CAPITAL BUDGETING

NAME : MANVI RANA

ROLL NO. : 574
B.COM : 3rd YEAR
SUBMITTED TO : SWATI MA’AM
SUBJECT : FINANCIAL MANAGEMENT
What is Capital Budgeting?
Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context,
capital expenditure is the spending of funds for large expenditures like purchasing
fixed assets and equipment. Budgeting is setting targets for projects to ensure
maximum profitability.
Capital budgeting is the process a business undertakes to evaluate potential major
projects or investments. Construction of a new plant or a big investment in an outside
venture are examples of projects that would require capital budgeting before they are
approved or rejected.
There are three types of capital budgeting
techniques to consider for your budgeting
purposes. They are:
1. Payback method
2. Net present value method
3. Internal rate of return method
 Payback method

This method refers to the period in which the proposal will generate cash to recover the initial
investment made. It purely emphasizes on the cash inflows, economic life of the project and the
investment made in the project, with no consideration to time value of money. Through this method
selection of a proposal is based on the earning capacity of the project. With simple calculations,
selection or rejection of the project can be done, with results that will help gauge the risks involved.
However, as the method is based on thumb rule, it does not consider the importance of time value of
money and so the relevant dimensions of profitability. Payback Period = (Initial Investment / Net
Annual Cash Inflow)

For example:
A company plans to buy a new IT server for $500,000, and that server is predicted to generate $50,000 cash
each year. This capital budgeting scenario implies that the purchase can be paid off in 10 years.

$50,000 cash flows over 10 years totals the $500,000 total purchase price.

The quicker the payback period is, the quicker the company is able to recover the cost of the new piece of
equipment.
 Payback method
Merits
 This method is Easy and
Simple
 Ranking of Projects
  It Stresses the Liquidity
Objective
 Useful in Case of
Uncertainty
 Handy Device or Method
Demerits
  It ignores annual cash
flow
  It considers only the
period of pay-back
 It overlooks capital cost
 No rational basis of
decision
 It is delicate and rigid
 Net present value method
The Net Present Value (NPV) is a method that is primarily used for financial analysis in determining the feasibility
of investment in a project or a business. It is the present value of future cash flows compared with the initial
investments.
Net present value is a tool of Capital budgeting to analyze the profitability of a project or investment. It is
calculated by taking the difference between the present value of cash inflows and present value of cash outflows
over a period of time.
(Cash flows)/(1+r)i = net present value

For example:
An investor decides to invest in Company XYZ. The company asks for an initial investment of $243,000. It has been
determined that the investment will generate a cash flow of $50,000 over the next 12 months. The anticipated rate of
return is 12% per year.
Using the NPV formula, the anticipated profit of the investment will be around $319,754. The formula would look
like this: 50,000 x (1-(1+1%)x-12)/ 1% - $243,000. 50,000 represents the cash inflow per period (each month), the
discount rate per period is 1% and the number of periods is 12 since the cash flow will be generated over 12
months.
 Net present value method
Merits Demerits
 Assumption of  Estimation of
Reinvestment Opportunity Cost
 Accepts Conventional  Ignoring Sunk Cost
Cash Flow Pattern  Difficulty in
 Consideration of all Determining the
Cash Flows Required Rate of Return
 Good Measure of  Optimistic Projections
Profitability  Difference in Size of
 Factors Risks Projects
Internal rate of return method
An internal rate of return (IRR) is a metric used to estimate an investment’s percentage rate of return,
typically for companies and organizations to determine the profitability of potential investments. Generally,
the higher the IRR, the more desirable it is as an investment.
The internal rate of return (IRR) is a calculation that helps you estimate the profit margins of investments.
Being able to calculate IRR will position you for careers within the finance and investment industries
 IRR > WACC then the project is profitable.

For example:
For example, a company can use this method to compare the internal rate of return of expanding operations
in an existing facility to the internal rate of return of expanding operations by building and opening a new
one. The two project options are conflicting because the company needs only one site to expand operations.
In this scenario, the company would choose the project that has a greater IRR percentage that exceeds the
cost of investment percentage.
 Internal rate of return method
Merits Demerits
 Time Value of Money  Economies of Scale Ignored
 Impractical Implicit
 Simplicity
Assumption of Reinvestment
 Hurdle Rate / Required Rate
Rate of Return Is Not  Dependent or Contingent
Required Projects
 Required Rate of Return  Mutually Exclusive Projects
is a Rough Estimate  Different Terms of Projects
ThankYou