The process through which different projects are evaluated is known as capital budgeting. Capital budgeting is defined ―as the firm‘s formal process for the acquisition and investment of capital. It involves firm‘s decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets‖.

―Capital budgeting is long term planning for making and financing proposed capital outlays‖

―Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern‖- Lynch.

The main features of capital budgeting are

  1. potentially large anticipated benefits
  2. a relatively high degree of risk
  3. the relatively long time period between the initial outlay and the anticipated return.

Significance of capital budgeting

  • The success and failure of business mainly depends on how the available resources are being utilized.
  • It‘s a main tool of financial management.
  • All types of capital budgeting decisions are exposed to risk and uncertainty.
  • They are irreversible in nature
  • Capital rationing gives sufficient scope for the financial manager to evaluate different proposals and only viable
  • project must be taken up for investments.
  • Capital budgeting offers effective control on cost of capital expenditure It helps the management to avoid
  • over investment and under investments.

Capital budgeting process involves the following

Project generation: Generating the proposals for investment is the first

  • The investment proposal may fall into one of the following categories:
  • Proposals to add new product to the product line,
  • proposals to expand production capacity in existing lines
  • proposals to reduce the costs of the output of the existing products without altering the scale of operation.

No standard administrative procedure can be laid down for approving the investment proposal. The       screening and selection procedures are different from firm to firm              

Project Evaluation: It involves two steps

1. Estimation of benefits and costs: the benefits and costs are

Once the proposal for capital expenditure is finalized, it is the duty of the finance manager to explore the different alternatives available for acquiring the funds. He has to prepare capital budget. Sufficient care must be taken to reduce the average cost of funds. He has to prepare periodical reports and must seek prior permission from the top management. Systematic procedure should be developed to review the performance of projects during their lifetime and after completion.

The follow up, comparison of actual performance with original estimates not only ensures better forecasting but also helps in sharpening the techniques for improving future forecasts.

2. Selection of appropriate criteria to judge the desirability of the project: It must be consistent with the firm‘s objective of maximizing its market value. The technique of time value of money may come as a handy tool in evaluation such proposals.

Factors influencing capital budgeting

  • Availability of funds
  • Structure of capital
  • Taxation policy
  • Government policy
  • Lending policies of financial institutions
  • Immediate need of the project
  • Earnings
  • Capital return
  • Economical value of the project
  • Working capital
  • Accounting practice
  • Trend of earnings

Methods of capital budgeting Traditional methods

  • Payback period
  • Accounting rate of return method

Discounted cash flow methods

  • Net present value method
  • Profitability index method
  • Internal rate of return method (IRR)

Merits of IRR

‘It considers the time value of money. Calculation of cost of capital is not a prerequisite for adopting IRR. IRR attempts to find the maximum rate of interest at which funds invested in the project could be repaid out of the cash inflows arising from the project. It is not in conflict with the concept of maximizing the welfare of the equity shareholders.

It considers cash inflows throughout the life of the project.

Cons

  • Computation of IRR is tedious and difficult to understand
  • Both NPV and IRR assume that the cash inflows can be reinvested at the discounting rate in the new However, reinvestment of funds at the cut off rate is more appropriate than at the IRR.
  • IT may give results inconsistent with NPV method.
  • This is especially true in case of mutually exclusive project

Step 1: Calculation of cash outflow

Cost of project/asset                                        xxxx

Transportation/installation charges                    xxxx

Working capital xxxx Cash outflow                 xxxx

Step 2: Calculation of cash inflow

Sales                                                                 xxxx

Less: Cash expenses                                           xxxx

PBDT                                                                  xxxx

Less: Depreciation                                              xxxx

PBT                                                                     xxxx

Less: Tax                                                           xxxx

PAT                                                                   xxxx

Add: Depreciation                                              xxxx

Cash inflow p.a                                                 xxxx