Financial Management

Unit V: Capital Budgeting

Gupteswar Patel
Assistant Professor

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Capital budgeting
● Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the goal of shareholders (owners)
wealth maximisation.
● Capital budgeting decisions pertain to fixed/long-term assets which
by definition refer to assets which are in operation, and yield a return,
over a period of time, usually, exceeding one year.
● They, therefore, involve a current outlay or series of outlays of cash
resources in return for an anticipated flow of future benefits.
● In other words, the system of capital budgeting is employed to
evaluate expenditure decisions which involve current outlays but are
likely to produce benefits over a period of time longer than one year.

● These benefits may be either in the form of increased revenues or

reduced costs.
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● Capital expenditure management, therefore, includes addition,

disposition, modification and replacement of fixed assets.

● From the preceding discussion may be deduced the following basic

features of capital budgeting:

(i) potentially large anticipated benefits;

(ii) a relatively high degree of risk; and
(iii) a relatively long time period between the initial outlay and the
anticipated returns.

● The term capital budgeting is used interchangeably with capital

expenditure decision, capital expenditure management, long-term
investment decision, management of fixed assets and so on.

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Importance of capital budgeting

Long Term Effect on Profitability

Huge Investments

Decision cannot be Undone

Expenditure Control

Information Flow

Helps in Investment Decision

Wealth Maximization

Risk and Uncertainty

Complicacies of Investment Decisions

National Importance

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Time Value of Money

● ‘Time value of money’ means that the value of a unit of money is
different in different time periods.

● The value of a sum of money received today is more than its value
received after some time. Conversely, the sum of money received in
future is less valuable than it is today.

● The present worth of a rupee received after some time will be less
than a rupee received today. Since a rupee received today has more
value, rational investors would prefer current receipt to future
receipts.

● The time value of money can also be referred to as time preference for
money.
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● The main reason for the time preference for money is to be found in
the reinvestment opportunities for funds which are received early.

● The time preference for money is, therefore, expressed generally in

terms of a rate of return or more popularly as a discount rate.

● The expected rate of return as also the time value of money will vary
from individual to individual depending on his perception.

● In order to have logical and meaningful comparisons between cash

flows that result in different time periods it is necessary to convert the
sums of money to a common point in time.

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Techniques to
convert the sums of
money to a common
point in time

Compounding Discounting

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● Compounding Technique: Interest is compounded when the amount

earned on an initial deposit (the initial principal) becomes part of the
principal at the end of the first compounding period.

● Compound interest is the interest earned on a given deposit/principal

that has become a part of the principal at the end of a specified period.

● Present Value or Discounting Technique: The concept of the present

value is the exact opposite of that of compound value.

● While in the latter approach money invested now appreciates in value

because compound interest is added, in the former approach (present
value approach) money is received at some future date and will be
worth less because the corresponding interest is lost during the period.

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Process of Capital Budgeting
Identifying and
generating
projects

Evaluating the
project

Selecting a
Project

Implementation

Performance
Review

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