Unit 3: Investment Decision – Capital

Budgeting
Long term and short term investment decisions - capital
budgeting - importance – procedure - Factors
Determining Capital Budgeting - Steps in Capital
Budgeting - Methods of capital budgeting - payback
period: Meaning, Advantages & Disadvantages – It’s
Applicability (Problems) - Accounting rate of return -
Meaning, Advantages & Disadvantages – It’s
Applicability (Problems) - Net present value &
profitability index - Meaning,
• Advantages &Disadvantages – It’s Applicability
(Problems) - Internal rate of return - Meaning,
Advantages & Disadvantages – It’s Applicability
(Problems) - Problems in capital budgeting
 Capital Budgeting
• The term Capital Budgeting refers to the long-term
planning for proposed capital outlays or
expenditure for the purpose of maximizing return
on investments. The capital expenditure may be :
– (1) Cost of mechanization, automation and replacement.
– (2) Cost of acquisition of fixed assets. e.g., land, building
and machinery etc.
– (3) Investment on research and development.
– (4) Cost of development and expansion of existing and
new projects.
 DEFINITION OF CAPITAL BUDGETING
• Capital Budget is also known as "Investment
Decision Making” or “Capital Expenditure
Decisions" or "Planning Capital Expenditure" etc.
• Charles T. Horngnen has defined capital budgeting
as "Capital Budgeting is long term planning for
making and financing proposed capital outlays.“
• Hamption, John, - "Capital budgeting is concerned
with the firm's formal process for the acquisition
and investment of capital."
 Importance of Capital Budgeting

Capital budgeting is important because of the following

reasons :
• (1) Capital budgeting decisions involve long-term implication
for the firm, and influence its risk complexion.
• (2) Capital budgeting involves commitment of large amount
of funds.
• (3) Capital decisions are required to assessment of future
events which are uncertain.
• (4) Wrong sale forecast ; may lead to over or under
investment of resources.
• (5) In most cases, capital budgeting decisions are irreversible.
This is because it is very difficult to find a market for the
capital goods. The only alternative available is to scrap the
asset, and incur heavy loss.
• (6) Capital budgeting ensures the selection of
right source of finance at the right time.
• (7) Many firms fail, because they have too
much or too little capital equipment.
• (8) Investment decision taken by individual
concern is of national importance because it
determines employment, economic activities
and economic growth.
 Objectives of Capital Budgeting
• The following are the .important objectives of
capital budgeting:
• (1) To ensure the selection of the possible
profitable capital projects.
• (2) To ensure the effective control of capital
expenditure in order to achieve by forecasting
the long-term financial requirements.
• (3) To make estimation of capital expenditure
during the budget period and to see that the
benefits and costs may be measured in terms of
cash flow.
• (4) Determining the required quantum takes
place as per authorization and sanctions.
• (5) To facilitate co-ordination of inter-
departmental project funds among the
competing capital projects.
• (6) To ensure maximization of profit by
allocating the available investible.
 Principles or Factors of Capital Budgeting
Decisions
• (1) A careful estimate of the amount to be invested.
• (2) Creative search for profitable opportunities.
• (3) A careful estimates of revenues to be earned and
costs to be incurred in future in respect of the project
under consideration.
• (4) A listing and consideration of non-monetary
factors influencing the decisions.
• (5) Evaluation of various proposals in order of priority
having regard to the amount available for investment.
• (6) Proposals should be controlled in order to avoid
costly delays and cost over-runs.
• (7) Evaluation of actual results achieved against those
budget.
• (8) Care should be taken to think all the implication of
long range capital investment and working capital
requirements.
• (9) It should recognize the fact that bigger benefits are
preferable to smaller ones and early benefits are
preferable to latter benefits.
 Capital Budgeting Process
The following procedure may be considered in the
process of capital budgeting decisions :
• (1) Identification of profitable investment proposals.
• (2) Screening and selection of right proposals.
• (3) Evaluation of measures of investment worth on the
basis of profitability and uncertainty or risk.
• (4) Establishing priorities, i.e., uneconomical or
unprofitable proposals may be rejected.
• (5) Final approval and preparation of capital expenditure
budget.
• (6) Implementing proposal, i.e., project execution.
• (7) Review the performance of projects.
 Types of Capital Expenditure
Capital Expenditure can be of two types :
• (1) Capital expenditure increases revenue.
• (2) Capital expenditure reduces costs.
– Capital Expenditure Increases Revenue: It is the
expenditure which brings more revenue to the firm either
by expanding the existing production facilities or
development of new production line.
– Capital Expenditure Reduces Costs: Such a capital
expenditure reduces the cost of present product and
thereby increases the profitability of existing operations. It
can be done by replacement of old machine by a new one.
 Types of Capital Budgeting Proposals
• A firm may have several investment proposals for
its consideration. It may adopt after considering
the merits and demerits of each one of them. For
this purpose capital expenditure proposals may
be classified into :
• (1) Independent Proposals
• (2) Dependent Proposals or Contingent Proposals
• (3) Mutually Excusive Proposals
• (1) Independent Proposals: These proposals
are said be to economically independent
which are accepted or rejected on the basis of
minimum return on investment required.
Independent proposals do not depend upon
each other.
• (2) Dependent Proposals or Contingent
Proposals: In this case, when the acceptance
of one proposal is contingent upon the
acceptance of other proposals. it is called as
"Dependent or Contingent Proposals." For
example, construction of new building on
account of installation of new plant and
machinery.
• (3) Mutually Exclusive Proposals: Mutually
Exclusive Proposals refer to the acceptance of
one proposal results in the automatic
rejection of the other proposal. Then the two
investments are mutually exclusive. In other
words, one can be rejected and the other can
be accepted. It is easier for a firm to take
capital budgeting decisions on such projects.
 Methods of Evaluating Capital Investment
Proposals
• A. Traditional Methods:
– Traditional methods are grouped in to the following :
• (1) Pay-back period method or Payout method.
• (2) Improvement of Traditional Approach to Pay-back
Period Method.
– (a) Post Pay-back profitability Method.
– (b) Discounted Pay-back Period Method.
– (c) Reciprocal Pay-back Period Method.
• (3) Rate of Return Method or Accounting Rate of
Return Method.
• B. Time Adjusted Method or Discounted Cash
Flow Method
– Time Adjusted Method further classified into:
• (1) Net Present Value Method.
• (2) Internal Rate of Return Method.
• (3) Profitability Index Method.
 A. Traditional Methods
(1) Pay-back Period Method :
• Pay-back period is also termed as "Pay-out
period" or Pay-off period.
• It is defined as the number of years required
to recover the initial investment in full with
the help of the stream of annual cash flows
generated by the project.
• In the case of constant annual cash inflows : If
the project generates constant cash flow the
• Pay-back period can be computed by dividing
cash outlays (original investment) by annual
cash inflows.
• The following formula can be used to
ascertain pay-back period :
• (b) In the case of Uneven or Unequal Cash
Inflows:
• In the case of uneven or unequal cash inflows,
the Pay-back period is determined with the
help of cumulative cash inflow. It can be
calculated by adding up the cash inflows until
the total is equal to the initial investment.
 Accept or Reject Criterion
• Among the mutually exclusive or alternative
projects whose pay-back periods are lower
than the cut off period. The project would be
accepted. if not it would be rejected.
 Post Pay-back Profitability Method:
• One of the limitations of the pay-back period method is that it ignores the
post pay-back returns of project.
• To rectify the defect, post pay-back period method considers the amount
of profits earned after the pay-back period. This method is also known as
Surplus Life Over Payback Method.
• According to this method, pay-back profitability is calculated by annual
cash inflows in each of the year, after the pay-back period. This can be
expressed in percentage of investment.
 Average Rate of Return Method (ARR) or
Accounting Rate of Return Method:
• This method focuses on the average net income generated in
a project in relation to the project's average investment
outlay. This method involves accounting profits not cash flows
and is similar to the performance measure of return on capital
employed. The average rate of return. can be determined by
the following equation:
 Net Present Value Method (NPV) :
• This is one of the Discounted Cash Flow technique which explicitly
recognizes the time value of money. In this method all cash inflows and
outflows are converted into present value (i.e., value at the present time)
applying an appropriate rate of interest (usually cost of capital).
 Profitability Index Method
• Profitability Index is also known as Benefit Cost Ratio. It gives the present
value of future benefits, computed at the required rate of return on the
initial investment. Profitability Index may either be Gross Profitability
Index or Net Profitability Index. Net Profitability Index is the Gross
Profitability Index minus one. The Profitability Index can be calculated by
the following equation:
 Internal Rate of Return Method (IRR) :
• Internal Rate of Return Method is also called as "Time
Adjusted Rate of Return Method." It is defined as the rate
which equates the present value of each cash inflows with the
present value of cash outflows of an investment. In other
words, it is the rate at which the net present value of the
investment is zero.
• Internal Rate of Return (IRR) is the discount rate at which net
present value of the project becomes zero. Higher IRR should
be preferred.
 Cash Flows
• Incoming/Outgoing of Money from the
operating activities of Business.
• In context of capital budgeting cash flows
refers to the revenue to the revenue
generated from the investment proposal after
deducting relevant expenses.
Initial Investment/Cash Outlay/Cash Outflow

Opport- Additional Initial

Cost of Working
unity Invest
Asset Capital
Cost ment
 Steps in calculation of Initial Investment/Cash Outlay
Particulars Amount
Cost of Asset XXXX

ADD: Installation, Insurance, Transportation, XX

Duties and Financing Cost
ADD: Opportunity Cost XX

ADD: Additional Working Capital XX

  XXXX

LESS: Scrap Value (only in case of replacement XX

decisions)
Initial Investment/Cash Outlay XXXX
 Net Annual Cash Inflows/Operating cash Flows
Revenue Increasing Investment Proposals
Particulars Amount
Sales Revenue XXXX
LESS: Expenses (Fixed and Variable) XX
Cash Flow before Depreciation and Tax
(CFBDT) XXX
LESS: Depreciation XXXX
Cash Flow after Depreciation and before Tax
(CFADBT) XX
LESS: Tax XXXX
Cash Flow after Depreciation and Tax (CFBDT) XX
ADD: Depreciation XXX
Net Annual Cash-flows or CFBDAT XXXX
NCF = Sales - Expenses - Dep - Tax + Dep
 
 For Cost Reduction Investment Proposals
Particulars Amount
I. Estimated Savings
a. Savings on A/C of decrease in Wages XXXX
b. Savings from sale of Scrap
(A) Total Savings XXXX
II. Estimated Additional Costs
a. Additional cost of Maintenance
b. Additional cost of Supervision XXXX
c. Additional cost of Depreciation
d. Cost of Indirect Material
(B) Total Additional Costs XXXX
Net Savings before Tax (A-B) XXXX
LESS: Income Tax XX
Net Savings after Tax XXXX
ADD: Depreciation XXXX
Net Savings after Tax/Cash Flows XXXX
 Pay Back Period
• Merits
– Easy to Calculate and simple to understand
– Emphasis on early return of amount invested
– Risk can be minimised by setting a lower payback
period
– Cost effective in terms of calculation
• Demerits
– Ignores time value of money
– Ignores the annual cash inflows after the payback
period
– Emphasis on liquidity and ignores profitability
– Overlooks the cost of capital i.e. interest factor if the
investment is made from borrowed funds
– Does not consider the magnitude and timing of cash
flow
– It does not take into account salvage value of asset
• Accept /Reject criteria
– If the actual pay-back period is less than the
predetermined pay-back period, the project would
be accepted. If not, it would be rejected.
 Post Pay back period
• One of the major limitations of pay-back
period method is that it does not consider the
cash inflows earned after pay-back period and
if the real profitability of the project cannot be
assessed. To improve over this method, it can
be made by considering the receivable after
the pay-back period. These returns are called
post pay-back profits.
Accounting Rate of Return or Average Rate
of Return
• Merits
– It is easy to calculate and simple to understand.
– It is based on the accounting information rather
than cash inflow.
– It is not based on the time value of money.
– It considers the total benefits associated with the
project.
• Demerits
– It ignores the time value of money.
– It ignores the reinvestment potential of a project.
– Different methods are used for accounting profit.
So, it leads to some difficulties in the calculation of
the project.
– It uses accounting figures which can be affected by
judgment, accounting policies and non cash
items(depreciation).
• Accept/Reject criteria
– If the actual accounting rate of return is more than
the predetermined required rate of return, the
project would be accepted. If not it would be
rejected.
 Net Present Value
• Merits
– It recognizes the time value of money.
– It considers the total benefits arising out of the
proposal.
– It is the best method for the selection of mutually
exclusive projects.
– It helps to achieve the maximization of
shareholders’ wealth.
• Demerits
– It is difficult to understand and calculate.
– It needs the discount factors for calculation of
present values.
– It is not suitable for the projects having different
effective lives.
• Accept/Reject criteria
– If the present value of cash inflows is more than
the present value of cash outflows, it would be
accepted. If not, it would be rejected.
 Internal Rate of Return
• Merits
– It consider the time value of money.
– It takes into account the total cash inflow and
outflow.
– It does not use the concept of the required rate of
return.
– It gives the approximate/nearest rate of return.
• Demerits
– It involves complicated computational method.
– It produces multiple rates which may be confusing
for taking decisions.
– It is assume that all intermediate cash flows are
reinvested at the internal rate of return.
• Accept/Reject criteria
– If the present value of the sum total of the
compounded reinvested cash flows is greater than
the present value of the outflows, the proposed
project is accepted. If not it would be rejected.
 Profitability Index
• Merits
– The time value of money is taken into consideration
– Considers cash flows generated from investment
proposal throughout its entire life
– Indicated whether investment proposal increases or
decreases the firms value
– Considers the risk involved in future cash flows with
the help of cost of capital
– Ascertains the exact rate of return of the investment
proposal
• Demerits
– Decisions made out of profitability index do not
show which of the mutually exclusive proposal has
a shorter return duration
– It is difficult to understand and accurately estimate
cost of capital or discount rate
• Accept/Reject criteria
– If PI > 1 accepted or else rejected
Key Considerations in Capital Budgeting Calculations
Calculations of cash flows and terminologies
 Cases
• http://news.webindia123.com/news/articles/i
ndia/20120530/1994885.html
• http://www.businesstoday.in/current/corporat
e/sahara-enters-retail-to-launch-800-q-shops/
story/187143.html
Need and Importance of Capital Budgeting

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.
CAPITAL BUDGETING PROCESS
FACTORS AFFECTING CAPITAL BUDGETING:

1. Availability of Funds: All the projects are not requiring the

same level of investments. Some projects require huge
amount and having high profitability. If the company does
not have adequate funds, such projects may be given up.
2. Minimum Rate of Return on Investment: Every
management expects a minimum rate of return or cut-off
rate on capital investment. It refers to the point of below
which a project would not be accepted.
3. Future Earnings: The future earnings may be uniform or
fluctuating. Even though, the company expects guaranteed
future earnings in total which affects the choice of a
project.
4. Quantum of Profit Expected: It is necessary to assess the
quantum of profit expected on implementation of
selected project. Here, the term profit refers to realized
amount of projects as per the accounting records.
5. Cash Inflows: The term cash inflows refers to profit after
tax but before depreciation. The reason is that recording
of depreciation is a book entry and there is no actual cash
outflow. Hence, depreciation amount is included in the
cash inflow.
6. Legal Compulsions: The management should consider
the legal provisions while-selecting a project. In the case
of leather and chemical industries, there are number of
legal provisions created to protect environment pollution.
Now, the management gives much importance to legal
provisions rather than cost and profit.
7. Ranking of the Capital Investment Proposal: Sometimes, a
company has two or more profitable projects in hand. If
there is only one profitable project out of many and huge
amount is available in the hands of management, there is
no need of ranking of capital investment proposal. Ranking
is necessary if there is many profitable projects in hand and
limited funds is available in the hands of management.
8. Degree of Risk and Uncertainty: Every proposal involves
certain risk and uncertainty due to economic conditions,
competition, demand and supply conditions, consumer
preferences etc. The degree of risk and uncertainty affects
the profitability of the project. Hence, degree of risk and
uncertainty of the project is taken into consideration for
selection.
9. Urgency: A project may be selected immediately due
to emergency or urgency. The reason is that such
immediate selection saves the life of the company i.e.
survival of a company is the primary importance than
other factors.
10. Research and Development Projects: Research and
Development project is highly required for technology
based industries. The reason is that there is a lot of
changes made within short period in technology. The
research and development project gives more benefits
in the long run. Hence, profitability is getting less
importance and survival of business is getting much
importance in the case of research and development
project.
11. Obsolescence: The replacement of existing fixed
assets is compulsory since there is an obsolescence of
plant and machinery.
12. Competitors Activities: Every company should
watch the activities of the competitors. The company
should take a decision by considering the activities of
the competitors. If so, the company can withstand in
competition by implementing new projects.
13. Intangible Factors: Goodwill of the company,
industries relations, safety and welfare of the
employees are considered while selecting a project
instead of considering profit alone. These factors are
also high responsible for selection of any project.
 Features of Capital Budgeting
• The features of capital budgeting are briefly explained below:
1. Capital budgeting involves the investment of funds currently for
getting benefits in the future.
2. Generally, the future benefits are spread over several years.
3. The long term investment is fixed.
4. The investments made in the project is determining the
financial condition of business organization in future.
5. Each project involves huge amount of funds.
6. Capital expenditure decisions are irreversible.
7. The profitability of the business concern is based on the
quantum of investments made in the project.