Capital Budgeting

Meaning of capital budgeting

Significance
Capital budgeting process
Investment criteria
Methods of capital budgeting

Developed by Dr.IKRAM UL HAQ 1

CHOUDHARY , CPA,PhD
 Capital Budgeting
Capital budgeting is the process in which a business
determines and evaluates potential expenses or
investments that are large in nature.
These expenditures and investments include projects
such as building a new plant or investing in a long-term
venture. Often times, a prospective project's lifetime
cash inflows and outflows are assessed in order to
determine whether the potential returns generated meet
a sufficient target benchmark, also known as
"investment appraisal."

2
Developed by Dr.IKRAM UL HAQ CHOUDHARY , CPA, PhD
 Meaning
The process through which different projects
are evaluated is known as capital budgeting
Capital budgeting is defined as the firms
formal process for the acquisition and
investment of capital. It involves firms
decisions to invest its current funds for
addition, disposition, modification and
replacement of fixed assets.
Capital budgeting is long term planning for
making and financing proposed capital
outlays- Charles T Horngreen. 3
Developed by Dr.IKRAM UL HAQ CHOUDHARY , CPA,PhD
 Capital budgeting consists in planning
development of available capital for the
purpose of maximising the long term
profitability of the concern Lynch
The main features of capital budgeting are
a. potentially large anticipated benefits
b. a relatively high degree of risk
c. relatively long time period between the
initial outlay and the anticipated return.
- Oster Young

Developed by Dr.IKRAM UL HAQ 4

CHOUDHARY , CPA,PhD
Significance of capital budgeting
The success and failure of business mainly
depends on how the available resources are
being utilised.
Main tool of financial management
All types of capital budgeting decisions are
exposed to risk and uncertainty.
They are irreversible in nature.
Capital rationing gives sufficient scope for the
financial manager to evaluate different proposals
and only viable project must be taken up for
investments.
Capital budgeting offers effective control on cost
of capital expenditure projects.
It helps the management to avoid over investment
and under investments.
Developed by Dr.IKRAM UL HAQ 5
CHOUDHARY , CPA,PhD
Capital budgeting process involves the following
1. Project generation: Generating the proposals for
investment is the first step.
The investment proposal may fall into one of the following
categories:
Proposals to add new product to the product line,
proposals to expand production capacity in existing lines
proposals to reduce the costs of the output of the
existing products without altering the scale of operation.
Sales campaining, trade fairs people in the industry, R
and D institutes, conferences and seminars will offer
wide variety of innovations on capital assets for
investment.
Developed by Dr.IKRAM UL HAQ 6
CHOUDHARY , CPA,PhD
2. Project Evaluation: it involves two steps
Estimation of benefits and costs: the benefits and
costs are measured in terms of cash flows. The
estimation of the cash inflows and cash outflows
mainly depends on future uncertainities. The risk
associated with each project must be carefully
analysed and sufficeint provision must be made
for covering the different types of risks.
Selection of an appropriate criteria to judge the
desirability of the project: It must be consistent
with the firms objective of maximising its market
value. The technique of time value of money may
come as a handy tool in evaluation such
proposals. Developed by Dr.IKRAM UL HAQ 7
CHOUDHARY , CPA,PhD
3. Project Selection: No standard administrative
procedure can be laid down for approving the
investment proposal. The screening and selection
procedures are different from firm to firm.
4. Project Evaluation: Once the proposal for capital
expenditure is finalised, it is the duty of the finance
manager to explore the different alternatives
available for acquiring the funds. He has to
prepare capital budget. Sufficient care must be
taken to reduce the average cost of funds. He has
to prepare periodical reports and must seek prior
permission from the top management. Systematic
procedure should be developed to review the
performance of projects during their lifetime and
after completion.
Developed by Dr.IKRAM UL HAQ 8
CHOUDHARY , CPA,PhD
The follow up, comparison of actual performance with
original estimates not only ensures better
forecasting but also helps in sharpening the
techniques for improving future forecasts.

Developed by Dr.IKRAM UL HAQ 9

CHOUDHARY , CPA,PhD
Factors influencing capital budgeting
Availability of funds
Structure of capital
Taxation policy
Government policy
Lending policies of financial institutions
Immediate need of the project
Earnings
Capital return
Economical value of the project
Working capital
Accounting practice
Trend of earnings Developed by Dr.IKRAM UL HAQ 10
CHOUDHARY , CPA,PhD
Methods of capital budgeting
Traditional methods
Payback period
Accounting rate of return method

Discounted cash flow methods

Net present value method
Profitability index method
Internal rate of return

Developed by Dr.IKRAM UL HAQ 11

CHOUDHARY , CPA,PhD
Pay back period method
It refers to the period in which the project will generate
the necessary cash to recover the initial investment.
It does not take the effect of time value of money.
It emphasizes more on annual cash inflows, economic
life of the project and original investment.
The selection of the project is based on the earning
capacity of a project.
It involves simple calcuation, selection or rejection of
the project can be made easily, results obtained is
more reliable, best method for evaluating high risk
projects.

Developed by Dr.IKRAM UL HAQ 12

CHOUDHARY , CPA,PhD
Cons
It is based on principle of rule of thumb,
Does not recognize importance of time value
of money,
Does not consider profitability of economic
life of project,
Does not recognize pattern of cash flows,
Does not reflect all the relevant dimensions
of profitability.

Developed by Dr.IKRAM UL HAQ 13

CHOUDHARY , CPA,PhD
Accounting Rate of Return method
IT considers the earnings of the project of the economic life.
This method is based on conventional accounting concepts.
The rate of return is expressed as percentage of the
earnings of the investment in a particular project. This
method has been introduced to overcome the disadvantage
of pay back period. The profits under this method is
calculated as profit after depreciation and tax of the entire
life of the project.
This method of ARR is not commonly accepted in assessing
the profitability of capital expenditure. Because the method
does to consider the heavy cash inflow during the project
period as the earnings with be averaged. The cash flow
advantage derived by adopting different kinds of
depreciation is also not considered in this method.
Developed by Dr.IKRAM UL HAQ 14
CHOUDHARY , CPA,PhD
Accept or Reject Criterion: Under the method, all project,
having Accounting Rate of return higher than the minimum
rate establishment by management will be considered and
those having ARR less than the pre-determined rate. This
method ranks a Project as number one, if it has highest
ARR, and lowest rank is assigned to the project with the
lowest ARR.
Merits
It is very simple to understand and use.
This method takes into account saving over the entire
economic life of the project. Therefore, it provides a better
means of comparison of project than the pay back period.
This method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects and
It can readily be calculated by using the accounting data.
Developed by Dr.IKRAM UL HAQ 15
CHOUDHARY , CPA,PhD
Demerits
1. It ignores time value of money.
2. It does not consider the length of life of the projects.
3. It is not consistent with the firm's objective of maximizing
the market value of shares.
4. It ignores the fact that the profits earned can be
reinvested. -

Developed by Dr.IKRAM UL HAQ 16

CHOUDHARY , CPA,PhD
Discounted cash flow method
Time adjusted technique is an improvement over pay
back method and ARR. An investment is essentially
out flow of funds aiming at fair percentage of return
in future. The presence of time as a factor in
investment is fundamental for the purpose of
evaluating investment. Time is a crucial factor,
because, the real value of money fluctuates over a
period of time. A rupee received today has more
value than a rupee received tomorrow. In evaluating
investment projects it is important to consider the
timing of returns on investment. Discounted cash
flow technique takes into account both the interest
factor and the return after the payback 'period.
Developed by Dr.IKRAM UL HAQ 17
CHOUDHARY , CPA,PhD
Discounted cash flow technique involves the following
steps:
Calculation of cash inflow and out flows over the
entire life of the asset.
Discounting the cash flows by a discount factor
Aggregating the discounted cash inflows and
comparing the total so obtained with the discounted
out flows.

Developed by Dr.IKRAM UL HAQ 18

CHOUDHARY , CPA,PhD
Net present value method
It recognises the impact of time value of money. It is
considered as the best method of evaluating the
capital investment proposal.
It is widely used in practice. The cash inflow to be
received at different period of time will be
discounted at a particular discount rate. The
present values of the cash inflow are compared
with the original investment. The difference
between the two will be used for accept or reject
criteria. If the different yields (+) positive value ,
the proposal is selected for invesment. If the
difference shows (-) negative values, it will be
rejected. Developed by Dr.IKRAM UL HAQ 19
CHOUDHARY , CPA,PhD
Pros:
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows by
using a discount rate equal to the cost of capital.
It is consistent with the objective of maximizing the
welfare of owners.
Cons:
It is very difficult to find and understand the concept
of cost of capital
It may not give reliable answers when dealing with
alternative projects under the conditions of unequal
lives of project.
Developed by Dr.IKRAM UL HAQ 20
CHOUDHARY , CPA,PhD
Internal Rate of Return
It is that rate at which the sum of discounted
cash inflows equals the sum of discounted
cash outflows. It is the rate at which the net
present value of the investment is zero.
It is the rate of discount which reduces the NPV
of an investment to zero. It is called internal
rate because it depends mainly on the outlay
and proceeds associated with the project and
not on any rate determined outside the
investment.
Developed by Dr.IKRAM UL HAQ 21
CHOUDHARY , CPA,PhD
Merits of IRR method
It consider the time value of money
Calculation of casot of capital is not a
prerequisite for adopting IRR
IRR attempts to find the maximum rate of
interest at which funds invested in the project
could be repaid out of the cash inflows
arising from the project.
It is not in conflict with the concept of
maximising the welfare of the equity
shareholders.
It considers cash inflows throughout the life
of the project. Developed by Dr.IKRAM UL HAQ
CHOUDHARY , CPA,PhD
22
Cons
Computation of IRR is tedious and difficult to
understand
Both NPV and IRR assume that the cash
inflows can be reinvested at the discounting
rate in the new projects. However,
reinvestment of funds at the cut off rate is
more appropriate than at the IRR.
IT may give results inconsistent with NPV
method. This is especially true in case of
mutually exclusive project.
Developed by Dr.IKRAM UL HAQ 23
CHOUDHARY , CPA,PhD
Step 1:Calculation of cash outflow

Cost of project/asset xxxx

Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx

Developed by Dr.IKRAM UL HAQ 24

CHOUDHARY , CPA,PhD
Step 2: Calculation of cash inflow
Sales xxxx
Less: Cash expenses xxxx
PBDT xxxx
Less: Depreciation xxxx
PBT xxxx
less: Tax xxxx
PAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx
Developed by Dr.IKRAM UL HAQ 25
CHOUDHARY , CPA,PhD
Note:
Depreciation = St.Line method
PBDT Tax is Cash inflow ( if the tax amount
is given)
PATBD = Cash inflow
Cash inflow- Scrap and working capital must
be added.

Developed by Dr.IKRAM UL HAQ 26

CHOUDHARY , CPA,PhD
Step 3: Apply the different techniques
Pay back period= No. of years + Amt to recover/
total cash of next years.
ARR = Average Profits after tax/ Net investment x
100
NPV= PV of cash inflows PV of cash outflows
Profitability index = PV of cash inflows/ PV of cash
outflows
IRR :
Pay back factor: Cash outflow/ Avg cash inflow p.a.
Find IRR range
PV of Cash inflows for IRR range and then calculate
IRR
Developed by Dr.IKRAM UL HAQ 27
CHOUDHARY , CPA,PhD
Thank You

Developed by Dr.IKRAM UL HAQ 28

CHOUDHARY , CPA,PhD