“Capital budgeting is long term

planning for making and financing

proposed capital outlays.”

Capital: Fixed assets used in production

Budget: Plan of in- and outflows during some period

Capital Budget: A list of planned investment (i.e.,

expenditures on fixed assets)
outlays for different projects.

Capital Budgeting: Process of selecting viable

investment projects
 The process in which a business determines
whether projects such as building a new plant
or investing in a long-term venture are worth
pursuing.
 Oftentimes, a prospective project's lifetime cash
inflows and outflows are assessed in order to
determine whether the returns generated meet
a sufficient target benchmark.
 Also known as "investment appraisal".
 A capital budgeting decision may be defined as the
firm’s decision to invest its current funds most
efficiently in the long term assets in anticipation of
an expected flow of benefits over a series of years.
 Types of investment decision –
 expansion and diversification,
 replacement and modernization
 Another classification –
 mutually exclusive investments,
 independent investments,
 contingent investments.
 Capital budgeting is the process of making
capital investment decisions.

Two types of capital budgeting projects:

1. Independent projects:
Projects that, if accepted or rejected, will not affect the cash flows of
another project.
2. Mutually exclusive projects:
Projects that, if accepted, preclude the accepting all other competing
projects.
 Effect of decision over a long time
 Decisions are irreversible
 Require an assessment of future events which
are uncertain
 Difference in capital projects
 Need for rationing the capital resources
Different from revenue budgeting:
 Cash outlay is comparative heavier

 Impact left over a longer period of time

 Time horizon is longer

 Growth

Risk

Irreversibility

Complexity

Funding
To improve profitability

Other reasons
•Statutory requirement of effluent
clearing plant
•Welfare projects
•Safety projects
 Cash inflows

Cash outlay for the project

Application of a decision rule for making

the choice
Factors Estimation of the required
rate of return

Estimate the time – time at

which cash flows i.e. outflows
and inflows are expected to
take place, expected productive
 Consider all cash flows
 Provide for an objective and unambiguous way
of separating good projects from bad projects
 Ranking of projects
 Bigger cash flows are preferable to smaller ones
and early cash flows to later ones
 Help to choose among mutually exclusive
projects
  Discounted cash flow Criteria
a. Net present value
b. Internal rate of return
c. Profitability index
 Non discounted cash flow criteria
a. Payback Period
b. Payback Profitability
c. Accounting rate of return
 Classic economic method
 Recognizes the time value of money
 Postulates that cash flow arising at different
time periods differ in value and are comparable
only when their equivalent
 Merits of the NPV method:
 Time value – a rupee received today is worth
more than a rupee received tomorrow
 Measure of true profitability – uses all cash
flow
 Value additivity = NPV(A+B) = NPV (A) +
NPV (B)
 Shareholders value = consistent with the
objective of shareholders – value maximisation
Limitations :
 Cash flow estimation

 Discount rate

 Mutually exclusive projects

 Ranking of projects
 Takes account of magnitude and timing of cash
flows
 Also termed as yield on an investment,
marginal efficiency of capital, rate if return
over cost, time adjusted rate of internal return
 A rate that equates the investment outlay with
the present value of cash inflow received after
one period
 Merits of IRR method:
 Time value
 Profitability measure
 Acceptance rule
 Shareholder value

 Limitations :
 Multiple rates
 Mutually exclusive projects
 Value additivity
 Benefit cost ratio
 Ratio of present value of cash inflows at the
required rate of return to the initial cash
outflow of the investment
 Merits :
 Time value
 Value maximization
 Relative profitability
 Payback is the number of years required to
recover the original cash outlay
 Merits :
 Simplicity
 Cost effective
 Short term effects
 Risk shield
 Liquidity
 Limitations:
 Cash flow after payback
 Cash flow ignored
 Cash flow patterns
 Administrative difficulties
 Inconsistent with shareholder value
 Ratio of the average after tax profit divided by
the average investment
 Merits : Simplicity, accounting data, accounting
profitability
 Limitations: Cash flow ignored, time value
ignored, arbitrary cut off
COMMON WEAKNESSES IN CAPITAL BUDGETING
Poor alignment between strategy and capital budgeting
Deficiencies in analytical techniques
Poor identification of base case
Inadequate treatment of risk
Improper evaluation of options
Lack of uniformity in assumptions
Neglect of side effects
No linkage between compensation and financial
measures
Reverse financial engineering
Weak integration between capital budgeting and expense
budgeting
Inadequate post - audits