Capital Budgeting:

Capital Budget is a budget for investment in a business. It is the process a business undertakes to evaluate
potential major projects or investments. It also refers to the decision making process related to investment
in long term projects,
Example:

a. Construction of a new plant or a big investment

b. Equipment selection
c. To decide that whether to continue with the existing machinery or buy a new one in place of the
old machinery.
d. Plant expansion
e. Lease or buy
f. Cost reduction
Cash inflow:
Cash inflow is the money coming into a business in any form.
Example:
Salvage Value: is the amount for which the asset can be sold at the end of its useful life.
Revenue: is the amount a company receives from selling goods and/or providing services to its
customers.
Cash outflow:
Cash inflow is the money going out of business in any form.
Example:
Investment
Repairs and Maintenance
Any types of Costs

Capital Budgeting Techniques:

Common Techniques includes-
Net Present Value (NPV), Profitability Index, Internal Rate of Return, Payback Period, Simple rate of
Return. The most effective techniques is Net Present Value (NPV).
Payback period :
The payback period is the length of time that it takes for a project to recover its initial cost. The result you
find in time ex- days, month, year etc.

Formula: Investment Required/ Net Annual Cash Inflow

Net Annual Cash Inflow = Cash Inflow-Cash Outflow

Example: Management at The Daily Grind wants to install an espresso bar in its restaurant.
The espresso bar:
1. Costs $140,000 and has a 10-year life.
2. Will generate revenue $65,000 and expense $30,000.

Investment required
Payback Period =
Net annual cash inflow

Net Cash flow = Cash Inflow-Cash Outflow = $65,000-$30,000 = $35,000

$140,000
Payback Period =
$35,000

Payback Period = 4.0 Years

Simple Rate of Return:

The goal of the simple rate of return method is to determine rate of return of an investment.

Formula: Simple Rate of Return =

Net annual cash inflow

Investment required

Example: Management at The Daily Grind wants to install an espresso bar in its restaurant.
The espresso bar:
1. Costs $140,000 and has a 10-year life.
2. Will generate revenue $65,000 and expense $30,000.

Simple Rate of Return = Net annual cash inflow

Investment required
 $140,000
= 0.25 or 25%
$65,000 - $30,000

Home Work:
1. Tam Company is negotiating for the purchase of equipment that would cost $100,000, with the
expectation that $20,000 per year could be saved in cash operating costs. Calculate Payback Period
and Simple Rate of Return.
2. Benson Designs has prepared the following estimates for a long term project it is considering. The
initial investment is $18,250 and the project is expected to provide an annual revenue of $6,000
with expense of $2,000 per year. Calculate Payback Period and Simple Rate of Return.

3. Overland Company has gathered the following data on a proposed investment project:

Investment…………………………........... $150,000
Annual cash inflows .............................. $100,000
Annual cash outflows .............................. $75,000
Calculate Payback Period and Simple Rate of Return.