CAPITAL BUDGETING

1. Introduction and Meaning

Every business has limited funds (capital) but unlimited investment opportunities. Therefore, management must carefully decide which long‑term projects or assets to invest in. The process of evaluating and selecting long‑term investment proposals is called Capital Budgeting.

Capital budgeting involves committing large sums of money today in exchange for expected future benefits over several years. These decisions are crucial because they determine the future growth, profitability, and survival of the business.

Examples of capital budgeting decisions:

• Purchasing a new factory building
• Buying heavy machinery for production
• Investing in a new product line
• Expanding into a new geographical market
• Replacing old equipment with modern technology

Definition (Charles T. Horngren):

Definition (I.M. Pandey):

2. Definitions from Experts

3. Features / Characteristics of Capital Budgeting

1. Long‑term period – Benefits of the investment are expected over several years (usually more than one year).
2. Large investment amount – Capital budgeting decisions involve substantial funds.
3. High risk and uncertainty – Future cash flows are uncertain; longer the period, higher the risk.
4. Irreversible (or hard to reverse) – Once a large asset is purchased, it is difficult to sell without loss.
5. Impact on future growth – These decisions shape the future direction and profitability of the business.
6. Requires specialised techniques – Quantitative methods (NPV, IRR, Payback, etc.) are used for evaluation.
7. Affects the entire business – Capital budgeting decisions influence production, marketing, finance, and other functions.

4. Importance / Need for Capital Budgeting

Capital budgeting is critically important for the following reasons:

• Long‑term impact – A wrong decision can damage the business for many years; a right decision can create lasting value.
• Large funds involved – These investments consume a major portion of the firm’s financial resources.
• Irreversibility – Once an asset is purchased, it cannot be easily reversed without significant loss.
• Risk and uncertainty – Future cash flows are estimates; the actual outcome may differ substantially.
• Growth and survival – Proper capital budgeting ensures the business grows profitably; poor decisions can lead to bankruptcy.
• Wealth maximisation – The primary goal of financial management (shareholder wealth maximisation) is achieved through sound capital budgeting.
• Competitive advantage – Investing in the right technology or capacity gives an edge over competitors.
• Regulatory compliance – Some investments are required by law (e.g., pollution control equipment).

5. Steps in Capital Budgeting Process

The capital budgeting process involves a series of logical steps:

6. Types of Capital Budgeting Decisions

7. Methods of Evaluating Capital Budgeting Proposals

Capital budgeting techniques are broadly classified into:

A. Traditional (Non‑discounting) Methods

• Do not consider the time value of money.
• Simpler but less accurate.

B. Discounted Cash Flow (DCF) Methods

• Consider the time value of money.
• More realistic and preferred.

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7.1 Traditional (Non‑discounting) Methods

7.1.1 Payback Period Method

The payback period is the time required to recover the original investment from the net cash inflows generated by the project.

Formula:
Payback Period = Initial Investment / Annual Cash Inflow (when cash flows are equal)

When cash flows are unequal, calculate cumulative cash flows until the investment is recovered.

Decision Rule: Accept the project if the payback period is less than a predetermined benchmark. Shorter payback is better.

Example 1 (Equal cash flows):

• Investment = ₹ 1,00,000
• Annual cash inflow = ₹ 25,000
• Payback Period = 1,00,000 / 25,000 = 4 years

Example 2 (Unequal cash flows):
Investment = ₹ 1,50,000

Advantages:

• Simple to calculate and understand.
• Emphasises liquidity (faster recovery of cash).
• Useful for risky industries where early recovery is important.

Disadvantages:

• Ignores time value of money.
• Ignores cash flows after the payback period.
• Does not measure profitability.

7.1.2 Accounting Rate of Return (ARR) / Average Rate of Return

ARR measures the average annual accounting profit as a percentage of the average investment.

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

Where:

• Average Annual Profit = Total profit after depreciation and tax / Number of years
• Average Investment = (Initial Investment + Salvage Value) / 2

Decision Rule: Accept the project if ARR is greater than a predetermined target rate.

Example:

• Initial Investment = ₹ 2,00,000
• Salvage Value = ₹ 20,000
• Total profit after tax and depreciation over 5 years = ₹ 80,000
• Average Annual Profit = 80,000 / 5 = ₹ 16,000
• Average Investment = (2,00,000 + 20,000) / 2 = ₹ 1,10,000
• ARR = (16,000 / 1,10,000) × 100 = 14.55%

Advantages:

• Simple to calculate.
• Uses accounting data readily available.
• Considers entire life of the project.

Disadvantages:

• Ignores time value of money.
• Uses accounting profit, not cash flows.
• Subject to different depreciation methods.

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7.2 Discounted Cash Flow (DCF) Methods

These methods use the concept of time value of money – a rupee today is worth more than a rupee tomorrow.

7.2.1 Net Present Value (NPV) Method

NPV is the difference between the present value of cash inflows and the present value of cash outflows over the project’s life, discounted at the firm’s cost of capital.

Formula:
NPV = PV of Cash Inflows – PV of Cash Outflows
Or: NPV = Σ [CFt / (1 + r)^t] – Initial Investment

Where:

• CFt = Cash flow at time t
• r = Discount rate (cost of capital)
• t = Year

Decision Rule:

• NPV > 0 → Accept the project (it adds value to the firm)
• NPV = 0 → Indifferent (project earns exactly the cost of capital)
• NPV < 0 → Reject the project (it destroys value)

Example:

• Initial Investment = ₹ 1,00,000
• Discount rate = 10%
• Cash inflows: Year 1: ₹ 30,000; Year 2: ₹ 40,000; Year 3: ₹ 50,000; Year 4: ₹ 20,000

Advantages:

• Considers time value of money.
• Considers all cash flows over the entire life.
• Directly measures value added to the firm.
• Consistent with wealth maximisation goal.

Disadvantages:

• Requires estimation of discount rate.
• Difficult to compare projects of different sizes (use profitability index for that).
• Sensitive to cash flow estimates.

7.2.2 Internal Rate of Return (IRR) Method

IRR is the discount rate that makes the NPV of a project equal to zero. It is the rate of return earned by the project.

Formula:
Σ [CFt / (1 + IRR)^t] – Initial Investment = 0

Decision Rule:

• IRR > Cost of capital → Accept
• IRR = Cost of capital → Indifferent
• IRR < Cost of capital → Reject

Calculation (Interpolation):
Using the same example as above, try r = 15%:

• Year 1: 30,000 × 0.8696 = 26,088
• Year 2: 40,000 × 0.7561 = 30,244
• Year 3: 50,000 × 0.6575 = 32,875
• Year 4: 20,000 × 0.5718 = 11,436
• Total PV = 1,00,643
• NPV @ 15% = ₹ 643 (Positive)

Try r = 16%:

• Year 1: 30,000 × 0.8621 = 25,863
• Year 2: 40,000 × 0.7432 = 29,728
• Year 3: 50,000 × 0.6407 = 32,035
• Year 4: 20,000 × 0.5523 = 11,046
• Total PV = 98,672
• NPV @ 16% = –₹ 1,328 (Negative)

Interpolation:
IRR = 15% + [643 / (643 + 1,328)] × (16% – 15%)
IRR = 15% + (643 / 1,971) × 1%
IRR = 15% + 0.326% = 15.33%
Since IRR (15.33%) > cost of capital (10%), accept the project.

7.2.3 Profitability Index (PI) / Benefit‑Cost Ratio

PI is the ratio of the present value of future cash inflows to the present value of cash outflows (initial investment).

Formula:
PI = PV of Cash Inflows / PV of Cash Outflows
Or: PI = 1 + (NPV / Initial Investment)

Decision Rule:

• PI > 1 → Accept (project creates value)
• PI = 1 → Indifferent
• PI < 1 → Reject

Example:
PV of inflows = ₹ 1,11,554, Initial investment = ₹ 1,00,000
PI = 1,11,554 / 1,00,000 = 1.1154 (>1, so accept)

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8. Comparison of Capital Budgeting Methods

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9. Capital Rationing

When a firm has limited funds but several acceptable projects, it cannot take all of them. This situation is called capital rationing.

Types:

• Hard capital rationing – External constraints (e.g., capital market restrictions).
• Soft capital rationing – Internal management policies (e.g., limiting budget).

Approach under capital rationing:

1. Rank projects by Profitability Index (or NPV per rupee of investment).
2. Select projects with the highest PI until the budget is exhausted.

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10. Estimating Cash Flows for Capital Budgeting

Accurate cash flow estimation is critical. Cash flows, not accounting profits, matter.

Types of Cash Flows:

1. Initial Investment (Year 0) – Cost of asset + installation + shipping + increase in working capital – salvage from old asset (if replacement).
2. Operating Cash Flows (Years 1 to n) – Annual net cash inflows = (Revenues – Expenses – Depreciation) × (1 – Tax rate) + Depreciation.
3. Terminal Cash Flow (Last Year) – Salvage value + recovery of working capital.

Principles to Remember:

• Use incremental cash flows (difference with and without the project).
• Ignore sunk costs (costs already incurred).
• Include opportunity costs (value of resources used elsewhere).
• Consider tax effects (depreciation tax shield).

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11. Illustrative Problems

Problem 1: Payback Period (Unequal Cash Flows)

Scenario: Project requires ₹ 2,00,000 investment. Cash flows: Year 1: ₹ 50,000; Year 2: ₹ 70,000; Year 3: ₹ 80,000; Year 4: ₹ 60,000; Year 5: ₹ 40,000.
Solution:

• Year 1: 50,000 (Cumulative: 50,000)
• Year 2: 70,000 (Cumulative: 1,20,000)
• Year 3: 80,000 (Cumulative: 2,00,000)
  Payback Period = 3 years.

Problem 2: ARR

Scenario: Initial investment ₹ 5,00,000, salvage value ₹ 50,000, useful life 5 years. Total profit after depreciation and tax = ₹ 1,80,000.
Solution:

• Avg Annual Profit = 1,80,000 / 5 = ₹ 36,000
• Avg Investment = (5,00,000 + 50,000) / 2 = ₹ 2,75,000
• ARR = (36,000 / 2,75,000) × 100 = 13.09%

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12. Practice Problems

Problem 1 (Payback Period)

Calculate payback period for a project requiring ₹ 4,00,000 investment with cash flows: Year 1: ₹ 80,000; Year 2: ₹ 1,20,000; Year 3: ₹ 1,50,000; Year 4: ₹ 1,00,000; Year 5: ₹ 70,000.

Problem 2 (ARR)

Initial investment ₹ 8,00,000; salvage value ₹ 40,000; useful life 6 years; total profit after tax = ₹ 3,60,000. Compute ARR.

Problem 3 (NPV & PI)

A project costs ₹ 5,00,000. Cash flows: Year 1: ₹ 1,20,000; Year 2: ₹ 1,80,000; Year 3: ₹ 2,00,000; Year 4: ₹ 1,50,000; Year 5: ₹ 1,00,000. Discount rate = 10%. Calculate NPV and PI.

Problem 4 (IRR)

For the same project as Problem 3, estimate IRR (by interpolation – try 12% and 14%).

Problem 5 (Capital Rationing)

Two projects are mutually exclusive. Project A: Investment ₹ 2,00,000, NPV ₹ 40,000. Project B: Investment ₹ 1,00,000, NPV ₹ 30,000. Which project should be selected under capital rationing if only ₹ 2,00,000 is available? (Hint: Use PI)

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13. Summary Table – Decision Rules

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14. Key Points to Remember

• Capital budgeting = long‑term investment decision making.
• Time value of money is the core of DCF methods (NPV, IRR, PI).
• NPV is the most theoretically sound method for wealth maximisation.
• IRR is popular but may conflict with NPV for mutually exclusive projects.
• Payback period is simple but ignores post‑payback cash flows and time value.
• ARR uses accounting profit, not cash flows – less reliable.
• Capital rationing requires ranking projects by PI.
• Always use incremental cash flows (not accounting profits) and ignore sunk costs.

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