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Capital budgeting is also known as investment decisions. The word investment refers to the expenditure which is required to
be made in connection with the acquisition and the development by which management selects those investment proposals
which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add
to or replace fixed assets in the light of overall objectives of the firm.
When a business makes a capital investment, it incurs a cash outlay in the expectation of future benefits. The expected
benefits generally extend beyond one year in the future. Out of different investment proposals available to a business, it has to
choose a proposal that provides the best return and the return equals to, or greater than that required by the investors. The
whole process is known as capital budgeting / expenditure.

Video 1: Meaning of Capital Budgeting.

Investment decision related to long-term asset are called capital budgeting. It involves the planning and control of capital
expenditure. The term capital expenditure means the expenditure which is intended to benefit future period, i.e. in more than
one year as opposed to revenue expenditure, the benefit of which is supposed to be exhausted within the year concerned.
Investment decision pertaining to long-term assets for the purpose of generating revenue
for the business entity (and not for sales such as land, building, machinery, furniture, etc.)
is term as 'Capital Budgeting'. It involves long-term planning and monitoring of capital
expenditure, beside examining each proposal in a very logical and scientific manner so as
to finalize the best proposal. Capital expenditure differs from the revenue expenditure in
the sense that the benefits from such expenditure are necessary generated after a long
gestation period which is generally beyond one year. In the case of revenue expenditure,
on the other hand, the benefit are generated and exhausted within the year. Some of the
authors have defined 'Capital Budgeting' as under:
Figure 1. Capital Budgeting.
According to Charles T. Horngren:
"Capital budgeting is long-term planning for making and financing proposed capital
outlays".
According to Robert N. Anthony:
"The capital budget is essentially a list of what management believes to be worthwhile projects for the acquisition of new
capital assets together with the estimated cost of each product".
According to Milton H. Spencer:
"Capital budgeting involves the planning of expenditures for assets, the returns from which will be realized in future time
period".
Features or Characteristics of Capital Budgeting
Large Investments
Capital Budgeting is related to taking decisions requiring large funds. It is a process used for selecting the high-value capital
projects by the management. Managers use capital budgeting for properly analyzing different investment opportunities and
take decision with proper care.
Irreversible Decision
The decisions taken through the capital budgeting process are irreversible in nature. This process requires making choices for
large fund investment in different capital projects available. A decision once taken becomes difficult to be amended as it
involves the allocation of large funds and affects company growth. High-value asset once purchased can’t be sold at the same
prices and at the same time.
High Risk
There is a high degree of risk involved in the capital budgeting process. Decisions taken in this process are concerned with
future return and the future is uncertain. Future unforeseen like change in fashion and taste, technological and research
advancement may lead to higher risk. It, therefore, involves critical analysis before taking any decision as there are a large
amount of funds allocated by business through this process.
Long Term Effect on Profitability
Capital Budgeting decisions have long term effects on the profit-earning capacity of the business. It involves decisions
regarding large investments providing return to business. Decisions taken through capital budgeting affects both current and
future earning potential of the company. Any unwise decision may affect business growth adversely and may be fatal.
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Therefore capital budget is termed us utmost function for every business which has great influence over its profitability.
Impacts Cost Structure
The decisions taken through the capital budgeting process have a direct impact on the cost structure of the business. Through
decision taken in this process, business commits themselves to costs like interest, insurance, rent, supervision etc. If the
investment taken does not generate the anticipated income for the business, then it would increase the cost expenses and
lead business to losses.
Difficult Decisions
Decisions taken through the capital budgeting process are difficult in nature. Decisions taken here are regarding the future
which is uncertain and may have many unforeseen. It, therefore, becomes difficult for managers to choose the most profitable
investment providing better return in future.
Affects Competitive Strengths
Capital budgeting process directly influences the future competitive strength of the business. Decisions taken in this process
are regarding the profit generating investments and affects the company growth. A right decision taken can lead the company
to great heights whereas a wrong decision may become fatal for the business. Therefore capital budgeting directly influences
the strengths and weaknesses of a business.
Factors Affecting Capital Budgeting
The capital budgeting decisions influenced by various elements present in the internal and external business environment.
Following are some of the significant factors affecting investment decisions:
Capital Structure
The company’s capital structure, i.e., the composition of shareholder’s
funds and borrowed funds, determines its capital budgeting decisions.
Working Capital
The availability of capital required by the company to carry out day to
day business operations influences its long-term decisions.
Capital Return
The management estimates the expected return from the prospective
capital investment while planning the company’s capital budget.
Availability of Funds
The company’s potential for capital budgeting is dependant on
its dividivent policy, availability of funds and the ability to acquire funds
from the other sources.
Earnings
If the company has a stable earning, it may plan for massive Figure 2. Factors affecting capital budgeting.
investment projects on leveraged funds, but the same is not suitable in
case of irregular earnings.
Lending Policies of Financial Institutions
The terms on which financial institutions provide loans such as interest rates, collateral, duration, etc. contributes to capital
budgeting decisions.
Management Decisions
The decision of the management to take a risk and invest funds in high-value assets or holding some other plan, also
determines the capital budgeting of the company.
Project Needs
The company needs to consider all the essentials of a new project. Also, the means to fulfil the requirements along with the
estimate of the related expenses should be clear.
Accounting Methods
The accounting rules, principles and methods of the company is another factor considered while capital budgeting to frame the
reporting of such expenses and revenue to be generated in future.
Government Policy
The restrictions imposed and the exemptions allowed by the government to the companies while investing in capital nature,
impacts the company’s capital budgeting decisions.
Taxation Policy
The taxation procedure and policy of the country also influences the long-term investment decision of the firm since additional
capital will be required for such expenses.
Project’s Economic Value
The total cost estimated for the long-term investment and the capacity of the company determines the capital budgeting
decisions.
Objectives of Capital Budgeting
What is the need for capital budgeting? Why do companies invest so much time and efforts in it? Capital budgeting is the long-
term decision which affects the business to a great extent.
To know more about the necessity of capital budgeting for the companies, let us go through the following objectives:
Control of Capital Expenditure
Estimating the cost of investment provides a base to the management for controlling and managing the required capital
expenditure accordingly.
Selection of Profitable Projects
The company have to select the most suitable project out of the multiple options available to it. For this, it has to keep in mind
the various factors such as availability of funds, project’s profitability, the rate of return, etc.
Identifying the Right Source of Funds

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Locating and selecting the most appropriate source of fund required to make a long-
term capital investment is the ultimate aim of capital budgeting. The management
needs to consider and compare the cost borrowing with the expected return on
investment for this purpose.
Importance of Capital Budgeting
Importance of capital budgeting for taking an investment decision is the most
effective and powerful tool. The importance of capital budgeting may be gauged from
the following points:

Figure 3. Objectives of capital budgeting.

Video 2: The Importance of Budgeting

1. Corporate Image
The profits are vitally affected by capital budgeting decisions. These influence the market value of the shares. All projects
which are accepted should yield profits leading to maximization of shareholders' wealth. The shareholders and other
investors should be convinced about the success and future prospects of the project. If they don't invest, the objectives of
the business would fail. The image of the company will also fall down. The capital budgeting decisions should improve the
image of the company.
Capital budgeting decisions have the capability to impact the profitability of a company. Such impact may be either way,
i.e. profit can increase or decrease (depending upon the quality of capital budgeting exercise). Market value of the
company's share also get impacted accordingly. Shareholders of a company are interested in dividents and appreciation
in the value of the shares held by them. Both are dependent on the profit of the company. Successful projects result in
increased profit of the company, which in turn leads to better dividents and appreciation in the value of shares. There
would be an increase in the demand of the company's shares and Goodwill in the market would improve.

2. Long-Term Effects
Decisions taken through capital budgeting are generally Irreversible, they can be reserved, if at all possible, with a lot of
difficulties. The outcome of a wrong decision may be heavy losses to the business enterprise. For example, if a company
decides to set up a factory in a backward rural area with a provision of housing facilities for its employees. Construction of
the factory and houses for the future employees stars. However, before the completion of the construction, the company
comes to know that there was a fault on its part regarding clearance from environment ministry and the factory cannot be
set up in that area. The company will have bear heavy losses in terms of money and time under the above circumstances.
Capital budgeting decisions cannot be changed so easily. Wrong decision, once taken will lead to heavy losses to the firm.
To take a simple example, suppose construction of a premise has been started and the management has gone half the
way. Now, the construction can't be left hanging in between since the amount spent cannot be recovered.

3. Risk and Uncertainty

A great deal of uncertainty surrounds a capital budgeting decision. Investment is present and return is future. The future is
uncertain and full of risk. Longer the period of the project, greater is the risk and uncertainty. The estimates about costs,
revenues and profits may not come true.
Capital Budgeting decisions are based on two important components, viz., investment and return. While the former is
certain and takes place in the present, the latter is totally uncertain, take place in future and only projections there of may
be made. A lot of risk is associated with the future. Uncertainty and risks are directly proportional to the period of project. A
long-term project has a higher degree of risk and uncertainty. Estimates and projections are based on certain
assumptions, which may prove to be wrong in future.

4. Large Funds
Large amount of funds are needed by any business organization for taking up any capital investment. The exercise of
capital budgeting gains a lot of importance due to the fact that huge amount of funds are at Stake and any error may lead
to a disastrous situation and heavy monetary loss of to the company.

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Any capital expenditure will naturally involve huge amount. The fixed commitment as regards large sums of money makes
capital budgeting is an important exercise.

1. TYPES OF CAPITAL BUDGETING

The Capital Budgeting Types is as follows:
1. Expansion and Diversification
A company may add capacity to its existing product lines to expand existing operations. For example, the Gujarat State
Fertilizer Company (GSFC) may increave its plant capacity to manufacture more urea. It is an example of related
diversification. A firm may expand its activities, in a new business, Expansion of a new business requires investment in
new products and a new kind of production activity within the firm.
If a packaging manufacturing company invest in a new plant and machinery to produce ball beanngs, which the firm has
not manufactured before, this represent expansion of new business or unrelated diversification. Sometimes a company
acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional
revenue. Investments in existing or new products may also be called as revenue-expansion investments.

2. Replacement and Modernization

The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings
will reflect in the increased profits, but the firms revenue may remain unchanged. Assets become outdated and obsolete
with technological changes. The firm must decide to replace those assets with new assets that operate more
economically.
Capital budgeting techniques with examples, a cement company changing from semi-automatic drying equipment to fully
automatic drying equipment. Replacement decisions help to introduce more efficient and economical assets and
therefore, are also called cost-reduction investments. However, replacement decisions that involve substantial
modernization and technological improvements expand revenues as well as reduce costs.

3. Mutually Exclusive Investments

They serve the same purpose and compete with each other. If one investment is undertaken, others will have to be
excluded. A company may, e.g. either use a more labor-intensive, semi automatic machine, or employ a more capital-
intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of
the highly automatic machine.

4. Independent Investments
They serve different purposes and do not compete with each other. For example, a heavy engineering company may be
considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities
to manufacture a new product light commercial vehicles. Depending on their profitability and availability of funds, the
company can undertake both investments.

5. Contingent investments
Contingent investments are dependent projects, the choice of one investment necessitates undertaking one or more other
investments. For example, if a company decide to build a factory in a remote, backward area, it may have to invest in
houses, roads, hospitals, schools etc. for employees to attract the workforce. Thus, building of factory also requires
investment in facilities for employees. The total expenditure will be treated as one single investment.

6. Research and Development Projects

Traditionally, R&D projects absorbed a very small praportion of capital budget in most Indian companies. Things, however,
are changing-Companies are now allocating more funds to R&D projects, more so in knowledge-intensive industries. R&D
projects are characterized by numerous uncertaintes and typically involve secquential decision making. Hence the
standard DCF analysis is not applicable to them. Such projects are decided on the basis of managerial judgement. Firms
which rely more on quantitative methods use decision tree analysis and option analysis to evaluate R&D projects.

7. Miscellaneous Projects
This is a catch-all category that includes items like, interior decoration, recreational facilities, executive air crafts,
landscaped gardens and so on. There is no standard approach for evaluating these projects and decisions regarding them
are based on personal preferences of top management.

2. CAPITAL BUDGETING TECHNIQUES / METHODS

There are different methods adopted for capital budgeting. The traditional methods or non discount methods include: Payback
period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index
method and IRR.
Payback Period Method
As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial
investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the
project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning
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capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help
gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of
money and so the relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow
Example
Project A Project B
Cost 1,00,000 1,00,000
Expected future cash
flow

Year 1 50,000 1,00,000

Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is superior to B.
Discounted Cash flow Method
The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then
discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes
into account the interest factor and the return after the payback period.
Accounting Rate of Return
Accounting rate of return (ARR) is a capital budgeting formula that is used to determine the potential profitability of long-term
investments over a period of time. The ARR formula takes the average yearly revenue generated by an asset, then divides that
figure by the initial cost. This decimal figure is then multiplied by 100 to yield the percentage rate of return.
Accounting rate of return gives a business a snapshot of the potential earning power of a particular investment. It is less
targeted toward risk assessment than the required rate of return (or RRR), which states a minimum profit that an investor
seeks. Accounting rate of return is also referred to as the simple rate of return, because it does not consider the time value of
money, which assumes that money earned in the present is more valuable than the same amount of money earned in the
future.
Accounting Rate of Return Formula
The Accounting Rate of Return formula is as follows:
ARR = average annual profit / average investment
That doesn’t mean too much on its own, so here’s how to put that into practice and actually work out the profitability of your
investments.
How to Calculate Accounting Rate of Return
Accounting rate of return is a simple formula that any business can use to assess the potential profit of an asset. The ARR
formula is “average annual revenue”/ “initial investment.” Keep in mind that each figure should have its own line item, and
spreadsheet templates in excel can organize the figures. Here is an example of an ARR calculation.
1. Calculate the average annual profit of the investment. This figure should represent the net income that your asset will
generate, minus any annual costs or expenses like taxes or COGs. For example, your asset may be a rental property that
has a net present value of $200,000 which has generated $100,000 in revenue. However, if the asset has cost the
company $25,000 in repairs (which are your operating expenses), the annual net profit for that particular year would be
$75,000. To determine the average annual profit, simply divide the net profit by the investment period or the number of
years that you will be using the asset for revenue. For the purpose of our example, we will be looking at the ARR of our
asset for one year: $75,000/1 = $75,000. Keep in mind that were we to sell off the asset at the end of the investment
period, that amount (the asset’s ‘scrap value’) would be included in our net annual profit.
2. Subtract the depreciation expense. If the investment is a fixed asset (like a new machine, real estate, and other
equipment), you need to adjust your net profit for the value depreciation of the asset over the useful life of the product.
Subtract the amount of depreciation from your annual profit to arrive at the net annual profit. If the rental property (from
the example above) was purchased for $200,000 at the beginning of the year, but now has been valued at $150,000, the
annual net profit will be $25,000 ($75,000 - $50,000).
3. Divide the annual net profit by the initial cost of the asset. Take the total profit and divide by the initial cost of the
investment—which, in the case of our example, is the $200,000 used to purchase the property. $25,000/$200,000 = 0.125
4. Multiply by 100 to arrive at the percentage rate. Now, you can determine the percentage rate of return for your
investment by multiplying your decimal figure by 100. Using our example, we would simply multiply 0.125 by 100 to arrive
at 12.5%. This means that our rental property would net a 12.5% internal rate of return over the course of a year.

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Net present Value (NPV) Method

As an organization expands, it needs to take important decisions which involve immense capital investment. An organization
must take the decisions regarding the expansion of business and investment very wisely. In such cases, the organization will
take assistance of Capital Budgeting tools, one of the most popular NPV method and take a call on the most profitable
investment.
Net present value is a tool of Capital budgeting to analyze the profitability of a project or investment. It is calculated by taking
the difference between the present value of cash inflows and present value of cash outflows over a period of time.
As the name suggests, net present value is nothing but net off of the present value of cash inflows and outflows by discounting
the flows at a specified rate
Advantages of Net Present Value Method
Time Value of Money
Net present value method is a tool for analyzing profitability of a particular project. It takes into consideration the time value of
money. The cash flows in the future will be of lesser value than the cash flows of today. And hence the further the cash flows,
lesser will the value. This is a very important aspect and is rightly considered under the NPV method.
This allows the organization to compare two similar projects judiciously, say a Project A with a life of 3 years has higher cash
flows in the initial period and a Project B with a life of 3 years has higher cash flows in latter period, then using NPV the
organization will be able to choose sensibly the Project A as inflows today are more valued than inflows later on.
Comprehensive Tool
Net present value takes into consideration all the inflows, outflows, period of time, and risk involved. Therefore NPV is a
comprehensive tool taking into consideration all aspects of the investment.
Value of Investment
The Net present value method not only states if a project will be profitable or not, but also gives the value of total profits.
Limitations of the Net Present Value Method
Discounting Rate
The main limitation of Net present value is that the rate of return has to be determined. If a higher rate of return is assumed, it
can show false negative NPV, also if a lower rate of return is taken it will show the false profitability of the project and hence
result in wrong decision making.
Different Projects are not Comparable
NPV cannot be used to compare two projects which are not of the same period. Considering the fact that many businesses
have a fixed budget and sometimes have two project options, NPV cannot be used for comparing the two projects different in
period of time or risk involved in the projects.
Multiple Assumptions
The NPV method also makes a lot of assumptions in terms of inflows, outflows. There might be a lot of expenditure that will
come to surface only when the project actually takes off. Also the inflows may not always be as expected. Today most software
perform the NPV analysis and assist management in decision making. With all its limitations, the NPV method in capital
budgeting is very useful and hence is widely used.
Profitability Index
The profitability index (PI), alternatively referred to as value investment ratio (VIR) or profit investment ratio (PIR), describes an
index that represents the relationship between the costs and benefits of a proposed project. It is calculated as the ratio
between the present value of future expected cash flows and the initial amount invested in the project. A higher PI means that
a project will be considered more attractive.
The PI is helpful in ranking various projects because it lets investors quantify the value created per each investment unit. A
profitability index of 1.0 is logically the lowest acceptable measure on the index, as any value lower than that number would
indicate that the project's present value (PV) is less than the initial investment. As the value of the profitability index increases,
so does the financial attractiveness of the proposed project.
The profitability index is an appraisal technique applied to potential capital outlays. The method divides the projected capital
inflow by the projected capital outflow to determine the profitability of a project. As indicated by the aforementioned formula, the
profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned
variables.
When using the profitability index to compare the desirability of projects, it's essential to consider how the technique disregards
project size. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit
margins are not as high.
Components of the Profitability Index
PV of Future Cash Flows (Numerator)
The present value of future cash flows requires the implementation of time value of money calculations. Cash flows are
discounted the appropriate number of periods to equate future cash flows to current monetary levels. Discounting accounts for
the idea that the value of $1 today does not equal the value of $1 received in one year because money in the present offers
more earning potential via interest-bearing savings accounts, than money yet unavailable. Cash flows received further in the
future are therefore considered to have a lower present value than money received closer to the present.
Investment Required (Denominator)
The discounted projected cash outflows represent the initial capital outlay of a project. The initial investment required is only
the cash flow required at the start of the project. All other outlays may occur at any point in the project's life, and these are
factored into the calculation through the use of discounting in the numerator. These additional capital outlays may factor in
benefits relating to taxation or depreciation.

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Calculating and Interpreting the Profitability Index

Because profitability index calculations cannot be negative, they consequently must be converted to positive figures before
they are deemed useful. Calculations greater than 1.0 indicate the future anticipated discounted cash inflows of the project are
greater than the anticipated discounted cash outflows. Calculations less than 1.0 indicate the deficit of the outflows is greater
than the discounted inflows, and the project should not be accepted. Calculations that equal 1.0 bring about situations of
indifference where any gains or losses from a project are minimal.
When using the profitability index exclusively, calculations greater than 1.0 are ranked based on the highest calculation. When
limited capital is available, and projects are mutually exclusive, the project with the highest profitability index is to be accepted
as it indicates the project with the most productive use of limited capital. The profitability index is also called the benefit-cost
ratio for this reason. Although some projects result in higher net present values, those projects may be passed over because
they do not have the highest profitability index and do not represent the most beneficial usage of company assets.

3. CAPITAL BUDGETING PROCESS

The Capital Budgeting process is the process of planning which is used to evaluate the potential investments or expenditures
whose amount is significant. It helps in determining the company’s investment in the long term fixed assets such as investment
in the addition or replacement of the plant & machinery, new equipment, Research & development, etc. This process the
decision regarding the sources of finance and then calculating the return that can be earned from the investment done.

Video 3: Capital Budgeting Process.

Figure 4. Process of Capital Budgeting.

Identification of Potential Investment Opportunities

The first step in the capital budgeting process is to explore the investment opportunities. There is generally a committee that
identifies the expected sales from a certain course of action, and then the investment opportunities are identified keeping these
targets as a basis. Before initiating the search for the potential investments, there are certain points that need to be taken care
of: monitor the external environment on a regular basis to know about the new investment opportunities, define the corporate
strategy based on the analysis of the firm’s strengths, weaknesses, opportunities and threats, share the corporate strategy and
objectives with the members of capital budgeting process and seek suggestions from the employees.
Assembling of Investment Proposals
Once the investment opportunities are identified, several proposals are submitted by different departments. Before reaching
the capital budgeting process committee, the proposals are routed through several persons who ensures that the proposals
are in line with the requirements and then classify these according to their categories Viz, Replacement, Expansion, New
product and Obligatory & welfare investments. This categorization is done to simplify the task of committee members and
facilitate quick decision making, budgeting, and control.
Decision Making
At this stage, the executives decide on the investment opportunity on the basis of the monetary power, each has with respect
to the sanction of an investment proposal. For example, in a company, a plant superintendent, work manager, and the
managing director may okay the investment outlays up to the limit of 15,00,000, and if the outlay exceeds beyond the limits of
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the lower level management, then the approval of the board of directors is required.
Preparation of Capital Budget and Appropriations
The next step in the capital budgeting process is to classify the investment outlays into the smaller value and the higher value.
The smaller value investments okayed by, the lower level management, are covered by the blanket appropriations for the
speedy actions. And if the value of an investment outlay is higher then it is included in the capital budget after the necessary
approvals. The purpose of these appropriations is to evaluate the performance of the investments at the time of the
implementation.
Implementation
Finally, the investment proposal is put into a concrete project. This may be time-consuming and may encounter several
problems at the time of implementation. For expeditious processing, the capital budgeting process committee must ensure that
the project has been formulated and the homework in terms of preliminary studies and comprehensive formulation of the
project is done beforehand.
Performance Review
Once the project has been implemented the next step is to compare the actual performance against the projected
performance. The ideal time to compare the performance of the project is when its operations are stabilized. Through a review,
the committee comes to know about the following: how realistic were the assumptions, was the decision making efficient, what
were the judgmental biases and were the desires of the project sponsors fulfilled.
4. CAPITAL BUDGETING DECISIONS
Financial management focuses not only on the procurement of funds, but also on their efficient use, with the objective of
maximizing the owner’s wealth. The efficient allocation of funds is an important function of financial management.
It involves the decision to allocate and invest funds, to assets and activities. Thus, it is known as an investment decision,
because it is making a choice, regarding the assets in which funds will be invested.
These assets fall into two categories:
a. Short term or current assets, and

b. Long term or fixed assets.

Thus there are two types of investment decisions. The first type is also known as management of current assets, or
working capital management. The second type of decision is known as long term investment decision, or capital
budgeting, or the capital expenditure decision.
I. M. Pandey defines capital budgeting decision as, “the firm’s decision to invest its current funds most efficiently in the
long term assets, in anticipation of an expected flow of benefits over a series of years”.
In other words, the system of capital budgeting is employed to evaluate expenditure decisions, which involve current
outlays, but are likely to produce benefits over a period of time, longer than one year.
Capital budgeting decisions may either be in the form of increased revenues, or reduction in costs. Capital expenditure
decisions therefore include, addition, disposition, modification and replacement of fixed assets.

For Example:
a. Dis-investment of a division of business.

b. Change in the method of sales distribution.

c. Changing the advertising campaign.

d. Major investment in the research and development program.

e. Labor welfare projects.

f. Diversification projects.

g. New projects-For example- installation of pollution control equipment as per the legal requirements, etc.

5. CHARACTERISTICS OF CAPITAL BUDGETING DECISIONS

The main characteristics of capital budgeting decisions may be summarized as under:
a. It involves huge outflow of funds or capital.

b. There is a time gap between the investment of funds and’ anticipated or future benefits.

c. Involves a high degree of risk as the decisions have a long term effect on the profitability of a company.

d. Most of the capital budgeting decisions are of irreversible nature i.e., once the firm has initiated the investment, it cannot
revert back otherwise it has to incur heavy losses.
e. It helps an enterprise from making over investment and under investment relative to its size of business.

Because of aforesaid features of the capital budgeting decisions, they constitute most important decisions in corporate
management and are exercised with great caution. Any decision taken under capital budgeting has long term effect on the
functioning and profitability of the company.

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If the decision taken goes in the right direction, it will have positive impact on the profitability of the company and if it goes
in the wrong direction it will have negative impact on the profitability of the company. Reversing the decisions already
initiated leads to unnecessary heavy loss to the company.

Capital Budgeting Decisions – Importance of Capital Investment Decisions

Capital investment involves a cash outflow in the immediate future in anticipation of returns at a future date. The capital
investment decisions assume vital significance in view of their marked bearing on corporate profitability needs no emphasis.
The investment proposals need to be related to the underlying corporate objectives and strategies.
A key challenge for all organizations is to identify projects which fit these strategies and promise to be profitable in the broadest
sense i.e., to create wealth for the organization. Capital investment decisions usually involve large sums of money, have long
time-spans and carry some degree of risk and uncertainty.
A capital investment decision involves a largely irreversible commitment of resources that is generally subject to significant
degree of risk. Such decisions have a far-reaching efforts on an enterprise’s profitability and flexibility over the long-term.
Acceptance of non-viable proposals acts as a drag on the resources of an enterprise and may eventually lead to bankruptcy.
For making a rational decision regarding the capital investment proposals at hand, the decision-maker needs some techniques
to convert the cash outflows and cash inflows of a project into meaningful yardsticks which can measure the economic
worthiness of projects.
Realistic investment appraisal requires the financial evaluation of many factors, such as the choice of size, type, location and
timing of investments, taxation, opportunity cost of funds available and alternative forms of financing the outlays.
This shows that capital investment decisions are difficult on account of their complexity and their strategic significance. The
planning and control of capital expenditure is termed as ‘capital budgeting’. Capital budgeting is the art of finding assets that
are worth more than they cost, to achieve a predetermined goal i.e., optimizing the wealth of a business enterprise.
Kinds of Capital Budgeting Decisions
Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure
alternatives. The firm allocates or budgets financial resources to new Investment proposals. Basically, the firm may be
confronted with three types of capital budgeting decisions:
Accept-Reject Decision
This is a fundamental decision in capital budgeting. If the project is accepted,
the firm would invest in it; if the proposal is rejected, the firm does not invest in
it. In general, all those proposals which yield a rate of return greater than a
certain required rate of return or cost of capital are accepted and the rest are
rejected. By applying this criterion, all independent projects are accepted.
Independent projects are the projects that do not compete with one another in
such a way that the acceptance of one precludes the possibility of acceptance
of another. Under the accept-reject decision, all independent projects that
satisfy the minimum investment criterion should be implemented.
Figure 5. Types of Capital Budgeting Decisions.
Mutually Exclusive Project Decision
Mutually Exclusive Projects are those which compete with other projects in such
a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and
only one may be chosen. Suppose a company is intending to buy a new folding machine. There are three competing brands,
each with a different initial investment and operating costs. The three machines represent mutually exclusive alternatives, as
only one of these can be selected. Moreover, the mutually exclusive project decisions are not independent of the accept-reject
decisions. The project should also be acceptable under the latter decision. Thus, mutually exclusive projects acquire
significance when more than one proposal is acceptable under the accept-reject decision.
Capital Rationing Decision
In a situation where the firm has unlimited funds, all independent investment proposals yielding returns greater than some pre-
determined level are accepted. However, this situation does not prevail in most of the business forms in actual practice. They
have a fixed capital budget. A large number of investment proposals compete for these limited funds. The firm must, therefore,
ration them. The firm allocates funds to projects in a manner that it maximizes long-run returns. Thus, capital rationing refers to
a situation in which a firm has more acceptable investments than it can finance. It is concerned with the selection of a group of
Investment proposals out of many investment proposals acceptable under the accept-reject decision. Capital rationing employs
ranking of acceptable Investment projects. These projects can be ranked on the basis of a pre-determined criterion such as the
rate of return. The projects are ranked in descending order of the rate of return.

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Video 4: Capital Budgeting Decision Methods.

Risk Analysis in Capital Budgeting Decisions
So far our analysis of investment decisions has been based on conditions of certainty regarding the future and the proposed
investment does not carry any risk. The assumptions of certainty and no risk were made simply to facilitate the understanding
of capital investment decisions.
But in practice, all investment decisions are undertaken under conditions of risk and uncertainty. Since investment decisions
involve projecting the future cash inflows and outflows, uncertainty inevitably creeps in.
Neither rupee amounts nor the dates of cash flows can be known with precision. The amount and timing of the long term future
cash flows could vary significantly from those predicted.
It is therefore essential to consider risk factors at the time of determining cash flows from a project for the purpose of capital
budgeting decisions. However, incorporation of risk factors in capital budgeting decisions is a difficult task.
Some of the popular methods used for this purpose are as follows:
1. Risk adjusted discount rate method

2. Certainty – equivalent method

3. Sensitivity analysis

4. Probability assignment

5. Standard deviation and coefficient of variation.

6. Decision tree analysis.

Method 1. Risk Adjusted Discount Rate Method

This method is also known as a varying discount rate method. It is based on the presumption that investors expect a higher
rate of return on risky projects as compared to less risky projects.
The rate requires determination of
a. risk free rate and

b. risk premium rate.

Risk free rate is the rate at which the future cash inflows should be discounted had there been no risk. Risk premium rate
is the extra return expected by the investors over the normal rate (i.e., the risk free rate), on account of the project being
risky.
Thus Risk adjusted discount rate is a composite discount rate that takes into account both the time and risk factors. A
higher discount rate will be applied for projects which are considered more risky, conversely, a lower discount rate is
applied for less risky projects.

Method 2. Certainty-Equivalent Method

Under this method, the risk element is compensated by adjusting cash inflows rather than adjusting the discount rate.
Expected cash flows are converted into certain cash flows by applying certainty-equivalent coefficients, depending upon
the degree of risk inherent in cash flows.

To the cash flows having higher degree of certainty, higher certainty – equivalent coefficient is applied and for cash flows
having low- degree of certainty, lower certainty equivalent coefficient is used. For evaluation of various projects, cash
flows so adjusted are discounted by a risk free rate.

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Method 3. Sensitivity Analysis

In the methods discussed above, only one figure of cash flow for each year is considered. However, there are chances of
making estimation errors. The sensitivity analysis approach takes care of this aspect by giving more than one estimate of
the future cash flow of a project.
It is thus superior to one figure forecast as it provides a more clear idea about the variability of the return. Generally,
sensitivity analysis gives information about cash inflows under three assumptions i.e., ‘Optimistic’, ‘Most likely’ and ”
Pessimistic” outcomes associated with the project.
It explains how sensitive the cash flows are under these three situations. Further cash inflows under these three situations
are discounted to determine net present values. The larger the difference between the pessimistic and optimistic cash
flows, the more risky is the project and vice versa.

Method 4. Probability Assignment

Although sensitivity analysis approach provides different cash flow estimates under three assumptions, it does not provide
chances of occurrence of each of these estimates. The chances of occurrence can be ascertained by assigning
appropriate probabilities to each of these estimates.
In most of the capital budgeting situations, the probabilities are usually assigned by the decision maker on the basis of
some relevant facts and figures and his subjective considerations. If the decision maker foresees a risk in the proposal,
then he has to prepare a separate probability distribution to summarize the possible cash flow for each year through the
economic life of the proposal. Thereafter he has to find out the expected value of probability distribution for each year.
To determine the expected value, each cash flow of the probability distribution is multiplied by the respective probability of
the cash flow and then adding the resulting products. This final figure is then considered as the expected value of the cash
flow of that year for which probability distribution has been considered.
This procedure is to be adopted for the probability distribution for all the years and the expected value of cash inflows are
discounted at an appropriate discount rate to determine the NPV of the proposal.

Method 5. Standard Deviation and Coefficient of Variation

The probability assignment discussed above does not give a precise value indicating about the variability of cash flows
and therefore the risk. This limitation can be overcome by following a standard deviation approach. Standard deviation
(SD) is a measure of dispersion. It is defined as the square root of squared deviation calculated from the mean.
In case of capital budgeting, SD is applied to compare the variability of possible cash flows of different projects from their
respective mean or expected value. A project having a larger SD will be more risky as compared to a project having
smaller SD.

Method 6. Decision Tree Analysis

This is a useful alternative for evaluating risky investment proposals. It takes into account the impact of all probabilistic
estimates of potential outcomes. Every possible outcome is weighed in probabilistic terms and then evaluated. A decision
tree is a pictorial representation in tree form which indicates the magnitude probability and inter-relationship of all possible
outcomes.

The format of the problem of the investment decision has an appearance of a tree with branches and therefore this
analysis is termed as decision tree analysis. The decision tree shows the sequential cash flows and NPV of the proposed
project under different circumstances.

Conditions Affecting Capital Budgeting (With Determination of Cash Flows)

Certain Conditions Affecting Capital Budgeting
The consideration of the formal process of capital budgeting analysis by examining it under conditions of certainty is the theme
of this section. By certainty we mean that the forecast of future cash flows a project may create is known with 100 percent
accuracy. No element of risk need be considered when examining the capital budgeting process under conditions of certainty.
The general goal in evaluating investment proposals is to judge them on the basis of the return they will yield and compare that
to what investors might demand in terms of a return. The measure of return on the project should be equal to or greater than
what the investors require. The measure of the rate of return is the key to determining the effect of the investment of the market
price of the common stock.
This is of vital importance, since we have defined as the primary goal of the firm the maximization of the value of the firm. This
is achieved through the maximization of the wealth of the shareholders, and this is reflected in the price of the common stock.
Firstly, we examine the process involved in gathering the rele­vant data necessary to evaluate the profitability of one project
versus another. This includes the definition of cash flows and an illustration of how a determination of future cash flow
estimates is arrived at.
When we estimate the benefits to be received from a project, we are interested in the cash flows the project will generate
rather than an estimate of future net income.

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This is because cash in essence is critical to all decisions of the firm. The firm is committing cash now in the form of an
investment in the hopes of receiving cash in the future that will be in excess of that investment.
In the final analysis, it is cash and only cash that can be reinvested in the firm or distributed to the shareholders in the form of
dividends. This is why, in the capital budgeting process, we are interested in cash flows rather than net income.
Later we shall examine some different methods for ranking investment alternatives and then consider which ranking technique
is the best to use for capital budgeting analysis.
Determination of Cash Flows
One of the primary tasks in the evaluation of investment alternatives is the determination of the net cash flow stream. This task
must be accomplished for all investment proposals under consideration. This determination is very important, because the
profitability analysis of alternatives depends on the accuracy of the net cash flow information.
Prospective investments which compete with one another in terms of the functions they perform are classified as mutually
exclusive; if you accept one you must automatically reject the other. Investments which do not compete in terms of their
function are classified as non-mutually exclusive investments.
When the cash flows generated from one project are contingent upon other projects, these investments are classified as
contingent cash flow streams. If the cash flows of a project do not depend upon any other project, they are termed
independent.

Video 5: Capital Budgeting Cash Flow.

Advantages and Limitations of Discounted Cash Flow Methods
Advantages of Discounted Cash Flow Methods:
The phrase ‘discounted cash flow’ has evoked considerable discussion in regular commercial enterprises as well as in those
which undertake development projects.
The World Bank and other financial institutions use the DCF method extensively while measuring the economic success of
new development ventures in order to arrive at sound capital expenditure decisions. A sound evaluation under this method
greatly depends on price stability.
Moreover, the DCF method is more suitable for long-term planning. In situations in which a strict credit squeeze and other
restrictions on credit prevail, entrepreneurs may not opt for a long-range plan and may prefer the convention payback principle
to pay off the original investment within the shortest possible time.
The DCF approach produces investment decisions which best serve the interest of shareholders. The DCF criterion
encourages managers to take a long-range view, for it takes into account benefits over many future periods.
Discounting methods make precise allowances for the distance (from the present) of receipts and payments and the notion of
the discounting is common to most methods of investments appraisal.
Because the discounted cash flow method explicitly and automatically weighs the time value of money, it is the best method to
use for long-range decisions.
Given that there will always be some uncertainty in investment decisions, the greatest contribution to investment appraisal
made by the discounted cash flow technique is to provide the frame-work for measuring the degree of uncertainty, thereby
reducing it to a quantifiable factor for making an investment decision.
Limitation of Discounted Cash Flow Methods
It is a neat, mathematical exercise but suffers from some drawbacks. What follows are factors which need to be considered
when an assessment of that likely return which a project will achieve is calculated.
In this connection, B.H. Walley says, “Some are obviously trite, others are of considerable significance. Together they form a
total criticism which shows that the DCF by itself is a highly suspect method of evaluating competitive projects”.
The DCF approaches do not consider the impact of an investment on accounting profits. The investment may generate a low,
or even a negative, net cash flow in early years, but produce high cash flows in subsequent years. In such cases, the
accounting profits of a firm are adversely affected.
The discounted present value notion, though exact in concept, is often fuzzy in use. From an accounting point of view, it may
be necessary to use procedures which are exact in use, but fuzzy in concept.
Possibly the greatest criticism of the current application of the DCF is that little or no discrimination is usually made between
the risk of the projects. There is a universal application of a standard required rate of return, no matter what the project, what
part of the company it is required for, or how well or badly it is likely to be managed.
The sophisticated DCF techniques can very well be applied in a country where there is a relative price stability. Long-term
financial planning is not quite feasible in India, primarily because of high inflation.
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A firm’s competitive position (besides some other factors) is a non-financial factor which is given much consideration in making
decisions on capital expenditure proposals in India. Community relations and shareholder relations are practically given no (or
very low) weightage. Under the present conditions, the traditional techniques (with modifications) are very effective in
developing economies.
An effective DCF analysis calls for much more than arithmetic calculations, important as these are. As we have seen, the
critical task of choosing a proper discount rate involves top management policy as to the financial and growth objectives of the
whole company.
Before arriving at a realistic estimate of future cash flows, many functional departments of the company have to combine their
specialized analysis into a consistent prediction, with an allowance for the risk element.
Although the idea of discounting the income stream of an investment is centuries old, non- discounting methods of investment
appraisal are still employed today. That the use of these methods should have persisted as long as it has utility in some
business circles is perplexing, but it is presumably accounted for by a reluctance to change and this survival, or even a good
living, is possible with poor decisions, if the quality of competition is low enough.
Many writers attribute the relatively slow acceptance of DCF to a lack of understanding or a feeling of futility about projecting
cash flows more than a few years into the future, or to a preference for payback benchmarks on the part of risk-conscious
decision-makers with strong liquidity preferences.
The familiar present value approach to capital budgeting requires that the project which lowers the present value of a company
should not be adopted at all.
The imposition of an earning growth constraint changes the approach to capital budgeting in two important ways:
a. It makes income flows as well as cash flows relevant to the investment decision. It, therefore, results in a portfolio of
accepted projects which have a lower present value that the unconstrained method allows,
b. More importantly, it raises a policy question of what planning horizon a corporation should use in preparing its capital
budget.

Much has been written about the use of the discounted cash flows (DCF) as a tool for investment appraisal and project
ranking. Little can be added to the theoretical framework at present.
But there is still a considerable misunderstanding about how to apply the DCF. The difficulties most often encountered
relate to the consequences of the decision to use the DCF; and all too often, these consequences are not fully understood
and are under-estimated. This is especially true when the cash flow is complex-that is when a great many variables are
involved.

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