CAPITAL BUDGETING

Q) What do you mean by capital budgeting?

Capital budgeting is long term planning for making and financing proposed capital outlay. It is a process by
which available resources are allocated among competitive long term investment opportunities so as to
promote the greatest profitability of a firm over a period of time. It refers to the total process of
generating, evaluating, selecting and following up on capital expenditure alternatives. It is the process a
business undertakes to evaluate potential major projects or investments.
Q) Explain the importance of capital budget.

Capital budgeting decisions are of paramount importance in financial decision. So it needs special care on
account of the following reasons:
i) Optimum use of Capital investment decisions require an amount of fund. Capital funds are
funds scarce in nature hence needs to be utilized in an optimum way.
It helps in analyzing risk involved in various projects under consideration.
ii) Analysis of risk Capital expenditure involves greater risk as the requirements of funds are
high.
iii) Maximization of Fixed assets require huge investments but also generate earnings. Cost
profit reduction and cost control ensure maximization of profit.
iv) Selection of best The company selects best proposal after keeping in mind its suitability along
proposal with various factors like rate of return, profitability, etc.
Capital budgeting helps in controlling the capital expenditures. Actual
v)Control over capital performance may be compared with budgeted results and necessary actions
expenditure may be taken by management.

vi)Replacement Capital budgeting helps in taking decisions regarding replacement of old

decisions asset by a new one. The new asset may be useful and profitable for the
business. A comparative study is made between these options and profitable
decisions may be taken

Q) Explain the factors influencing capital investment decision.

Some of the relevant factors that affects investment decisions are:

Management The decision of management to take a risk and invest funds in high value
Decisions assets or holding other plans, determines capital budgeting decisions.
Project’s economic The total cost estimated for long term investments and the capacity of
value company determines the decision.
The restrictions imposed and the exemptions allowed by government to the
Fiscal policy companies while investing in capital market nature, determines capital
budgeting decision.
Both short and long run market forecasts are influential factors in capital
Market forecast investment decisions. In order to participate in long-run forecast for market
potential critical decisions on capital investment have to be taken.
Degree of risk and Every proposal involves certain risk and uncertainty due to some economic
uncertainty factors, demand and supply conditions, etc. which affects the decision.
Competitor’s activities The company takes a decision by considering the activities of competitors,
which help the company to withstand in competition by implementing new
project, thus affecting the capital budgeting decision.
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Q) Explain Capital budgeting process.

Capital expenditure proposals may originate at any level, to facilitate the

Project Generation origination of such ideas a periodic review and comparison of earnings, costs,
procedures and product-line should be made by the management on a
continuous basis.
Appraisal of capital projects is important aspect of capital budgeting. It is
concerns with evaluating the costs involved in a capital investment proposal
Project Evaluation and benefits that accrual from it.

Capital expenditure requests should be properly screened in order to weed out

Screening and those projects which are undesirable. After screening, selection is made on the
Selection basis of criteria of the firm. Such criteria should encompass the supply and cost
of capital the expected returns from alternative investment opportunities.
The funds are appropriated for capital expenditure after the final selection of
Project Execution investment proposals. The project execution committee must ensure that the
funds are spent in accordance with appropriations made in the capital budget.
This step involves evaluation of the program after its implementation. This
Follow-Up involves comparison of actual performance with the budgeted data. Such
follow up comparison will ensure better forecasting for the future
Q) Explain the scope of capital budgeting.

Broadly speaking, capital budgeting decisions are long-term investment decisions. They include the
following:
Expansion Decisions Decisions on the matters such as acquisition of new machinery of building,
addition of building and machinery
etc. are taken on the basis of cost of investment and expected profits from
goods produced
Replacement A company may have to replace its existing or obsolete machinery by new and
Decisions latest model machinery. Decisions on such matters are taken on the basis of
saving on account of decrease in operating costs and profits from additional
volume produced by new plant.
Buy or Lease The management may have to take decision on acquiring a fixed asset by
Decisions purchase it from the market or by arranging it on lease basis. Such decisions
are taken by comparing the cost of funds required for the purchase of asset
with the amount payable on lease.
Choice of Equipment The management may have to select the best machine out of available several
alternative machines. Decisions on such matters are taken by comparing the
cost of different assets with their respective profitability.
Product of Process This concern with decision on matters related to cost reduction or
Improvement improvement in the quality of product. Decision on such matters is taken on
the basis of a comparative study of cost of change and possible additional
income or saving as a result of change.
Q) Explain the techniques of capital budgeting.

The ultimate objective of the capital budgeting process is to achieve maximum benefit from the project.
For this purpose, there are various techniques of capital budgeting which are as follows:
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Traditional or non discounted cash flow techniques

Payback period is that time period in which net cash inflow from investment recovers
the cost of investment. It is calculated as:
Payback Period = E + B
C
Payback period Where, E = number of years immediately preceding the year of final recovery
B = the balance amount still to be recovered
C = cash flow during the year of final recovery

Advantages and disadvantages:

Advantages Disadvantages
i) Universally applied method. i) No consideration of time value.
ii) Can be determined easily ii) Overlooks cost of capital.
iii) Easy to make decisions. iii) It ignores profitability.
iv) Emphasis on liquidity. iv) Ignores cash flow after payback
period.
Under this method, percentage rate of return of the annual net profit on investment
is calculated. If it is calculated on initial investment, it is called Return on Investment
Accounting (ROI) and if it is calculated on average investment, it is called as Average Rate of
Rate of Return Return.
Method (ARR) Calculated as: Average Annual Net Income (Savings)
Method ARR =------------------------------------------------------ X 100
Average Investment
Advantages and disadvantages:
Advantages Disadvantages
i) Simple and widely used method. i) Does not consider time factors
ii) Simple decision rules. ii) Ignores cash flows.
iii) Measurement of profitability. iii) Ignores terminal value of the project
Modern or discounted cash flow techniques

This method is used when the management has prescribed minimum (or target) rate
of return or cut-off rate.
Present Value = Annual Cash Inflow x Present Value Factor

Net Present Value = Total Present Value of Cash Inflows - Total Present Value of Cash
Outflows
Net Present
Value Method DECISION RULE
(NPV Method) (i) If NPV is positive, project is accepted.
(ii) If NPV is negative, the project is rejected.
Advantages and Disadvantages:

Advantages Disadvantages
i) Considers time value of money. i) Complex to calculate and difficult to
understand
ii) Easy to make decision. ii) It relies on discount rates.
iii) Scientific and most reliable method. iii) Difficult to forecast future cash flows.
iv) Focus on profitability. iv) Difficult to determine the required
rate of return.
It is defined as the rate of present value of the future cash benefits at the required
Profitability rate of the return to the initial cash outflow of the investment.
index method:
Calculated as :
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