020991606) B.COM(HONS) Department
Gurpreet Singh Chahal(2020991638) Dr. Sonal Trivedi
Robin Atwal (2020991619)
Shubhdeep Verma(2020991611)

CHITKARA BUSINESS SCHOOL

CHITKARA UNIVERSITY
2021
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ACKNOWLEDGEMENT

I would like to express my special thanks to my teacher DR. SONAL TRIVEDI who
gave us the golden opportunity to work on this marvellous research paper of
economics on the topic “WHICH CAPITAL BUDGETING TECHNIQUE IS BEST
AND WHY?”. It was very informative and we even learned new things. I am
completely grateful to my teacher and the department.
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TABLE OF CONTENT

SR. PARTICULARS PAGE NO.

NO.
1. Introduction
4
2. Details of actual topic
5-7
3. Capital Budgeting Techniques
8-9
4. Examples
10-11
7. Conclusion
12
8. Suggestions
13
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INTRODUCTION

INTRODUCTION TO CAPITAL BUDGETING, capital budgeting is the process of

making investment decisions in long term assets. It is the process of deciding whether
or not to invest in a particular project as all the investment possibilities may not be
rewarding. 
Thus, the manager has to choose a project that gives a rate of return more than the
cost financing such a project. That is why he has to value a project in terms of cost
and benefit. Capital budgeting is important because it creates accountability and
measurability. Any business that seeks to invest its resources in a project without
understanding the risks and returns involved would be held as irresponsible by its
owners or shareholders. Furthermore, if a business has no way of measuring the
effectiveness of its investment decisions, chances are the business would have little
chance of surviving in the competitive marketplace. 
Businesses (aside from non-profits) exist to earn profits. The capital budgeting
process is a measurable way for businesses to determine the long-term economic and
financial profitability of any investment project. 
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DETAILS OF ACTUAL TOPIC

Features of Capital Budgeting

Huge Funds: Capital budgeting involves expenditures of high value which makes it a
crucial function for the management.

High Degree of Risk: To take decisions which involve huge financial burden can be
risky for the company.

Affects Future Competitive Strengths: The company’s future is based on such

capital expenditure decisions. Sensible investing can improve its competitiveness,
whereas a wrong investment may lead to business failure.

Difficult Decision: When the future is dependant on capital budgeting decisions, it

becomes difficult for the management to grab the most appropriate investment
opportunity.

Estimation of Large Profits: Any investment decision taken by the company is made
with the perspective of earning desirable profits in the long term.

Long Term Effect: The effect of the decisions taken today, whether favourable or
unfavourable, will be visible in the future or the long term.

Benefits of Capital Budgeting

 Consistency and flexibility
 Better financial decisions
 Access risk and uncertainty
 Analyze long-term repercussions

Factors Affecting Capital Budgeting

Capital Structure: The company’s capital structure, i.e., the composition of

shareholder’s funds and borrowed funds, determines its capital budgeting decisions.

Working Capital: The availability of capital required by the company to carry out
day to day business operations influences its long-term decisions.
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Capital Return: The management estimates the expected return from the prospective
capital investment while planning the company’s capital budget.

Earnings: If the company has a stable earning, it may plan for massive investment
projects on leveraged funds, but the same is not suitable in case of irregular earnings.

Project Needs: The company needs to consider all the essentials of a new project.
Also, the means to fulfil the requirements along with the estimate of the related
expenses should be clear.

Accounting Methods: The accounting rules, principles and methods of the company
is another factor considered while capital budgeting to frame the reporting of such
expenses and revenue to be generated in future.

Government Policy: The restrictions imposed and the exemptions allowed by the
government to the companies while investing in capital nature, impacts the company’s
capital budgeting decisions.

Taxation Policy: The taxation procedure and policy of the country also influences the
long-term investment decision of the firm since additional capital will be required for
such expenses.

CAPITAL BUDGETING DECISION

Accept / Reject decision – If a proposal is accepted, the firm invests in it and if
rejected the firm does not invest. Generally, proposals that yield a rate of return
greater than a certain required rate of return or cost of capital are accepted and the
others are rejected. All independent projects are accepted. Independent projects are
projects that do not compete with one another in such a way that acceptance gives a
fair possibility of acceptance of another.
Mutually exclusive project decision – Mutually exclusive projects compete with
other projects in such a way that the acceptance of one will exclude the acceptance of
the other projects. Only one may be chosen. Mutually exclusive investment decisions
gain importance when more than one proposal is acceptable under the accept / reject
decision. The acceptance of the best alternative eliminates the other alternatives.
Capital rationing decision – In a situation where the firm has unlimited funds,
capital budgeting becomes a very simple process. In that, independent investment
proposals yielding a return greater than some predetermined level are accepted. But
actual business has a different picture. They have fixed capital budget with large
number of investment proposals competing for it. Capital rationing refers to the
situation where the firm has more acceptable investments requiring a greater amount
of finance than that is available with the firm. Ranking of the investment project is
employed on the basis of some predetermined criterion such as the rate of return. The
project with highest return is ranked first and the acceptable projects are ranked
thereafter.
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OBJECTIVE OF CAPITAL BUDGETING

1. To ensure the selection of the possible profitable capital projects.

2. To guarantee the effective control of capital expenditure in order to achieve

by forecasting the long-term financial requirements.

3. To make estimation of capital expenditure during the budget period and to

see that the benefits and costs may be measured in terms of cash flow.

4. Determining the required quantum takes place as per authorization and

sanctions.

5. To expedite co-ordination of inter-departmental project funds among the

competing capital projects.

6. To guarantee maximization of profit by allocating the available investible.

SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management

 Capital budgeting provides a wide scope for financial managers to evaluate

different projects in terms of their viability to be taken up for investments

 It helps in exposing the risk and uncertainty of different projects

 It helps in keeping a check on over or under investments

 The management is provided with an effective control on cost of capital

expenditure projects

 Ultimately the fate of a business is decided on how optimally the available

resources are used.

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CAPITAL BUDGETING TECHNIQUES

1) AVERAGE RATE OF RETURN

Under ARR method, the profitability of an investment proposal can be determined
by dividing average income after taxes by average investment, which is average
book value after depreciation. 

Thus, ARR = Average Net Income After Taxes/Average Investment x 100

Where, Average Income After Taxes = Total Income After Taxes/Total

Number of Years

Average Investment = Total Investment/2

Based on this method,  a company can select those projects that have ARR higher
than the minimum rate established by the company. And, it can reject the projects
having ARR less than the expected rate of return. 

2) PAYBACK PERIOD
Payback period refers to the number of years it takes to recover the initial cost of an
investment. Therefore, it is a measure of liquidity for a firm. Thus, if an entity has
liquidity issues, in such a case, shorter a project’s payback period, better it is for the
firm. 
Therefore,
Payback period = Full years until recovery + (unrecovered cost at the
beginning of the last year)/
Cash flow during the last year
Here, full years until recovery is nothing but the payback that occurs when cumulative
net cash flow equals to zero. Cumulative net cash flow is the running total of cash
flows at the end of each time period. 

3) NET PRESENT VALUE

NPV is the sum of the present values of all the expected incremental cash flows of a
project discounted at a required rate of return less than the present value of the cost of
the investment. 
In other words, NPV is the difference between the present value of cash inflows of a
project and the initial cost of the project. As per this technique, the projects whose
NPV is positive or above zero shall be selected. 
If a project’s NPV is less than zero or negative, the same must be rejected. Further, if
there is more than one project with positive NPV, then the project with the highest
NPV shall be selected. 
NPV = CF1/(1 + k)1 + ……….. CFn / (1 + k)n + CF0
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where CF0 = Initial Investment Outlay (Negative Cash flow)

           CFt = after tax cash flow at time t
                k = required rate of return

4) PROFITABILITY INDEX
Profitability Index is the present value of a project’s future cash flows divided by
initial cash outlay. Thus, it si closely related to NPV. NPV is the difference between
the present value of future cash flows and the initial cash outlay. 
Whereas, PI is the ratio of the present value of future cash flows and initial cash
outlay. 
 PI = PV of future cash flows/CF0 = 1 + NPV/CF0
Thus, if the NPV of a project is positive, PI will be greater than 1. If NPV is negative,
PI will be less than 1. Therefore, based on this, if PI is greater than 1, accept the
project otherwise reject. 

5) INTERNAL RATE OF RETURN

Internal Rate of Return refers to the discount rate that makes the present value of
expected after-tax cash inflows equal to the initial cost of the project. 
In other words, IRR is the discount rate that makes present values of a project’s
estimated cash inflows equal to the present value of the project’s estimated cash
outflows. 
If IRR is greater than the required rate of return for the project, then accept the
project. And if IRR is less than the required rate of return, then reject the project. 
PV (inflows) = PV (outflows)
NPV = 0 = CF0 + CF1/(1 + IRR)1 + ……….. CFn/ (1 + IRR)n + CF0
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EXAMPLES
Example1

A company is considered the purchase of a machine. the machines A and B are

available for $80,000 each. Earnings after taxation are as:

Year Machine A Machine B

$ $

1 24,000 8,000

2 32,000 24,000

3 40,000 32,000

4 24,000 48,000

5 16,000 32,000
Evaluate the two alternatives according to (a). Payback Method, (b). Rate of Return
Method and (c). Net Present Value Method (A discount rate of 10% is to be used).

Solution
(a). Payback Method
24,000 of 40,000 = 2 years and 7.2 month

Payback period:

Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.

Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.
According to the payback method Machine, A will be preferred.

(b). Rate of return on Investment Method

Particular Machine A Machine B

Total Cash Flows 1,36,000 1,44,000

Average Annual Cash Flows 1,36,000 / 5 = $27,000 1,44,000 / 5 = $28,800

Annual Depreciation 80,000 / 5 = $16,000 80,000 / 5 = $16,000

Annual Net Savings 27,200 – 16,000 = 28,800 – 16,000 =

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$11,200 $12,800

Average Investment 80,000 / 2 = $40,000 80,000 / 2 = $40,000

ROI = (Annual Net Savings /

(11,200 / 40,000) x 100 (12,800 / 40,000) x 100
Average Investments) x 100

= 28% = 32%
According to rate of return on investment method machine B will be preferred due to
higher rate of return on investment

ExampleII

The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000,
$25,000 and $10,000 in four years. Using present value index method, appraise
profitability of the proposed investment assuming a 10% rate of discount.

Solution
Calculation of present value and profitability index
Year Cash Inflows Present Value Factor Present Value

$ @10% $

1 20,000 .909 18,180

2 15,000 .826 12,390

3 25,000 .751 18,775

4 10,000 .683 6,830

56,175
Total present value = $56,175

Less: intial Outlay = $50,000

Net present value= $6,175

Profitability Index (gross) = Present value of cash inflows / intial cash outflow
= 56,175 / 50,000
= 1.1235
As the P.I. is higher than 1, the proposal can be accepted.
Net Profitability = NPV / Initial cash outlay
= 6,175 / 50,000 = .1235
N.P.I. = 1.1235 – 1 = 0.1235
As the net profitability index is positive, the proposal can be accepted.
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CONCLUSION
Capital budgeting is an important tool for leaders of a company when evaluating
multiple opportunities for investment of the firm’s capital. However, this is not the
only step in budgeting for a new asset. It would be best to talk with a financial
professional when applying the concepts discussed above while budgeting for a
purchase. Capital budgeting is a predominant function of management. Right
decisions taken can lead the business to great heights. However, a single wrong
decision can inch the business closer to shut down the number of funds involved and
the tenure of these project.

The decision process before making capital budgeting decisions, finance professionals
often generate, review, analyze, select, and implement long term investment proposals
that meet firm-specific criteria are consistent with the firm’s strategic goals.
Companies often use several methods to evaluate the project’s cash flows and each of
them has its benefits and disadvantages.

To assist the organization in selecting the best investment there are various techniques
available based on the comparison of cash inflows and outflows. Payback period
method is the entity calculates the time period required to earn the initial investment
of the project or investment. Net present value is calculated by taking the difference
between the present value of cash inflows and the present value of cash outflows over
a period of time. Accounting rate of return is the total net income of the investment is
divided by the initial or average investment to derive at the most profitable
investment. Internal rate of return is the rate at which the NPV becomes zero. The
project with higher IRR is usually selected. Profitability index is the ratio of the
present value of future cash flows of the project to the initial investment required for
the project. Each technique comes with inherent advantages and disadvantages. An
organization needs to use the best-suited technique to assist it in budgeting. It can
also select different techniques and compare the results to derive at the best profitable
projects.

As the degree of leverage increases, the proportion of cheaper source of funds, i.e.,
debt in the capital structure increases. As a result, weighted average cost of capital
decline leading to an increase in total value of firm. The different measures provide
different types of information to decision makers. Since it is easy to calculate all of
them, all should be considered in the decision process. For any specific decision, more
weight might be given to one measure than another, but it would be foolish to ignore
the information provided by any of the methods. Thus, quantitative methods provide
valuable information, but they should not be used as the sole criteria for accept/reject
decisions in the capital budgeting process. Rather, managers should use quantitative
methods in the decision-making process but also consider the likelihood that actual
results will differ from the forecasts. In summary, quantitative methods should be
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considered as an aid to informed decisions but not as a substitute for sound

managerial judgment.

SUGGESTIONS
In capital budgeting, there are a number of different approaches that can be used to
evaluate a project. Each approach has its own distinct advantages and disadvantages.

Most managers and executives like the method that look at a company’s capital
budgeting and performance expressed in percentage rather than dollar figures. One
would focus on the range of profits and losses that may be encountered over the
course of investment period. One would calculate the ratio of an investment’s average
annual profits to the amount invested in it. This suggests the following:

 Keep budgeting and forecasting flexible.

 Implement rolling forecasts and budgets.
 If you can't identify the reason a project has a positive projected, then its
actual will probably not be positive.
 Positive projects don't just happen—they result from hard work to develop
some competitive advantage. At the risk of oversimplification, the primary
job of a manager is to find and develop areas of competitive advantage.
 Budget to your plan.
 Communicate early and often.
 Involve your entire team.
 It is relatively easy to replicate nonpatentable features on products. The
bottom line is that managers should strive to develop nonreplicable sources
of competitive advantage, and if such an advantage cannot be demonstrated,
then you should question projects with high, especially if they have long
lives.
 Be clear about your goals.
 Plan for various scenarios.