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The word capital refers to be the total investment of a company of firm in money, tangible and intangible assets

Capital Budgeting Decisions 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.

The examples of capital expenditure:


1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets.
3. The replacement of fixed assets.
4. Research and development project

According to the definition of Charles T. Hrongreen, capital budgeting is a long-term planning for making and
financing proposed capital out lays.

According to the definition of Lyrich, capital budgeting consists in planning development of available capital
for the purpose of maximizing the long-term profitability of the concern.

1. Huge investments: Capital budgeting requires huge investments of funds, butthe available funds are
limited, therefore the firm before investing projects, plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks
involved in the investment decision are more. If higher risks are involved, it needs careful planning of capital
budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the decision
is taken for purchasing a permanent asset, it is very difficult to dispose off those assets without involving
huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in longterm and will bring significant changes in the profit of the company by avoiding over or more investment or
under investment. Over investments leads to be unable to utilize assets or over utilization of fixed assets.
Therefore before making the investment, it is required carefully planning and analysis of the project
thoroughly.

1.Identification
of various
investments
proposals

2. Screening
or matching
the proposals

3. Evaluation

4. Fixing
property

5. Final
approval

6.
Implementing

7.
Performance
review of
feedback

Non- Discounted
Cash Flows

Discounted
Cash Flows

Net Present Value (


Net Present Value
This is one of the Discounted Cash Flow technique which explicitly recognizes the time value of money. In this
method all cash inflows and outflows are converted into present value (i.e., value at the present time) applying an
appropriate rate of interest (usually cost of capital).
In other words, Net Present Value Method discount inflows and outflows to their present value at the appropriate
cost of capital and set the present value of cash inflow against the present value of outflow to calculate Net Present
Value. Thus, the Net Present Value is obtained by subtracting the present value of cash outflows from the present
value of cash inflows.

NPV > Zero Accept the proposal


NPV < Zero Reject the Proposal

Advantages of Net Present Value Method


(1) It recognizes the time value of money and is thus scientific in its approach.
(2) All the cash flows spreadover the entire life of the project are used for calculations.
(3) It is consistent with the objectives of maximizing the welfare of the owners as it depicts the positive or
otherwise present value of the proposals.

Disadvantages
(1) This method is comparatively difficult to understand or use.
(2) When the projects in consideration involve different amounts of investment, the Net Present Value Method
may not give satisfactory results.

IF CASH INFLOWS ARE GIVEN

Solution :

Internal Rate of Return Method is also called as "Time Adjusted Rate of Return Method." It is defined as the rate which equates
the present value of each cash inflows with the present value of cash outflows of an investment. In other words, it is the rate at
which the net present value of the investment is zero.
Horngren and Foster define Internal Rate of Return as the rate of interest at which the present value of expected cash inflows
from a project equals the present value of expected cash outflows of the project.
The Internal Rate of Return can be found out by Trial and Error Method. First, compute the present value of the cash flow from an
investment, using an arbitrarily selected interest rate, for example 10%. Then compare the present value so obtained with the
investment cost.
If the present value is higher than the cost of capital, try a higher interest rate and go through the procedure again. On the other

hand if the calculated present value of the expected cash inflows is lower than the present value of cash outflows, a lower rate
should be tried. This process will be repeated until and unless the Net Present Value becomes zero. The interest rate that brings
about this equality is defined as the Internal Rate of Return.

Alternatively, the internal rate can be obtained by Interpolation Method when we come across 2 rates. One with
positive Net Present Value and other with negative Net Present Value. The IRR is considered as the highest rate of
interest which a business is able to pay on the funds borrowed to finance the project out of cash inflows generated by
the project.

The Interpolation formula can be used to measure the Internal Rate of Return as follows :

A firm has an investment opportunity involving Rs.50000. The cost of capital is 10%. From
the details given find out the IRR and see whether the project is acceptable.
Cash flow for the 1st year

- Rs.5000
2nd year - Rs.10000
3rd year - Rs.15000
4th year - Rs.25000

5th year - Rs.30000

Discount factors
Year
1
2
3
4
5

10%
0.909
0.826
0.751
0.683
0.621

15%
0.870
0.756
0.658
0.572
0.497

20%
0.833
0.694
0.579
0.482
0.402

25%
0.800
0.640
0.512
0.410
0.328

Year cash inflow PV factor

discounted PV factor

discounted

at 15%

cash inflow at 20%

cash inflow

5000

0.870

4350

0.833

4165

10000

0.756

7560

0.694

6940

15000

0.658

9870

0.579

8685

25000

0.572

14300

0.582

12000

30000

0.497

14910

0.402

12060

50990

43900

Thus the actual rate of return is between 15% and 20%. The actual rate of
return can be found out by interpolation

IRR = L + P1 Q x D
P1 P2

L = lower discount rate


P1 = P. V at lower rate
P2 = P.V at higher rate
Q = actual investment

D = difference in rate
IRR = 15 + 50990 50000 x 5
50990- 43900
= 15.7%

As the IRR is higher than cost of capital the project is accepted.

Average Rate of Return Method (ARR) or Accounting Rate of Return Method: Average Rate of Return
Method is also termed as Accounting Rate of Return Method. This method focuses on the average net income
generated in a project in relation to the project's average investment outlay. This method involves accounting
profits not cash flows and is similar to the performance measure of return on capital employed.
The average rate of return. can be determined by the following equation: