Meaning and definition of Capital Budgeting (2 marks)

Capital budgeting is a company’s formal process used for evaluating potential expenditures or
investments that are significant in amount. It involves the decision to invest the current funds for
addition, disposition, modification or replacement of fixed assets

Definitions: (2marks)

Charles. T.Horngreen defined capital budgeting as “Long term planning for making and
financing proposed capital out lay”.

Need and Significance/Importance of Capital Budgeting:5 marks

Capital budgeting decisions have given the primary importance in financial decision-making
since they are the most crucial and critical business decisions and they have significant impact on
the profitability aspect of the firm. Capital budgeting decision is an important, crucial
and critical business decision due to

1. Huge investments:

Capital budgeting requires huge investments of funds, but the 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 long-term 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

4) Complex decision :

Capital investment decision involves an assessment of future events, which in

fact are difficult to predict, further, it is difficult to estimate in quantitative
terms all benefits or costs relating to a particular investment decision

CAPITAL BUDGETING PROCESS:

A) Project identification and generation:

The first step towards capital budgeting is to generate a proposal for investments. There could be
various reasons for taking up investments in a business. It could be addition of a new product
line or expanding the existing one. It could be a proposal to either increase the production or
reduce the costs of outputs.
B) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria’s to judge the desirability of a proposal.
This has to match the objective of the firm to maximize its market value. The tool of time value
of money comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash inflow and
outflow along with the uncertainties and risks associated with the proposal has to be analyzed
thoroughly and appropriate provisioning has to be done for the same.
C) Project Selection:
There is no such defined method for the selection of a proposal for investments as different
businesses have different requirements. That is why, the approval of an investment proposal is
done based on the selection criteria and screening process which is defined for every firm
keeping in mind the objectives of the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring funds
have to be explored by the finance team. This is called preparing the capital budget. The average
cost of funds has to be reduced. A detailed procedure for periodical reports and tracking the
project for the lifetime needs to be streamlined in the initial phase itself. The final approvals are
based on profitability, Economic constituents, viability and market conditions.
D) Implementation:
Money is spent and thus proposal is implemented. The different responsibilities like
implementing the proposals, completion of the project within the requisite time period and
reduction of cost are allotted. The management then takes up the task of monitoring and
containing the implementation of the proposals.
E) Performance review:
The final stage of capital budgeting involves comparison of actual results with the standard ones.
The unfavorable results are identified and removing the various difficulties of the projects helps
for future selection and execution of the proposals.
Traditional Methods of capital budgeting
These methods are based on the principles to determine the desirability of an investment project
on the basis of its useful life and expected returns. These methods depend upon the accounting
information available from the books of accounts of the company. These will not take into
account the concept of ‘time value of money’ which is a signification factors to desirability of a
project in terms of present value.
1. Pay-back Period
It is the most popular and widely recognized traditional methods of evaluating the investment
proposals. It can be defined as “the number of years to recover the original capital invested
in a project”.
a) When cash flows are uniform:
If the proposed project’s cash inflows are uniform the following formula can be used to calculate
the payback period.
Payback period = Initial Investment/ Annual Cash inflows
b) When cash flows are not uniform
When the project’s cash inflows are not uniform, but vary from year to year, payback period is
calculated by the process of cumulating cash inflows till the time when cumulative cash flows
become equal to the original investment outlay.
The payback period can be used as an accept or reject criterion as well as a method of ranking
projects. The payback period is the number of years to recover the investment made in a project.
If the payback period calculated for a project is less than the maximum payback period set-up by
the company, it can be accepted. As a ranking method it gives the highest rank to a project
which has the lowest payback period, and the lowest rank to a project with the highest payback
period. Whenever a company faces the problem of choosing among two or more mutually
exclusive projects, it can select a project on the basis of payback period, which has shorter
period than the other projects.
Merits:
The following are the merits of the payback period method:
(i) Easy to calculate: It is one of the easiest methods of evaluating the investment projects. It is
simple to understand and easy to compute.
(ii) Knowledge: The knowledge of payback period is useful in decision-making, the shorter the
period better the project.
(iii) Protection from loss due to obsolescence: This method is very suitable to such industries
where mechanical and technical changes are routine practice and hence, shorter payback period
practice avoids such losses.
(iv) Easily availability of information: It can be computed on the basis of accounting
information, what is available from the books.
Demerits: However, the payback period method has certain demerits:
(i) Failure in taking cash flows after payback period: This methods is not taking into account
the cash flows received by the company after the payback period.
(ii) Not considering the time value of money: It does not take into account the time value of
money.
(iii) Non-considering of interest factor: It does not take into account the interest factor involved
in the capital outlay.
(iv) Maximisation of market value not possible: It is not consistent with the objective of
maximizing the market value of share.
(v) Failure in taking magnitude and timing of cash inflows: It fails to consider the pattern of
cash inflows i.e. the magnitude and timing of cash inflows
2. Accounting or Average Rate of Return (ARR)
This technique uses the accounting information revealed by the financial statements to
measure the profitability of an investment proposal. It can be determined by dividing the
average income after taxes by the average investment.
On the basis of this method, the company can select all those projects whose ARR is higher than
the minimum rate established by the company. It can reject the projects with an ARR lower than
the expected rate of return.
This method also helps the management to rank the proposal on the basis of ARR.
Accounting Rate of Return (ARR) = Average Net Income x 100 / Original Investment
OR
Accounting Rate of Return (ARR) = Average Net Income x 100 / Average Investment
Acceptance Rule:
The project which gives the highest rate of return over the minimum required rate of return is
acceptable
Merits:
The following are the merits of ARR method:
(i) It is very simple to understand and calculate;
(ii) It can be readily computed with the help of the available accounting data;
(iii) It uses the entire stream of earnings to calculate the ARR. Demerits:
This method has the following demerits:
(i) It is not based on cash flows generated by a project;
(ii) This method does not consider the objective of wealth maximization;
(iii) It ignores the length of the projects useful life;
(iv) If does not take into account the fact that the profile can be re-invested; and
(v) It ignores the time value of money
Discounted Cash Flow Techniques

The popular discounted cash flows techniques are:

(a) Net Present Value (b) Internal Rate of Return, and (c) Profitability Index

Time Value of Money( 2 marks)

The value of money received today is more than the value of money received after some time in
the future is called time value of money
1. Net Present Value (NPV):

The net present value method is a classic method of evaluating the investment proposals. It is
one of the methods of discounted cash flow techniques, which recognizes the importance of time
value of money. It is a method of calculating the present value of cash flows (inflows and
outflows) of an investment proposal using the cost of capital as an appropriate discounting
rate. The net present value will be arrived at by subtracting the present value of cash outflows
from the present value of cash inflows. The net present value is the difference between the
present value of cash inflows and the present value of cash outflows.

***Acceptance Rule( 2 marks)

If the NPV is positive or atleast equal to zero, the project can be accepted. If it is negative,
the proposal can be rejected. Among the various alternatives, the project which gives the highest
positive NPV should be selected.

Merits:

The following are the merits of the net present value (NPV) methods:

(i) Consideration to total Cash Inflows:

The NPV methods considers the total cash inflows of investment opportunities over the entire life-time
of the projects unlike the payback period methods.

(ii) Recognition to the Time Value of Money: This methods explicitly recognizes the time value of
money, which is investable for making meaningful financial decisions.

(iii) Changing Discount Rate: Due to change in the risk pattern of the investor different discount rates
can be used.

(iv) Best decision criteria for Mutually Exclusive Projects: This Method is particularly useful for the
selection of mutually exclusive projects. It serves as the best decision criteria for mutually exclusive
choice proposals.

(v) Maximisation of the Shareholders Wealth: Finally, the NPV method is instrumental in achieving the
objective of the maximization of the shareholders’ wealth. This method is logically consistent with the
company’s objective of maximizing shareholders’ wealth in terms of maximizing market value of shares,
and theoretically correct for the selections of investment proposals.

Demerits: The following are the demerits of the net present value method:

(i) It is difficult to understand and use.

(ii) The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of capital
itself is difficult to understand and determine.
(iii) It does not give solutions when the comparable projects are involved in different amounts of
investment.
(iv) It does not give correct answer to a question when alternative projects of limited funds are available,
with unequal lives.

2. Profitability Index (PI)

This method is also known as ‘Benefit Cost Ratio’.

According to Van Horne, the profitability Index of a project is “the ratio of the present value of future
net cash inflows to the present value of cash outflows”.
Profitability Index = present value of cash inflows/ Present value of cash outflows

Decision criteria: If the Profitability Index is greater than or equal to one, the project should be accepted
otherwise reject.

Merits: The merits of this method are:

(i) It takes into account the time value of money

(ii) It helps to accept / reject investment proposal on the basis of value of the index.
(iii) It is useful to rank the proposals on the basis of the highest /lowest value of the index.
(iv) It takes into consideration the entire stream of cash flows generated during the life of the asset.
Demerits: However, this technique suffers from the following limitations:
(v) It is somewhat difficult to compute.
(vi) It is difficult to understand the analytical of the decision on the basis of profitability index.

Demerits: However, this technique suffers from the following limitations:

(i) It is somewhat difficult to compute.

(ii) It is difficult to understand the analytical of the decision on the basis of profitability index

Discounted Pay Back Method:

Under this method the discounted cash inflows are calculated and where the discounted cash flows are
equal to original investment then the period which is required is called discounting payback period.

While calculating discounting cash inflows the firm’s cost of capital has been used.

Formula:

Discounted payback period (DPP) = Investment/Discounted Annual cash inflow

DECISION CRITERIA:

Out of two projects, selection should be based on the period of discounting pay back period (Lesser
payback period should be preferred.