Capital Budgeting Decision

Capital Budgeting Decisions, which are also known as

Investment decisions are concerned with the selection of the
investment proposal/proposals and the investment of funds
in the selected proposal/proposals

Those proposals are selected that assure a higher return

than the required rate of return
 Investment proposals necessarily involves risk as they

deal in future benefits (which can not be known with

certainty). Consequently, they should be evaluated in
relation to their expected return and risk
 Capital Budgeting Techniques

Discounted Cash Non-Discounted Cash

Flow Criteria Flow Criteria

1. Net Present Value 1. Pay Back period

2. Benefit Cost Ratio/ 2. Accounting Rate of
Profitability Index Return
3. Internal Rate of
Return
 Data Required for any Capital Budgeting
decision
 Projected Cash Inflows
 Projected Cash Outflows

 Cost of Capital
 Cost of Capital

The Company Cost of capital is the rate of

return expected by the capital providers
Two main sources of funds

Equity-
-Results in dilution of control
-Costly source of finance as investors require high rate of return due to high risk

involved
-No fixed obligation to pay any returns at regular intervals

Debt-
- No Dilution of control
-Not as costly as equity as risk involved for investors is low as compared to equity
-Fixed obligation to pay returns at regular intervals
 Pay back period
Payback period is defined as the number of
years required to recover the initial cost of
the project
 When the inflows are equal

For Example- If a project requires a cash outflow

of Rs.1,00,000 and is expected to generate
cash inflows of Rs. 20,000.

In the above case the payback period will

become 1,00,000 / 20,000 = 5 years
 When the inflows are Unequal
 For Example a project requires Rs. 20,000 and
is expected to generate Cash inflows of Rs.
8,000 , 6,000 , 4,000 , and Rs. 2,000

Year Annual CF Cumulative CF

1 8,000 8,000
2 6,000 14,000
3 4,000 18,000
4 2,000 20,000


 If in the above example the initial

outflow is Rs. 18,500 then calculate the
payback period

500
3 + --------- = 3.25 years
2000