CAPITAL BUDGETING

-Vinamra Nayak
Capital Budgeting
It is the process of evaluating and selecting
long term investments that are consistent
with the goal of shareholders wealth
maximization.
In other words, the system of capital budgeting
is employed to evaluate expenditure
decisions which involves current outlays
(expenditure) but are likely to produce
benefits over a period of time longer than
one year.
Capital Budgeting
These benefits may be either in the form of
increased revenues or reduced cost.
The term capital budgeting is used
interchangeably with capital expenditure
decisions, capital expenditure management,
long term investment decisions, management
of fixed assets.
Capital expenditure management includes
addition, disposition, modification and
replacement of fixed assests.
Features of Capital Budgeting
 Potentially large anticipated benefits
 A relatively high degree of risk
 A relatively long time period between the

initial outlay and the anticipated returns.

Capital Expenditure
Capital Expenditure is an outlay of funds that is
expected to produce benefits over a period of
time exceeding one year.
Importance of Capital Budgeting
 It is useful in making financial decisions.
 Capital Budgeting decisions affect the

profitability of a firm.
 Have a bearing on the competitive position

of the enterprise because of the fact that hey

relate to fixed assets.
 The fixed assets represents, the true earning

assets of the firm (they enable the firm to

generate finished goods that can ultimately
be sold for profits).
Importance of Capital Budgeting
Capital Budgeting decisions determine the
future destiny of the company.
 A capital expenditure decisions has its effect

over a long time span & inevitably affects the

company’s future cost structure.
Types of Capital Budgeting
It is a process which includes generating ,
evaluating, selecting and following up on capital
expenditure alternatives.
1. Accept – Reject decision / approval: It is the
evaluation of capital expenditure proposal to
determine whether they meet the minimum
acceptance criterion.
2. Mutually exclusive projects / decisions: Are
projects that compete with one another, the
acceptance of one eliminates the others from
further consideration.
Types of Capital Budgeting
3. Capital Rationing: This is the financial
situation in which a firm has only fixed
amount to allocate among competing capital
expenditures.
Techniques of Capital Budgeting
Traditional
 ARR (Average Rate of Return)
 Pay Back Period

Time Adjusted
 NPV (Net Present Value)
 IRR (Internal Rate of Return)
 Profitability Ratio
Net Present Value (NPV)
 It takes into consideration time value of money
and attempts o calculate the return on
investments by introducing the factor of time
element. It recognizes the fact that a rupee
earned today is worth more than the same
rupee earned tomorrow.
 The PV of Re 1 due in any number of year can

be found with the use of the following formula:

PV= 1
(1+r)n
Net Present Value (NPV)
Where,
PV = Present Value
r = Rate of interest / discount rate
n = Number of years
The PV for all the cash inflows for a number of years is
thus found as:
PV= A1 + A2 + A3 + … An
(1+r) (1+r) (1+r) (1+r)
Where,
A1, A2 = Future net cash flows
r =rate of interest
1,2 / n = number of years
Profitability Index Method / Benefit
Cost Ratio
It is the relationship between Present Value(PV)
of cash inflow and PV of cash outflow.
Profitability Index = PV of cash Inflow
PV of cash outflow

The profitability index (net) may be found for

NPV of inflows.
PI (Net) = Net Present Value
Initial Cash Outlay
Proposal is accepted if PI > 1
 Also refer to Internal Rate of Return and Pay
Back Period approach