Capital Budgeting Concepts and Methods:

1. Capital Budgeting Process

Capital budgeting involves evaluating long-term investments and choosing projects that
maximize shareholder wealth.

Steps in the Process:

1. Identification of Investment Opportunities

●​ Firms generate ideas for capital investment: new equipment, plant expansion, R&D, etc.

2. Screening and Matching

●​ Filter feasible projects that align with strategic and financial goals.

3. Cash Flow Estimation

●​ Forecast all future inflows and outflows over the project's life.

4. Project Evaluation
●​ Use appraisal techniques like NPV, IRR, Payback, etc., to assess viability.

5. Project Selection
●​ Choose the best project(s) based on evaluation outcomes and resource availability.

6. Implementation
●​ Allocate resources, begin project execution, and monitor progress.

7. Post-Implementation Review
●​ Compare actual performance with projections to learn and improve future decisions.

2. Cash Flow Estimation

Correct estimation of cash flows is critical for accurate capital budgeting.

Types of Cash Flows:

1. Initial Outlay (Year 0)

●​ Purchase price, installation costs, working capital requirements.
2. Operating Cash Flows (Years 1 to n)
●​ Revenue – Expenses (excluding depreciation) + Tax Savings from Depreciation.

3. Terminal Cash Flow

●​ Salvage value of assets, recovery of working capital, tax effects on asset sale.

Important Notes:
●​ Use incremental cash flows, not total company cash flows.
●​ Ignore sunk costs (already incurred and non-recoverable).
●​ Consider opportunity costs and externalities (e.g., impact on other projects).

3. Payback Period Method

Concept:

Time required to recover the original investment from project cash inflows.

Formula (if cash flows are equal):

Payback Period = Initial Investment / Annual Cash Flow

Example:

If a project costs ₹1,00,000 and earns ₹25,000/year,

Payback = ₹1,00,000 / ₹25,000 = 4 years

Pros:
●​ Simple to understand.
●​ Useful for liquidity analysis.

Cons:
●​ Ignores time value of money.
●​ Ignores cash flows after the payback point.
●​ Doesn’t measure profitability.
4. Discounted Payback Period Method

Concept:

Time taken to recover investment from discounted cash flows.

Steps:

1. Discount each cash inflow using present value.

2. Accumulate discounted inflows till they equal the initial investment.

Pros:
●​ Accounts for time value of money.
●​ Better risk evaluation than simple payback.

Cons:
●​ Still ignores cash flows after recovery.
●​ Complex compared to basic Payback.

5. Accounting Rate of Return (ARR)

Concept:
Measures average annual accounting profit relative to investment.

Formula:
ARR = (Average Accounting Profit / Average Investment) × 100

Example:
If avg. profit = ₹10,000 and avg. investment = ₹50,000, ARR = 20%

Pros:
●​ Simple to calculate.
●​ Uses familiar accounting data.

Cons:
●​ Ignores cash flows and time value of money.
●​ Focuses on book profit, not actual cash.
6. Net Present Value (NPV)

Concept:
Present value of all cash inflows minus initial investment.

Formula:
NPV = ∑ [Cash Inflow / (1+r)^t] – Initial Investment

Where:
r = discount rate (cost of capital)
t = time period

Decision Rule:
NPV > 0: Accept
NPV < 0: Reject

Pros:
●​ Accounts for time value of money.
●​ Considers all cash flows.
●​ Direct measure of value addition.

Cons:
●​ Requires accurate discount rate.
●​ Not intuitive to non-financial users.

7. Net Terminal Value (NTV)

Concept:
Calculates the future value of cash inflows and compares it with future value of outflows.

Formula:
NTV = Future Value of Inflows – Future Value of Outflows

Use Case:
●​ When evaluating projects that end with a large cash inflow or terminal value.
●​ Focuses on end-of-life project value.

Pros:
●​ Useful in scenarios where future value perspective is important.

Cons:
●​ Not as common as NPV.
●​ Requires compounding rather than discounting.
8. Internal Rate of Return (IRR)

Concept:
IRR is the rate at which NPV = 0 (i.e., breakeven rate of return).

Interpretation:
If IRR > cost of capital → project is acceptable.

Steps:
Trial and error or use of financial calculator/software.

Pros:
●​ Popular with managers due to percentage format.
●​ Considers time value of money and all cash flows.

Cons:
●​ May give multiple IRRs for non-standard cash flows.
●​ Can conflict with NPV for mutually exclusive projects.

9. Profitability Index (PI)

Concept:
Ratio of present value of cash inflows to initial investment.

Formula:
PI = Present Value of Future Cash Inflows / Initial Investment

Decision Rule:
PI > 1: Accept project
PI < 1: Reject project

Pros:
●​ Useful in ranking projects under capital rationing.
●​ Indicates value created per unit of investment.

Cons:
●​ Like IRR, may give wrong ranking for mutually exclusive projects.
●​ Requires accurate discount rate.
Capital Budgeting under Risk & Uncertainty

Capital budgeting decisions involve estimating future cash flows, which are often uncertain. To
make better investment decisions, risk and uncertainty must be considered using methods like:

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1. Certainty Equivalent (CE) Approach

Meaning:

Converts risky future cash flows into risk-free equivalents before discounting.

Uses a Certainty Equivalent Coefficient (alpha) between 0 and 1.

Key Points:

Each year's cash flow is adjusted separately using alpha.

The adjusted cash flows are discounted using the risk-free rate.

Formula:

PV = (CE × Expected Cash Flow) / (1 + risk-free rate)^t

Advantages:

Accurate when risk varies across years.

Provides a detailed view of project risk.

Disadvantages:

Estimating CE coefficients is subjective.

Requires more time and data, less used in practice.

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2. Risk-Adjusted Discount Rate (RADR) Method

Meaning:

Adjusts the discount rate instead of cash flows to reflect project risk.

Riskier projects get higher discount rates.

Key Points:

Applies a single rate to all cash flows.

RADR = Risk-Free Rate + Risk Premium

Formula:

NPV = ∑ [Cash Flow / (1 + RADR)^t] – Initial Investment

Advantages:

Simple and easy to apply.

Common in real-world finance.

Disadvantages:

May not reflect different risk levels over time.

Selecting a proper risk premium can be difficult.

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Comparison: Certainty Equivalent vs. RADR

1. Risk Adjustment:
●​ CE: Adjusts cash flows
●​ RADR: Adjusts discount rate

2. Discount Rate Used:

●​ CE: Risk-free rate
●​ RADR: Risk-adjusted rate

3. Risk Flexibility:
●​ CE: Handles year-wise variation
●​ RADR: Same rate for all years

4. Complexity:
●​ CE: More complex
●​ RADR: Simpler

5. Accuracy:
●​ CE: More accurate when risk varies
●​ RADR: Less precise

6. Subjectivity:
●​ CE: Requires CE coefficient
●​ RADR: Requires risk premium

7. Practical Use:
●​ CE: Less common
●​ RADR: More widely used

8. Interpretation:
●​ CE: Focus on converting risk into certainty
●​ RADR: Focus on adjusting return for risk
Responsible Investment, including ESG (Environmental, Social,
Governance) factors.

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Responsible Investment (RI)

Responsible Investment refers to incorporating Environmental, Social, and Governance (ESG)

factors into investment decisions to manage risks and generate long-term sustainable returns. It
moves beyond pure financial analysis by factoring in the broader impact of business practices.

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1. Concept of Responsible Investment

●​ A strategy that aligns financial goals with ethical, social, and environmental values.
●​ Focuses on long-term performance rather than short-term gains.
●​ Supported by global initiatives like the UN Principles for Responsible Investment (UN
PRI).

2. ESG Factors in Responsible Investment

A. Environmental (E):
●​ Covers the company’s impact on the natural world. Key considerations include:
●​ Climate change and carbon emissions
●​ Pollution and waste management
●​ Water and energy efficiency
●​ Biodiversity protection
●​ Renewable energy usage

B. Social (S):
●​ Focuses on a company’s impact on people and communities. Key aspects include:
●​ Labor practices and employee rights
●​ Diversity and inclusion
●​ Human rights policies
●​ Community engagement
●​ Customer satisfaction and data protection
C. Governance (G):
●​ Relates to internal corporate systems and leadership. Key factors include:
●​ Board structure and independence
●​ Executive compensation
●​ Shareholder rights
●​ Transparency and reporting
●​ Ethical business conduct

3. Significance of Responsible Investment

●​ Risk Management: ESG-aware companies tend to be better at managing operational

and reputational risks.
●​ Sustainable Returns: Companies focused on ESG performance often have long-term
financial stability and investor trust.
●​ Regulatory Compliance: Aligns with growing global regulations and stakeholder
expectations.
●​ Brand and Reputation: Positive ESG credentials enhance corporate image and
stakeholder loyalty.

4. Integration of ESG in Investment Decisions

Investors may use various strategies such as:

●​ Negative Screening: Excluding industries like tobacco, weapons, or fossil fuels.

●​ Positive Screening: Investing in companies with strong ESG performance.
●​ ESG Integration: Embedding ESG data directly into financial analysis and valuation.
●​ Impact Investing: Targeting investments that generate measurable social/environmental
impact.
●​ Active Ownership: Using shareholder power to influence ESG practices in companies.

5. Examples of ESG Integration

●​ Investing in a company that uses renewable energy, promotes gender equality, and has
transparent governance.

●​ Avoiding firms with poor environmental records or unethical labor practices.

Conclusion

Responsible Investment with ESG considerations is no longer optional—it is a vital part of

modern portfolio strategy. It helps align ethical responsibility with financial performance,
ensuring long-term value for both investors and society.
Use of Expert Systems in Capital Budgeting Decisions

An Expert System (ES) is a computer-based decision-making tool that simulates the judgment
and behavior of a human expert. In the context of capital budgeting, expert systems are
increasingly used to enhance the quality, consistency, and speed of investment decisions.

1. Concept of Expert System

●​ An Expert System uses a knowledge base and inference engine to analyze data and
provide recommendations.
●​ It mimics human expertise in evaluating investment projects and capital allocation
decisions.

2. Components of an Expert System

1. Knowledge Base:
●​ Stores domain-specific rules, formulas, and procedures used in capital budgeting (e.g.,
NPV, IRR rules).

2. Inference Engine:
●​ Applies logical rules to the knowledge base to derive conclusions or recommend actions.

3. User Interface:
●​ Allows users (managers, analysts) to interact with the system and input data.

4. Explanation Module:
●​ Explains the logic or reasoning behind recommendations, increasing transparency and
trust.

3. Applications in Capital Budgeting

A. Project Evaluation

●​ Evaluates alternative investment projects based on financial and non-financial data.

●​ Applies consistent criteria like NPV, IRR, and risk-adjusted returns.

B. Risk Assessment

●​ Identifies and quantifies project risks using historical data and scenario analysis.
●​ Incorporates uncertainty through AI-based simulations.
●​
C. Decision Support

●​ Provides recommendations on project selection and resource allocation.

●​ Suggests optimal investment strategies using multiple criteria.

D. Sensitivity Analysis

●​ Automatically evaluates how changes in assumptions affect project outcomes.

●​ Helps managers prepare for best-case and worst-case scenarios.

4. Advantages of Using Expert Systems

●​ Consistency: Applies standardized rules, reducing human error or bias.

●​ Speed: Processes complex calculations and scenarios faster than manual analysis.
●​ Data-Driven: Utilizes real-time and historical data for better decision-making.
●​ Scalability: Can evaluate multiple projects across business units simultaneously.
●​ Learning Capability: Some systems integrate AI to improve recommendations over time.

5. Limitations

●​ High Development Cost: Requires time and resources to build a customized system.
●​ Data Dependency: Quality of output depends on the accuracy and availability of data.
●​ Lack of Intuition: May overlook qualitative factors like strategic fit or market trends.
●​ Maintenance: Needs regular updates to remain relevant and accurate.

6. Real-World Example

●​ A multinational company might use an expert system to:

●​ Screen hundreds of proposed capital projects.
●​ Automatically rank them based on ROI, NPV, and risk scores.
●​ Recommend a portfolio mix within the available capital budget.

Conclusion
Expert systems in capital budgeting help organizations make efficient, accurate, and objective
investment decisions. While not a replacement for managerial judgment, they serve as powerful
tools that enhance decision-making quality, especially in complex or large-scale investment
environments.