4.

Capital bugeting
define capital budgeting ? why Capital budgeting is one of the important dicisions of a farm? list of
capital budgeting techniques?
Capital budgeting is the process of making long-term investment decisions that involve large
amounts of capital. It is a critical decision-making process for a firm because it involves selecting
investments in fixed assets such as buildings, machinery, and equipment, that are expected to
generate cash flows over a long period of time.

Capital budgeting is important for a firm because it helps to allocate financial resources effectively
and efficiently, to maximize the value of the firm. It involves a systematic evaluation of potential
investments, based on various criteria such as expected cash flows, risk, cost of capital, and payback
period.

The following are some of the capital budgeting techniques that firms use to evaluate potential
investments:

1. Net Present Value (NPV) - It measures the present value of expected cash flows from an
investment, minus the initial investment cost.
2. Internal Rate of Return (IRR) - It is the rate of return at which the NPV of an investment is
zero.
3. Payback period - It is the length of time required for an investment to recover its initial cost.
4. Profitability Index (PI) - It measures the present value of expected cash inflows relative to the
initial investment.

5. Average rate of returnThe average the average annual amount

expected from an investment.

why discounting cash flow technique of capital budgeting is superior to the traditional techniques of
the capital budgeting?
The discounting cash flow technique of capital budgeting, such as Net Present Value (NPV) and
Internal Rate of Return (IRR), is superior to the traditional techniques of capital budgeting such as
payback period and avarage rate of return(ARR) for several reasons:

1. Time Value of Money: Discounting cash flow techniques take into account the time value of
money, which means that a dollar received in the future is worth less than a dollar received
today due to inflation, opportunity cost, and other factors. The traditional techniques ignore
this crucial aspect of financial analysis.
2. Considers all Cash Flows: Discounting cash flow techniques consider all future cash flows,
including the initial investment, operating cash flows, and terminal cash flows. Traditional
techniques only consider the initial investment and average cash flows.

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3. Incorporates Risk: Discounting cash flow techniques incorporate risk through the use of a
discount rate, which reflects the cost of capital and the risk associated with the investment.
Traditional techniques do not consider risk.
4. Maximizes Shareholder Wealth: Discounting cash flow techniques aim to maximize
shareholder wealth by selecting investments that generate a positive NPV or IRR. Traditional
techniques only focus on recovering the initial investment or achieving a certain accounting
rate of return.

Overall, discounting cash flow techniques provide a more comprehensive and accurate analysis of an
investment's profitability and potential to generate value for the firm. By taking into account the time
value of money, all cash flows, risk, and the goal of maximizing shareholder wealth, discounting cash
flow techniques can help a firm make better capital budgeting decisions.

Mutually exclusive projects and independent projects are two different types of
investment projects that a company may consider in capital budgeting.

A mutually exclusive project is one where accepting one project automatically means
rejecting the other. In other words, these projects compete against each other for the
same resources, and only one of them can be selected. For example, a company may be
considering investing in either a new manufacturing plant or an expansion of an existing
plant. Accepting one project means that the other project is automatically rejected.

On the other hand, independent projects are projects that do not compete with each
other and can be accepted or rejected independently of each other. For example, a
company may be considering investing in both a new product line and a new marketing
campaign. Accepting one project does not affect the viability of the other project.

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ARR
To calculate the ARR for each project, we need to first determine the average annual profit and
the average investment.

In question noting say about depreciation

So we suppose that depreciation is Straight line depreciation

So no salvage value then depreciation+ initial investment

For Project S:

Average annual profit = (Total cash flows - Initial investment) / Number of years =
(6,500 + 3,000 + 3,000 + 1,000 - 10,000) / 4 = 1,125

Average investment = Initial investment / 2 = 10,000 / 2 = 5,000

ARR = (Average annual profit / Average investment) x 100% = (1,125 / 5,000) x 100% =
22.5%

For Project L:

Average annual profit = (Total cash flows - Initial investment) / Number of years =
(3,500 + 3,500 + 3,500 + 3,500 - 10,000) / 4 = 1,250

Average investment = Initial investment / 2 = 10,000 / 2 = 5,000

ARR = (Average annual profit / Average investment) x 100% = (1,250 / 5,000) x 100% =
25%

Therefore, the ARR for Project S is 22.5% and the ARR for Project L is 25%. Based on the
ARR method, Project L is preferred over Project S as it has a higher rate of return.