CAPITAL

BUDGETING
 OVERVIEW
Organizational Responsibility/ Time Duration
Plans Authority
1. Operational Plans Lower Management Short term ≤ 1 yr

2. Tactical Plans Middle Management Medium term 1-5 yrs

3. Strategic Plans Top level Long term ≥ 5 yrs

Management
 CAPITAL BUDGETING
 the process of identifying, evaluating, planning,
and financing capital decision projects of an
organization

2 types of decision made:

1. Financing Decision- judgement regarding the
method of raising capital to fund an investment.
2. Investment Decision- judgement about which
assets to acquire to achieve the company's stated
objectives.
 CHARACTERISTICS OF CAPITAL
INVESTMENT DECISIONS
o Usually require large commitment of resources

o Involve long term commitments

o Are more difficult to reverse than short term

decisions

o Involve so much risk and uncertainty

ADVANTAGES AND DISADVANATGES
 ADVANTAGES
Capital budgeting helps a company to
understand various risks involved in an
investment opportunity and how these risks affect
the returns of the company.
 It helps a company in a competitive market to
choose its investments wisely.
 it allows management to abstain from over
investing and under investing.
ADVANTAGES AND DISADVANATGES
 ADVANTAGES
 All the techniques/methods of capital budgeting
try to increase shareholders wealth and give the
company an edge in the market.
 It helps the company to estimate which
investment option would yield the best possible
return.
 It helps the company to make long-term strategic
investments.
ADVANTAGES AND DISADVANATGES
 DISADVANTAGES
 Most of the times, these techniques are based on
the estimations and assumptions as the future
would always remain uncertain.
 A wrong capital budgeting decision taken can
affect the long term durability of the company and
hence it needs to be done judiciously by
professionals who understands the project well.
 STAGES IN CAPITAL
BUDGETING PROCESS
1. Identification and definition
2. Search for potential investment decisions
3. Information gathering- both quantitative and
qualitative
4. Selection
5. Financing
6. Implementation and monitoring
 TYPES OF CAPITAL
INVESTMENT PROJECTS
1.Independent Projects
 projects that are evaluated individually
 Cash flows of one project are unaffected
by acceptance of other project
 TYPES OF CAPITAL
INVESTMENT PROJECTS
2.Mutually Exclusive Projects
 projects that require company to choose
from among specific alternatives
 Cash flows of one project can be adversely
impacted by the acceptance of other
project.
 CAPITAL INVESTMENT
FACTORS
• Net investment- costs or cash outflows less
cash inflows or savings incidental to the
acquisition of the investment projects

• Cost of Capital- cost of using funds

• Net Returns
 CAPITAL INVESTMENT
DECISIONS MODELS
• Nondiscounting models- ignore the time value of
money
1. Payback Period
2. Accounting Rate of Return
• Discounting models- explicitly consider the time
value of money
1. Net Present Value
2. Internal rate of return
 PAYBACK PERIOD
ADVANTAGES
 Payback is easy to compute an easy to
understand. There is no need to compute or
consider any interest rate
 Payback gives information about project’s
liquidity
 It is a good surrogate for risk. A quick
payback period indicates a less risky
project.
 PAYBACK PERIOD
DISADVANTAGES
Payback Period does not consider Time value of
money
It gives more emphasis on liquidity rather than
profitability.
It does not consider the salvage value of the
project
It ignores the cash flows that may occur after the
payback period.
 ACCOUNTING RATE OF
RETURN
ADVANTAGES
 It closely parallels accounting concepts of income
measurement and investment return
 It facilitates re-evaluation of projects due to the
ready availability of data from accounting records
 This method considers income over the entire life
of the project.
 It indicates the project’s profitability
 ACCOUNTING RATE OF
RETURN
DISADVANTAGES
 It does not consider the time value of money

 With the computation of book value and income

based on historical cost accounting data, the
effect of inflation is ignored.
 NET PRESENT VALUE
ADVANTAGES
 Emphasizes cash flows
 Recognizes the time value of money
Assumes discount rates as the reinvestment
rates
 Easy to apply
 NET PRESENT VALUE
DISADVANTAGES
 It requires predetermination of the cost of
capital or the discount rate to be used

 The NPV of different competing projects may not

be comparable because of differences in
magnitude or sizes of the project
INTERNAL RATE OF RETURN
ADVANTAGES
 Emphasizes cash flows

 Recognizes the time value of money

 Computes the true return of the project

INTERNAL RATE OF RETURN
DISADVANTAGES
 Assumes the IRR to be re-investment rate

 When the project includes earnings during their

economic life, different rates of return may
result.