CAPITAL BUDGETING

By, S.K.Gupta
HEAD, DEPT. OF COMMERCE
S.D.JAIN GIRLS’ COLLEGE
DIMAPUR: NAGALAND
1
 CAPITAL BUDGETING

Capital budgeting is a decision situation where large funds

are committed (invested) in the initial stages of the project
and the returns are expected over a long period of time.
These decisions are related to allocation of investible funds
to different long-term assets.

Capital budgeting is a continuous process and it is carried

out by different functional areas of management such as
production, marketing, engineering, financial management
etc.
2
 BASIC FEATURES OF CAPITAL
BUDGETING

 Capital budgeting decisions have long-term

implications.
 These decisions involve substantial commitment of
funds.
 These decisions are irreversible and require analysis
of minute details.
 These decisions determine and affect the future
growth of the firm.
3
CAPITAL BUDGETING PROCESS:

Capital budgeting is a difficult process to the

investment of available funds. The benefit
will attained only in the near future but, the
future is uncertain. However, the following
steps followed for capital budgeting, then the
process may be easier are.

4
Capital-Budgeting Process

5
 KINDS OF CAPITAL BUDGETING
DECISIONS
The overall objective of capital budgeting is to
maximize the profitability. If a firm
concentrates return on investment, this
objective can be achieved either by increasing
the revenues or reducing the costs. The
increasing revenues can be achieved by
expansion or the size of operations by adding a
new product line. Reducing costs mean
representing obsolete return on assets.
6
 DECISION CRITERIA TECHNIQUES OF
EVALUATION

Traditional or Time-adjusted or
Non-discounting Discounted cash flows

1. Payback period 1. Net Present Value

2. Accounting Rate of 2. Profitability Index
Return 3. Internal Rate of Return
7
 TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES

I . PAYBACK PERIOD:
# The payback period is defined as “the number of
years required for the proposal’s cumulative cash inflows to be
equal to its cash outflows.”
# The payback period is the length of time required
to recover the initial cost of the project.
# The payback period may be suitable if the firm
has limited funds available and has no ability or willingness to
raise additional funds.
8
II . ACCOUNTING RATE OF RETURN (OR) AVERAGE

RATE OF RETURN
(ARR)
# The ARR may be defined as “the annualized net
income earned on the average funds invested in a project.”
# The annual returns of a project are expressed as a
percentage of the net investment in the project.

COMPUTATION OF ARR:

Average Annual profit (after tax)

ARR = x 100 9
 DISCOUNTED CASH FLOWS OR TIME
ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at
different point of time are not having same economic worth.

I. NET PRESENT VALUE (NPV) METHOD:

The NPV of an investment proposal may be defined as the sum
of the present values of all the cash inflows less the sum of present
values of all the cash outflows associated with the proposal.
The decision rule is “ Accept the proposal if its NPV is positive
and reject the proposal if the NPV is negative”.

10
II. PROFITABILITY INDEX METHOD:
This technique is a variant of the NPV technique and is also
known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows

PI =
Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject

the proposal if the PI is less than 1.

11
III. INTERNAL RATE OF RETURN (IRR) METHOD:
 The IRR of a proposal is defined as the discount rate which
produces a zero NPV, i.e., the IRR is the discount rate which will
equate the present value of cash inflows with the present value of
cash outflows.

 The IRR is also known as Marginal Rate of Return or

Time Adjusted Rate of Return.

 The time-schedule of occurrence of future cash flows is

known but the rate of discount is not.

 The discount rate calculated will equate the present value of

cash inflows with the present value of cash outflows.
--------------------- 12
THANKS YOU

13