## What Is Capital Budgeting?

Capital budgeting is the process of planning and taking decisions regarding the long-term investments of the company in fixed assets. Such long-term investments are called as capital investments and the amount spent for such long-term investments is called as capital expenditure. By doing capital budgeting it can be determined whether the potential long-term investment projects of the company are worth pursuing or not. Capital budgeting is also called as investment appraisal.

### Importance Of Capital Budgeting:-

Capital budgeting decisions are very crucial for a company because of the following reasons:-

- Capital budgeting decisions have long-term implications on the operations of the company and may affect the long-term survival of the company in case of a wrong decision.
- Capital investments involve commitment of large amount of funds which remain blocked for a long period of time and so it is necessary to take decisions of capital investments very carefully by doing capital budgeting.
- Capital budgeting decisions are mostly irreversible because it is very difficult to find a market for the capital goods. The only alternative is to scrap the assets and incur heavy loss.
- The company has many capital investment proposals which can be undertaken. Capital budgeting helps in deciding which proposal or proposals are beneficial and should be undertaken by the company.
- Capital budgeting decisions have a major effect on the value of the firm and the wealth of its shareholders. Correct capital budgeting decisions enhance the value of the firm and maximizes the shareholder’s wealth.

### Classification Of Capital Investment Projects:-

Capital investment projects can be classified into four types:-

**(1) Replacement Projects:-**

Existing fixed assets of the company are replaced with similar fixed assets on account of them being worn out or becoming out-dated because of new inventions.

**(2) Expansion Projects:-**

The company expands its business by increasing the current operations to a larger scale like increasing the production capacity to produce more products because of high demand.

**(3) Diversification projects:-**

The company diversifies its business by starting a new product line different from the existing one or enters into new markets to reduce risk.

**(4) Mandatory projects:-**

The company has to compulsorily undertake such projects as required by the government and are usually related to safety or environment which do not directly result into profits.

### Capital Investment Projects May be –

Independent Projects Or Mutually

Exclusive Projects:-

Independent projects are unrelated and are not dependent on each other. Independent projects are the projects that do not compete with each other in such a way that the acceptance of one rejects the others. Accepting or rejecting one project does not affect the decision on other projects. All the independent projects can be accepted if they meet the investment criteria and can be pursued simultaneously.

Mutually exclusive projects are related to each other. They compete with each other in such a way that the acceptance of one rejects the others. Accepting or rejecting one project affects the decision on other projects. Only one project can be accepted which is the most profitable among the other alternative projects which meet the investment criteria. So mutually exclusive projects cannot be pursued simultaneously.

### Capital Budgeting Techniques:-

There are various techniques or methods used in capital budgeting to evaluate the capital investment proposals. These techniques can be divided into two heads:-

(A) Non-discounting techniques

(B) Discounting techniques

*(A) Non-Discounting Techniques:-*

Non-discounting methods do not consider the time value of money. There are two non-discounting techniques used in capital budgeting which are as under:-

**(1) Payback period:-**

Payback period is the period within which the cost of capital investment would be completely recovered. It indicates the number of years required to recover the initial investment in the project from the future cash inflows generated by the project.

The payback period in case of the project generating equal cash inflows annually is calculated as:-

*payback period = initial investment in project ÷ annual cash inflows of project*

The payback period in case of the project generating unequal cash inflows annually is calculated by adding up the cash inflows till the total is equal to the initial investment in the project.

The management decides the maximum acceptable payback period for independent projects. If the payback period is less than or equal to the maximum acceptable payback period decided by management, the project is accepted and if the payback period is more than the maximum acceptable payback period decided by management, the project is rejected. In case of mutually exclusive projects, the project with the shortest payback period is selected.

**Advantages of payback period method:- **(i) It is simple to calculate and easy to understand.

(ii) It shows the liquidity of the project by indicating the period within which the cost of a project can be recovered.

**(i) It ignores the time value of money.**

Disadvantages of payback period method:-

Disadvantages of payback period method:-

**(ii) It ignores the cash inflows after the payback period.**

**Example:-**

A project requires an initial investment of Rs 800000 and is expected to generate cash inflows of Rs 200000 annually for five years (equal cash inflows each year).

The payback period of the project would be

Rs 800000 ÷ Rs 200000 = 4 years

If a project requires an initial investment of Rs 500000 and is expected to generate cash inflows of Rs 100000, Rs 125000, Rs 75000, Rs 150000 and Rs 100000 respectively for five years. (unequal cash inflows each year)

In this case we need to add the cash inflows. While adding the cash inflows we see that in the first four years Rs 450000 (100000+125000+75000+150000) of the initial investment is recovered. Fifth year generates cash inflow of Rs 100000 whereas only Rs 50000 (500000-450000) remains to be recovered. The period which will be required to recover Rs 50000 will be

Rs 50000 ÷ Rs 100000 × 12 = 6 months

So the payback period of the project would be

4.6 years i.e. 4 years and 6 months.

**(2) Accounting rate of return:-**

Accounting rate of return is also called as average rate of return. It calculates the average annual accounting profit the project would generate in relation to the average investment in the project or its average cost.

Accounting rate of return is calculated as under:-

*Accounting rate of return = average annual profit – depreciation & taxes ÷ average investment in project × 100*

*Average annual profit = profit of all the years ÷ number of years*

*Average investment in project = initial investment – scrap value ÷ 2*

The management decides the minimum acceptable average rate of return for independent projects. If the average rate of return is more than the minimum acceptable average rate of return decided by management, the project is accepted and if the average rate of return is less than the minimum acceptable rate of return decided by management, the project is rejected. In case of mutually exclusive projects, the project yielding the highest average rate of return is selected.

**Advantages of accounting rate of return method:- **(1) It is simple to calculate and easy to understand.

(2) It considers the profit of all the years involved in the life of the project.

**Disadvantages of accounting rate of return method:-**

(1) It ignores the time value of money.

(2) It considers accounting profit and not cash inflows.

**Example:-**

A project requires an initial investment of Rs 1000000 and is expected to generate profit of Rs 80000, Rs 120000, Rs 130000, Rs 110000 and Rs 100000 respectively for five years after depreciation and tax. At the end of the fifth year, the equipment in the project can earn a scrap value of Rs 70000.

First we need to find out the average annual profit.

Average annual profit = 80000 + 120000 + 130000 + 110000 + 100000 ÷ 5

= 540000 ÷ 5

= Rs 108000

Next we need to find out the average investment.

Average investment = 1000000 – 70000 ÷ 2

= 930000 ÷ 2

= Rs 465000

Accounting rate of return = 108000 ÷ 465000 × 100

= 23.23%

*(B) Discounting Techniques:-*

Discounting techniques consider the time value of money. There are four discounting techniques used in capital budgeting which are as under:-

**(1) Discounted payback period:-**

Discounted payback period improves the payback period method by taking into consideration the time value of money. It indicates the number of years required to recover the initial investment in the project from the discounted cash inflows generated by the project i.e present value of future cash inflows generated by the project. For discounting the future cash inflows, an appropriate discount rate is used which is usually the weighted average cost of capital.

**Advantages of discounted payback period method:- **(1) It is easy to understand.

(2) It considers the time value of money.

**Disadvantages of discounted payback period method:-**

(1) It ignores the cash inflows after the payback period.

(2) It requires to calculate the weighted average cost of capital.

**Example:-**

A project requires an initial investment of Rs 400000 and is expected to generate cash inflows of Rs 150000 annually for five years. The discount rate is 15%.

First we need to calculate the discounted cash inflows for each year by using the discount rate of 15%.

Discounted cash inflows for 1st year = 150000 ÷ (1.15) = Rs 130435

Discounted cash inflows for 2nd year = 150000 ÷ (1.15)^{2 }= Rs 113422

Discounted cash inflows for 3rd year = 150000 ÷ (1.15)^{3 }= Rs 98627

Discounted cash inflows for 4th year = 150000 ÷ (1.15)^{4 }= Rs 85763

Discounted cash inflows for 5th year = 150000 ÷ (1.15)^{5 }= Rs 74577

Now we need to add the discounted cash inflows. While adding the discounted cash inflows we see that in the first three years Rs 342484 (130435+113422+98627) of the initial investment is recovered. Fourth year generates discounted cash inflow of Rs 85763 whereas only Rs 57516 (400000-342484) remains to be recovered. The period which will be required to recover Rs 57516 will be

Rs 57516 ÷ Rs 85763 × 12 = 8 months

So the discounted payback period of the project would be

3.8 years i.e. 3 years and 8 months.

**(2) Net present value:-**

Net present value is the difference between the present value of future expected cash inflows and the present value of cash outflows. Cash outflows are the initial investment in the project or cost of the project and any future expected cash outflows of the project. If the present value of cash inflows is more than the present value of cash outflows, the net present value is positive and if the present value of cash inflows is less than the present value of cash outflows, the net present value is negative. The cash inflows and outflows are brought to their present values by using an appropriate discount rate which is usually weighted average cost of capital.

Net present value is calculated as under:-

*Net present value = present value of cash inflows – present value of cash outflows*

In case of independent projects, the projects with a positive net present value are accepted and in case of mutually exclusive projects, the project with the highest positive net present value is selected.

**Advantages of net present value method:- **(1) It considers the time value of money.

(2) It is consistent with the goal of maximizing shareholder wealth.

(3) It considers cash flows from the project throughout its life.

**Disadvantages of net present value method:-**

(1) It may not give satisfactory results if the mutually exclusive projects involve different investment outlay.

(2) The output of net present value method is monetary amount and not a rate of return.

(3) It requires to calculate the weighted average cost of capital.

**Example:-**

A project requires an initial investment of Rs 1200000 and there are no other cash outflows expected. The project is expected to generate cash inflows of Rs 300000, Rs 400000, Rs 550000 and Rs 200000 respectively for four years. At the end of the fourth year, the machine in the project can earn a scrap value of Rs 100000. The discount rate is 10%.

First we need to calculate the discounted cash inflows for each year by using the discount rate of 10% and add them.

Discounted cash inflows for 1st year = 300000 ÷ (1.10) = Rs 272727

Discounted cash inflows for 2nd year = 400000 ÷ (1.10)^{2 }= Rs 330579

Discounted cash inflows for 3rd year = 550000 ÷ (1.10)^{3 }= Rs 413223

Discounted cash inflows for 4th year = 300000 (200000+100000) ÷ (1.10)^{4 }= Rs 204904

Total discounted cash inflows = Rs 1221433 (272727+330579+413223+204904)

Present value of cash inflows = Rs 1221433

Present value of cash outflows = Rs 1200000

Net present value = present value of cash inflows – present value of cash outflows

= Rs 1221433 – Rs 1200000

= Rs 21433

So the net present value of the project is Rs 21433 which is positive net present value.

**(3) Profitability index:-**

Profitability index is a variation of net present value. It is the ratio of present value of expected cash inflows to the present value of expected cash outflows of a project. Net present value method is an absolute measure as it finds the monetary amount of difference between the present value of expected cash inflows and present value of expected cash outflows whereas profitability index is a relative measure as it finds the ratio.

Profitability index is calculated as under:-

*Profitability index = present value of cash inflows ÷ present value of cash outflows*

In case of independent projects, those projects are accepted whose profitability index is more than 1 and in case of mutually exclusive projects, the project with highest profitability index is selected provided it is more than 1. Profitability index of more than 1 suggests that the present value of project’s expected cash inflows is more than the present value of its expected cash outflows i.e. the net present value is positive and a profitability index of less than 1 suggests that the present value of project’s expected cash inflows is less than the present value of its expected cash outflows i.e. the net present value is negative. If the profitability index is exactly 1, it means that the present value of project’s expected cash inflows and expected cash outflows is equal i.e. the net present value is zero.

**Advantages of profitability index:- **(1) It considers the time value of money.

(2) It considers the cash flows from the project throughout its life.

(3) It is useful in selecting projects when in capital rationing situation.

**Disadvantage of profitability index:-**

(1) It requires to calculate the weighted average cost of capital.

**Example:-**

A project requires an initial investment of Rs 700000 and there are no other cash outflows expected. The project is expected to generate cash inflows of Rs 200000, Rs 250000, Rs 150000 and Rs 150000 respectively for four years. There is no scrap value expected. The discount rate is 12%.

First we need to calculate the discounted cash inflows for each year by using the discount rate of 12% and add them.

Discounted cash inflows for 1st year = 200000 ÷ (1.12) = Rs 178571

Discounted cash inflows for 2nd year = 250000 ÷ (1.12)^{2} = Rs 199298

Discounted cash inflows for 3rd year = 150000 ÷ (1.12)^{3 }= Rs 106767

Discounted cash inflows for 4th year = 150000 ÷ (1.12)^{4 }= Rs 95328

Total discounted cash inflows = Rs 579964 (178571+199298+106767+95328)

Present value of cash inflows = Rs 579964

Present value of cash outflows = Rs 700000

Profitability index = present value of cash inflows ÷ present value of cash outflows

= Rs 579964 ÷ Rs 700000

= 0.83

So the profitability index of the project is 0.83 which is less than 1.

**(4) Internal rate of return:-**

Internal rate of return is the rate of return on a capital investment project. It is the discount rate at which the present value of expected cash inflows and present value of expected cash outflows of a project is equal. In other words, it is the discount rate at which the net present value of a project is zero.

There is no fixed formula to calculate the internal rate of return. It is found out by trial and error method either by using a calculator or by using Microsoft excel. Different discount rates are tried till the discount rate which brings net present value of the project to zero is found out. If the net present value is positive, a higher discount rate is tried and if the net present value is negative, a lower discount rate is tried. This process is continued till the discount rate where net present value becomes zero or close to zero is found.

The management decides the minimum acceptable rate of return for independent projects which is usually the weighted average cost of capital. If internal rate of return is more than the weighted average cost of capital, the project is accepted and if the internal rate of return is less than the weighted average cost of capital, the project is rejected. In case of mutually exclusive projects, the project yielding the highest internal rate of return is selected provided it is more than the weighted average cost of capital.

**Advantages of internal rate of return method:- **(1) It considers the time value of money.

(2) It considers cash flows from the project throughout its life.

(3) The output of internal rate of return method is in the form of a rate of return and not a monetary amount.

**Disadvantages of internal rate of return method:-**

(1) It is comparatively difficult to calculate as it requires trial and error.

**(2) There is a problem of multiple internal rate of returns in case of unconventional cash flows involved in a project i.e. expected cash inflows followed by expected cash outflows in the next year and again followed by expected cash inflows next year and so on.**

**(3) Internal rate of return method assumes that the cash inflows from the project should be reinvested to yield a return equal to internal rate of return which is unrealistic.**

**Example:-**

A project requires an initial investment of Rs 600000 and there are no other cash outflows expected for the project. The project is expected to generate cash inflows of Rs 300000, Rs 350000 and Rs 250000 respectively for three years. There is no scrap value expected.

We can try to find out the internal rate of return by trying different discount rates until the net present value of the project is zero or close to zero. If we try 24% discount rate, the net present value comes to 684 (total discounted cash inflows of Rs 600684 minus initial investment of Rs 600000). If we try 24.1% discount rate, the net present value comes to (-) 193 (total discounted cash inflows of Rs 599807 minus initial investment of Rs 600000). So we can say that the discount rate that brings net present value to zero or close to zero is between 24% and 24.1%. If we try 24.075% discount rate, the net present value comes to (-) 15 (total discounted cash inflows of Rs 599985 minus initial investment of Rs 600000) which is close to zero. So we can conclude that the internal rate of return of the project is approximately 24.075%. To get the exact internal rate of return, Microsoft excel can be used.

### Capital Rationing:-

Capital rationing is a situation in which the company may not be able to undertake all the profitable capital investment projects because of lack of adequate funds to finance all the profitable projects. In such a situation, the company has to allot the limited available funds among the most profitable projects. The company estimates the amount of maximum investment it can make for undertaking all the profitable projects. So the company creates a capital budget. Then the company ranks all the profitable projects starting from the most profitable to the least profitable i.e. in the descending order of their profitability and starts selecting from the most profitable project to the next profitable one till the maximum investment amount the company can invest is reached.

**Example:-**

A company has a capital budget of Rs 5000000 and has four profitable capital investment proposals as under:-

Project A | Project B | Project C | Project D | |

Initial investment | Rs 2000000 | Rs 1500000 | Rs 1000000 | Rs 1200000 |

Present value of cash inflows | Rs 2500000 | Rs 1700000 | Rs 1200000 | Rs 1800000 |

Profitability index | 1.25 | 1.13 | 1.20 | 1.50 |

The company will rank projects as (1) project D (2) project A (3) project C and (4) project B based on their profitability.

Then the company will select the (1) project D first then (2) project A next and then (3) project C.

The company cannot undertake (4) project B because of lack of funds. Project B requires Rs 1500000 investment while the company has only Rs 800000 (5000000-4200000) remaining out of its total capital budget of Rs 5000000 after selecting the first three projects.(1200000+2000000+1000000)