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 Also known as investment appraisal capital budgeting is the planning
process used to determine a farm͛s long term investment such as replacing an old
machinery or buying a new machinery, to make new plant or a new project are
worth mentioning.

According to I.M Pandey, ͞A capital budgeting decision may be defined as the

firms decision to invest its current funds most efficiently in the long term assets in
anticipation of an expected flow of benefits over a series of years.͟

So to take a logical and efficient decision in capital budgeting is of utmost

importance since they determine the value of the firm by influencing its growth,
profitability and risk.


Capital budgeting means planning for capital assets. Capital budgeting decisions
are vital to any organisation as they include the decision to:

1)  hether or not funds should be invested in long term projects such as
setting of an industry, purchase of plant and machinery etc.
2) Analyze the proposal for expansion or creating additional capacities.
3) To decide the replacement of permanent assets such as building and
4) To make financial analysis of various proposals regarding capital
investments sp as to choose the best out of many alternative proposals.

The importance of capital budgeting can be well understood from the fact that an
unsound investment decision may prove to be fatal to the very existence of the
concern. The need, significance or importance of capital budgeting arises mainly
due to the following:

a) Large investment

b) Long-term commitment of funds
c) Irreversible nature
d) Long term effect on profitability
e) Difficulties of investment decisions
f) National importance


The key function of the financial management is the selection of the most
profitable assortment of capital investment. The need of the 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 complicacies of the decision making.

The importance of the capital budgeting decision is the following ʹ

1. —
 ʹ Capital budgeting decisions have long term
implications for the firm because they affect the future profitability of the
firm and cost structure. It influences the rate and the direction of firm͛s
growth. A wrong decision may lead the firm to a disastrous future and may
endanger the very survival of the firm.


 ʹ The capital investment decisions involve a heavy
amount of funds. In most of the cases, the capital budgeting decisions are
irreversible and the amount invested cannot be taken back without causing
a substantial loss because it is very difficult to find a market for the second
hand capital goods, and their conversion into other uses may not be
financially feasible.
   ›   ʹ By taking a capital
expenditure decision, a firm commits itself to a sizeable amount of fixed
costs in terms of labour, supervisor͛s salary, insurance, rent of the building
and so on. In short firm͛s future costs break-even points, sales and profits
will all be determined by the firm͛s selection of assets.
4. Bearing on Competitive Position of the Firm ʹ The capital investment in
fixed assets decisions also have a bearing on the competitive position of the
firm because the fixed assets, represent in a sense, true earning assets of
the firm. They enable the firm to generate finished goods that can
ultimately be sold for profit.
5. Cash Forecast ʹ Capital investment requires substantially large amount of
funds which can only be arranged by making determined efforts to ensure
their availability at the right time. Thus it facilitates cash forecasts to plan
the investment programme carefully, so that the firm can meet its long
term obligations without any difficulty.

6.  orth maximization to share- holders ʹ The impact of long term capital
investment decision is far reaching. It protects the interests of the
shareholders and of the enterprise because it avoids over ʹ investment and
under ʹ investment in fixed assets.

7. Other factors ʹ The following other factors can also be considered for its
significance ʹ

a) It assists in formulating a sound depreciation and assets

replacement policy.
b) The feasibility of replacing manual work by machinery may be
seen from the capital forecast by comparing the manual cost
and the capital cost.
c) It facilitates the management in making of the long term plans
and assists in the formulation of general policy.


Three steps are involved in the evaluation of investment ʹ

Estimation of cash flows

Estimation of the required rate of return (the opportunity cost of capital)
Application of decision rules for making the choice.


The investment decision rule may be referred to as capital budgeting

techniques, or investment criteria. A sound appraisal technique should be used to
measure the economic worth of an investment project. The essential property of
a sound technique is that it should maximize the share holder͛s wealth.

r It should consider all cash flows to determine the true

profitability of the project.
r It should provide for an objective and unambiguous way of
separating good projects from bad projects.
r It should help ranking of projects according to their true
r It should help to choose among mutually exclusive projects that
project which maximizes the shareholders͛ wealth.
r It should be a criterion which is applicable to any conceivable
investment project independent of others.


There are number of methods in use for evaluating a capital budgeting decision.
Different firms may use different methods for evaluating the project proposals.
 hich method is appropriate for the particular purpose of the firm will depend
upon the circumstances. The most commonly used methods are the following ʹ

1. Payback Approach

2. Accounting rate of Return
3. Time adjusted rate of Return calculated by

r The present value method

r Discounted cash flow method

 !  " #   Payback period represents the length of time required
for the stream of cash proceeds produced by the investment to be equal to the
original cash outlay, i.e., the time required for the project to pay for itself. The
formula is simple:- 

Payback Period = original investment

Annual cash flow

$ #

ʹ Under this method, capital employed and related
income are determined by the following principles and practices commonly used
in accounting for assets and income. Rate of return may be calculated by taking
(a)income before taxes depreciation (b)income after taxes but including cash
flows from depreciation (c)income after taxes and after depreciation. The rate of
return will be very depending whether original investment or average investment
is used. Thus this method provides several rates of return.

There are two main variations; (i) original investment measure and (ii) average
investment measure. In the original investment method, the average annual
earnings over the life of the investment are compared with the amount of original
investment. The accounting method is simply a ratio of earnings to investment.
However, average investment assumes regular recovery of capital over the life of
the project. Accounting method does not allow for the time element in the return
of funds. It gives the same weight to the future rupees as it does to current
rupees. The time value of money is ignored which makes the rate of return

& '  (       

  In recent years , the time discounted rate of
return has come to be recognized as the most meaningful tool for the financial
decision making with respect to future commitments and the projects. Various
surveys have been made to ascertain the extent to which companies employ to
the different methods of calculating rate of return for decision making purposes.
Moreover, despite the growing awareness of the implications of the time
adjusted rate method, the payback still is a very popular method. The time ʹ
adjusted rate of return calculated either as the net present value or discounted
cash flow yield is being increasingly used not only to screen and rank proposed
capital expenditure but also employed in make ʹ or- by decision, in lease ʹ or ʹ
own judgments and in mergers and acquisitions. It has come to be one of the
most promising tools in financial decision making. The time adjusted methods can
be examined under two heads: - a) Present value method; and b) internal rate of
return method.

a) Present value method ʹ the present value method, also known as the
discounted benefit cost ratio method, takes account of all income whenever
received and to this extent complies with the bigger the better principle. Under
the present value method, minimum required rate of return is assumed and the
calculation is made to use a present value amount which is compared with the
original investment required. This discounting rate of return factor is also referred
to as the required earning rate .Thus the present value for a payment of Re 1 to
be received after n years at any rate of return can be found with the formula:

PV =


 here PV is the present value and k the discount rate.

)  (NPV) The net present value is the difference between present
value of benefits and the present value of costs. If the net present value is
positive the conclusion is favorable to go ahead with the project, but it is negative
the project is rejected.
 *ʹ If the present value method is used, the present value of one
project cannot be compared directly with the present value of earnings of
another unless the investments are of the same size. This is done by dividing the
present value of earnings by the amount of investments, to give a ratio that is
called the profitability index.

Benefit cost ratios ʹ Benefit cost ratios are often called profitability indexes. It
may be defined by the following equation ʹ

Present value of cash inflows

B/c ratio =

Net investment

b) Internal rate of return (IRR) In the present value method, the required earnings
rate is selected in advance. There is an alternative method which finds the
earnings rate at which the present value of the earnings equals the amount of

The internal rate of return for an investment is the discount rate that equates the
present value of them equates the present value of the expected cash outflows
with the present value of the expected inflows. It is represented by the rate, r ,
such that

 here A is the cash flow period t, whether it be a net cash inflow or outflow, and
n is last period in which a cash flow is expected.

Capital budgeting is a process of making decision regarding investments in fixed
assets which are not meant for sale such as land, building, machinery or furniture.
So to take a logical and efficient decision in capital budgeting is of utmost
importance since they determine the value of the firm by influencing its growth,
profitability and risk. As discussed earlier capital budgeting is an utmost necessity
in a business.


1.Financial management by- Shasi K. Gupta and R. K. Sharma

2.Financial management by- I. M Pandey