Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital budgeting usually involves the calculation of each project's future ACCOUNTING profit by period, the cash flow by period, the present value of the CASH FLOWS after considering the time value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and other factors. Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time.

1. CAPITALCAPITAL
BUDGETINGBUDGETING
Capital Budgeting TechniquesCapital Budgeting Techniques

2. CHAPTER FOCUSCHAPTER FOCUS
 PROCESS OFPROCESS OF DECISION MAKINGDECISION MAKING
WITH RESPECT TO INVESTMENT INWITH RESPECT TO INVESTMENT IN
FIXED ASSETSFIXED ASSETS- PROPOSED- PROPOSED
PROJECT BE ACCEPTED ORPROJECT BE ACCEPTED OR
REJECTED?REJECTED?
 THIS PROCESS IS KNOWN ASTHIS PROCESS IS KNOWN AS
CAPITAL BUDGETINGCAPITAL BUDGETING

3. CAPITAL BUDGETINGCAPITAL BUDGETING
 C.B . MAY BE DEFINED AS THE DECISIONC.B . MAY BE DEFINED AS THE DECISION
MAKING PROCESS BY WHICHMAKING PROCESS BY WHICH A FIRMA FIRM
EVALUATES THE PURCHASE OF MAJOREVALUATES THE PURCHASE OF MAJOR
FIXED ASSETS.FIXED ASSETS.
 IT DEALS EXCLUSIVELY WITH MAJORIT DEALS EXCLUSIVELY WITH MAJOR
INVESTMENT PROPOSALS WHICH AREINVESTMENT PROPOSALS WHICH ARE
ESSENTIALLY LONG TERM PROJECTSESSENTIALLY LONG TERM PROJECTS
AND IS CONCERNED WITH THEAND IS CONCERNED WITH THE
ALLOCATION OF FIRM’S SCARCEALLOCATION OF FIRM’S SCARCE
FINANCIAL RESOURCES AMONG THEFINANCIAL RESOURCES AMONG THE
AVAILABLE MARKET OPPORTUNITIESAVAILABLE MARKET OPPORTUNITIES

4. THREE ASPECTS OFTHREE ASPECTS OF
C.BUDGETINGC.BUDGETING
 1.1.IT RANKS VARIOUS PROPOSALSIT RANKS VARIOUS PROPOSALS BYBY
MEASURING THEIR PROFITABILITYMEASURING THEIR PROFITABILITY
 2.2.REJECTION OR ACCEPTANCE OFREJECTION OR ACCEPTANCE OF
THE PROJECTTHE PROJECT BASED ON THEBASED ON THE
“CUTOFF POINT”“CUTOFF POINT”
 3.3.TOTAL VOLUME OF INVESTMENTTOTAL VOLUME OF INVESTMENT

5. RATIONALE OF CAPITALRATIONALE OF CAPITAL
BUDGETINGBUDGETING
 1.CAPITAL INVESTMENT –1.CAPITAL INVESTMENT – COMMITMENTCOMMITMENT
TO FUTURETO FUTURE- FINANCIAL FLEXIBILITY- FINANCIAL FLEXIBILITY
 2.ASSET EXPANSION IS RELATED TO2.ASSET EXPANSION IS RELATED TO
FUTURE SALES- ANFUTURE SALES- AN ERRONEOUSERRONEOUS
FORECASTFORECAST OF ASSET NEEDS CANOF ASSET NEEDS CAN
RESULT TORESULT TO OVERINVESTMENT OR UNDEROVERINVESTMENT OR UNDER
INVESTMENT IN FIXED ASSETINVESTMENT IN FIXED ASSET
 3.PROPER C.B.WOULD LEAD TO3.PROPER C.B.WOULD LEAD TO BETTERBETTER
TIMING OF ASSETS ACQUISITIONTIMING OF ASSETS ACQUISITION
 4.4.FUND PLANNING CAN BE DONEFUND PLANNING CAN BE DONE

6. FACTORS TO BEFACTORS TO BE
CONSIDERED IN C.BCONSIDERED IN C.B
 1.1. ALL ESTIMATED CASH COSTSALL ESTIMATED CASH COSTS
 2.SAVINGS IN MATERIAL COSTS2.SAVINGS IN MATERIAL COSTS
 3.3.REDUCTION IN SCRAPSREDUCTION IN SCRAPS
 4.CHANGES IN DIRECT LABOUR4.CHANGES IN DIRECT LABOUR
,MATERIALS,HANDLING, INSPECTION,MATERIALS,HANDLING, INSPECTION
 5.5.ANTICIPATED INCREASE OR DECREASEANTICIPATED INCREASE OR DECREASE
IN SPECIFIC OVERHEAD COSTS,SUCH ASIN SPECIFIC OVERHEAD COSTS,SUCH AS
TAXES,INSURANCE,POWERTAXES,INSURANCE,POWER
,MAINTENANCE ,REPAIRS,SUPPLIES ETC.,MAINTENANCE ,REPAIRS,SUPPLIES ETC.

7. METHODS OFMETHODS OF
INVESTMENTINVESTMENT
APPRAISALAPPRAISAL
 1.PAYBACK PERIOD1.PAYBACK PERIOD
 2.AVERAGE RATE OF RETURN METHOD2.AVERAGE RATE OF RETURN METHOD
 4.TIME VALUE OF MONEY (DISCOUNTED CASH4.TIME VALUE OF MONEY (DISCOUNTED CASH
FLOW METHOD)FLOW METHOD)
 A. DISCOUNTED PAY BACK METHODA. DISCOUNTED PAY BACK METHOD
 B. NET PRESENT VALUE METHODB. NET PRESENT VALUE METHOD
 C. MODIFIED / ADJUSTED NPVC. MODIFIED / ADJUSTED NPV
 D.IRRD.IRR
 E. MIRRE. MIRR
 F. ANNUAL CAPITAL CHARGEF. ANNUAL CAPITAL CHARGE


8. PAYBACK METHODPAYBACK METHOD
 THE P.B PERIOD IS DEFINED AS THETHE P.B PERIOD IS DEFINED AS THE
LENGTH OF TIME REQUIRED FORLENGTH OF TIME REQUIRED FOR
THE STREAM OF CASH RECEIPTSTHE STREAM OF CASH RECEIPTS
PRODUCED BY AN INVESTMENT TOPRODUCED BY AN INVESTMENT TO
EQUAL CASH OUTLAY REQUIREDEQUAL CASH OUTLAY REQUIRED
BY THE INVESTMENTBY THE INVESTMENT

9. PAYBACK PERIODPAYBACK PERIOD
 EVEN EARNINGSEVEN EARNINGS
 P.B PERIOD = INVESTMENTP.B PERIOD = INVESTMENT
 ------------------------------------------------
NET ANNUAL CASH FLOWNET ANNUAL CASH FLOW
 NACF= ANNUAL EARNINGS AFTER TAX BUTNACF= ANNUAL EARNINGS AFTER TAX BUT
BEFORE DEPRECIATIONBEFORE DEPRECIATION
 LOW P.B.PERIOD PROJECT WILL BE SELECTEDLOW P.B.PERIOD PROJECT WILL BE SELECTED

10. AVERAGE RATE OFAVERAGE RATE OF
RETURN METHODRETURN METHOD
 ARR = NET PROFIT AFTER TAXARR = NET PROFIT AFTER TAX
 ---------------------------------- X 100---------------------------------- X 100
 INVESTMENT OR AVERAGEINVESTMENT OR AVERAGE
INVESTMENTINVESTMENT

11. TIME VALUE OFTIME VALUE OF
MONEYMONEY
 ONE DOLLAR OF TODAY IS NOTONE DOLLAR OF TODAY IS NOT
EQUAL TO ONE DOLLAR OFEQUAL TO ONE DOLLAR OF
TOMORROW.TOMORROW.
 HENCE, ALL FUTURE CASH FLOWSHENCE, ALL FUTURE CASH FLOWS
MUST BE DISCOUNTED TO EQUATEMUST BE DISCOUNTED TO EQUATE
THE FUTURE VALUE TO THETHE FUTURE VALUE TO THE
PRESENT VALUE OF INVESTMENTPRESENT VALUE OF INVESTMENT

12. DISCOUNTEDDISCOUNTED
PAYBACK PERIODPAYBACK PERIOD
 IT IS THE PERIOD WHERE THEIT IS THE PERIOD WHERE THE
DISCOUNTED FUTURE CASHDISCOUNTED FUTURE CASH
INFLOWS EQUATE THE INVESTMENTINFLOWS EQUATE THE INVESTMENT

13. NET PRESENT VALUENET PRESENT VALUE
 THE NPV OF AN INVESTMENTTHE NPV OF AN INVESTMENT
PROPOSAL IS EQUAL TO THEPROPOSAL IS EQUAL TO THE
PRESENT VALUE OF ITS ANNUALPRESENT VALUE OF ITS ANNUAL
AFTER TAX NET CASH INFLOWSAFTER TAX NET CASH INFLOWS
LESS THE INVESTMENT’S INITIALLESS THE INVESTMENT’S INITIAL
OUTLAYOUTLAY
 NPV IS GREATER THAN OR EQUALNPV IS GREATER THAN OR EQUAL
TO ZERO THE PROJECT ISTO ZERO THE PROJECT IS
ACCEPTEDACCEPTED

14. INTERNAL RATE OFINTERNAL RATE OF
RETURNRETURN
 IT IS DEFINED AS THE DISCOUNTIT IS DEFINED AS THE DISCOUNT
RATE THAT EQUATES THE PRESENTRATE THAT EQUATES THE PRESENT
VALUE OF THE PROJECT’S FUTUREVALUE OF THE PROJECT’S FUTURE
NET CASH FLOWS WITH THENET CASH FLOWS WITH THE
PROJECT’S INITIAL CASH OUTLAYPROJECT’S INITIAL CASH OUTLAY

15. METHOD TO IDENTIFYMETHOD TO IDENTIFY
THE DISCOUNT RATETHE DISCOUNT RATE
 I . IF THE CASH INFLOWS ARE EVENI . IF THE CASH INFLOWS ARE EVEN
 STEPSSTEPS
 1. IDENTIFY THE FACTOR1. IDENTIFY THE FACTOR
 FACTOR= INVESTMENTFACTOR= INVESTMENT
 ----------------------------------------------
 ANNUAL CASH INFLOWSANNUAL CASH INFLOWS

16. METHOD TO IDENTIFYMETHOD TO IDENTIFY
DISCOUNT RATEDISCOUNT RATE
 STEPSSTEPS
 2. USE PRESENT VALUE TABLE 1 TO2. USE PRESENT VALUE TABLE 1 TO
IDENTIFY TWO VALUES WHICH ISIDENTIFY TWO VALUES WHICH IS
VERY CLOSE TO THE FACTORVERY CLOSE TO THE FACTOR
CORRESPONDING TO THE LIFE OFCORRESPONDING TO THE LIFE OF
THE ASSETTHE ASSET
 3. MAKE AN INTERPOLATION TO3. MAKE AN INTERPOLATION TO
ARRIVE THE DISCOUNT RATEARRIVE THE DISCOUNT RATE

17. METHOD TO IDENTIFYMETHOD TO IDENTIFY
THE DISCOUNT RATETHE DISCOUNT RATE
 II. IF THE CASH INFLOWS ARE UNEVENII. IF THE CASH INFLOWS ARE UNEVEN
 STEPSSTEPS
 1.IDENTIFY THE FACTOR AND THE1.IDENTIFY THE FACTOR AND THE
DISCOUNT RATE THROUGH TRIAL ANDDISCOUNT RATE THROUGH TRIAL AND
ERROR METHOD ( USE P.V.TABLE 1)ERROR METHOD ( USE P.V.TABLE 1)
 FACTOR= INVESTMENTFACTOR= INVESTMENT
 --------------------------------------------
 AVERAGE CASH INFLOWSAVERAGE CASH INFLOWS

18. METHODS……METHODS……
 2.A DISCOUNT RATE NEAR TO THE2.A DISCOUNT RATE NEAR TO THE
FACTOR IS LOCATEDFACTOR IS LOCATED
 3. USE P.V.TABLE 2 TO DISCOUNT THE3. USE P.V.TABLE 2 TO DISCOUNT THE
CASH INFLOWSCASH INFLOWS
 4.TWO PRESENT VALUES- ONE JUST4.TWO PRESENT VALUES- ONE JUST
ABOVE THE ORIGINAL INVESTMENT ANDABOVE THE ORIGINAL INVESTMENT AND
ONE JUST BELOW THE ORIGINALONE JUST BELOW THE ORIGINAL
INVESTMENT IS CALCULATED .INVESTMENT IS CALCULATED .
 5.THROUGH INTERPOLATION THE5.THROUGH INTERPOLATION THE
DISCOUNT RATE IS OBTAINEDDISCOUNT RATE IS OBTAINED

19. PROFITABILITY INDEXPROFITABILITY INDEX
(BENEFIT /COST RATIO)(BENEFIT /COST RATIO)
 THE PI IS THE RATIO OF THE PRESENT VALUE OF THETHE PI IS THE RATIO OF THE PRESENT VALUE OF THE
FUTURE NET CASH FLOW S TO THE INITIAL OUTLAYFUTURE NET CASH FLOW S TO THE INITIAL OUTLAY
 Benefit cost ratio= Total present value of cash in flowBenefit cost ratio= Total present value of cash in flow
 ------------------------------------------------------------------------------------------
 InvestmentInvestment
 IF THE BCR IS GREATER THAN OR EQUAL TO ONE THEIF THE BCR IS GREATER THAN OR EQUAL TO ONE THE
PROJECT IS ACCEPTEDPROJECT IS ACCEPTED

20. Net Benefit cost ratioNet Benefit cost ratio
 NBCR = NPV / InvestmentNBCR = NPV / Investment
 The project which gives the highestThe project which gives the highest
NBCR will be selected ( Per dollar return)NBCR will be selected ( Per dollar return)

21. Modified NPV andModified NPV and
Modified IRR ( MIRR)Modified IRR ( MIRR)
 The NPV calculation is based on the assumption thatThe NPV calculation is based on the assumption that
cash inflows can be reinvested at the project’s riskcash inflows can be reinvested at the project’s risk
adjusted Weighted Average Cost of Capital , whereasadjusted Weighted Average Cost of Capital , whereas
IRR is calculated based on the assumption that theIRR is calculated based on the assumption that the
cash inflows are reinvested at the IRR. But thiscash inflows are reinvested at the IRR. But this
assumption is may not be true always. In such cases ,assumption is may not be true always. In such cases ,
the project decision will be based on Modified NPV orthe project decision will be based on Modified NPV or
Modified IRR. ( DISCOUNTING RATE ANDModified IRR. ( DISCOUNTING RATE AND
REINVESTMENT RATES ARE DIFFERENT)REINVESTMENT RATES ARE DIFFERENT)


22. NPV ProfileNPV Profile
 NPV at number of different discount ratesNPV at number of different discount rates
and then plot those values to create aand then plot those values to create a
graph. Some times NPV and IRRgraph. Some times NPV and IRR
methods produce conflicting results ,methods produce conflicting results ,
then we can make use of NPV profiles tothen we can make use of NPV profiles to
decide the selection of the project.decide the selection of the project.

23. Cross-over point orCross-over point or
raterate
 The cost of capital at which the NPVThe cost of capital at which the NPV
profiles of two projects cross ( intersect)profiles of two projects cross ( intersect)
and thus, at which the project’s NPV’sand thus, at which the project’s NPV’s
are equal. That point is known as cross-are equal. That point is known as cross-
over point.over point.

24. NPV and IRR of two projects giveNPV and IRR of two projects give
conflicting resultsconflicting results
 If NPV and IRR of two projects give conflictingIf NPV and IRR of two projects give conflicting
result , then decision will be based onresult , then decision will be based on
incremental cash flows and the resultantincremental cash flows and the resultant
incremental IRR.incremental IRR.
 If incremental IRR is greater than the cost ofIf incremental IRR is greater than the cost of
capital , the project with highest NPV will becapital , the project with highest NPV will be
selected.selected.
 If incremental IRR is less than the cost ofIf incremental IRR is less than the cost of
capital , then the project with highest IRR iscapital , then the project with highest IRR is
selected.selected.