CAPITAL

BUDGETI
NG

Submitted to: Submitted by:

Prof. M. Idrees 1. Kainat Arif (16)

2. Hira Zubair (50)
3. Hafsa Tariq (68)
4. Kinza Fayyaz (34)
5. Noor ul Huda (30)
 Capital Budgeting
The term “Capital Budgeting” is the combination of two words:

1. Capital
2. Budgeting

What is Capital?
Capital refers to the financial resources that businesses
can use to fund their operations like cash,
machinery, equipment and other resources.

What is Budget?
A budget is an estimation of revenue and

expenses for a specified period of time.

What is Capital Budgeting?

Capital budgeting is the process of evaluating and selecting long-term investments that are
consistent with the firm´s goal of maximizing owner´s wealth.

Maximizing Owner’s Wealth or Profit?

The primary goal of capital budgeting is to maximize the wealth of the owner. This goes beyond
just maximizing profits, as it considers the long-term sustainability and growth of the company.

Whereas maximizing profits is a short-term goal, and it does not consider the long-term
implications of financial decisions on the company's value.

Wealth maximization or Profit Maximization?

The primary goal of capital budgeting is to maximize the wealth of the owner. This goes beyond
just maximizing profits, as it considers the long-term sustainability and growth of the company.
Whereas maximizing profits is a short-term goal, and it does not consider the long-term
implications of financial decisions on the company's value.
 The SCARCITY Principle:
There´s a principle in Economics, named “The Scarcity Principle” which
tells us that our wants are limitless but the resources we are provided
with are limited. So, we have to make judicious decisions about
effective allocation of limited available resources to gain optimum
return. Capital Budgeting is the practical application of the scarcity
Principle.
THE CAPITAL BUDGETING PROCESS
Step 01:

Generating Ideas: Investment ideas can come from anywhere, from the top or the bottom of
the organization, from any department or functional area, or from outside the company.
Generating good investment ideas to consider is the most important step in the process.

Step 02

Analyzing individual proposals: This step involves gathering the information to forecast cash
flows for each project and then evaluating the project’s profitability.

Step 03

Planning the capital budget: The company must organize the profitable proposals into a
coordinated whole that fits within the company’s overall strategies, and it also must consider
the projects’ timing. Some projects that look good when considered in isolation may be
undesirable strategically. Because of financial and real resource issues, scheduling and
prioritizing projects are important.

Step 04

Follow up: Results are monitored, and actual costs and benefits are compared with those that
were expected. Action may be required if actual outcomes differ from projected ones.
 Idea
generatio
n

Analyzing
Follow up individual
proposals

Planning
the
capital
budget

Why Do Businesses Need Capital Budgeting?

Capital budgeting is important because it creates accountability and measurability. Any

business that seeks to invest its resources in a project without understanding the risks and
returns involved would be irresponsible by its owners or shareholders. Furthermore, if a
business has no way of measuring the effectiveness of its investment decisions, chances are
the business would have little chance of surviving in the competitive marketplace. Choosing
the most profitable capital expenditure proposal is a key function of a company's financial
manager. As mentioned earlier, these are long-term and substantial capital investments, which
are made with the intention of increasing profits in the coming years.

“According to a survey about 70% of Businesses fail at their startup due to poor Capital
Budgeting and poor management”.

The need for capital budgeting can be highlighted as follows:

 Analysis of Capital Expenditure:

Assessing the Potential Costs and Benefits Associated with Capital Investments. This Includes
evaluating the Initial Outlay, Ongoing Operational Costs, And Expected Returns.

 Selection of Best Projects:

Choosing the Most Beneficial Projects Based on Criteria Such as Return on Investment (ROI), Net
Present Value (NPV), and Internal Rate of Return (IRR).

 Coordination Between Various Capital Expenditures:

Ensuring That All Capital Expenditures Are Aligned and Integrated With the Company’s Overall
Strategic Plan to Avoid Duplication and Ensure Resource Optimization.

 Avoiding Losses for the Company:

Risk Mitigation: Identifying and Mitigating Risks Associated With Large Investments.

Informed Decisions: Making Decisions Based on Thorough Analysis to Prevent Financial

Losses.

 Control Over Capital Expenditure:

Budgeting: Setting and Adhering to Budgets for Capital Projects.

Monitoring: Regularly Monitoring Expenditures to Stay Within Budget.

 Analysis of Uncertainty and Risk:

Risk Assessment: Evaluating the Uncertainty and Risks Associated With Long-Term
Investments.

Contingency Planning: Preparing for Potential Adverse Scenarios.

 Managing the Source of Finance:

Deciding Whether to Use Debt, Equity, or a Combination of Both to Finance Capital Projects.
Understanding the Cost of Each Financing Option and Its Impact on the Company’s Financial
Structure.

 Success of the Firm:

How Well the Selected Projects Contribute to the Overall Success of the Company, Measured
Through Profitability, Growth, and Competitive Advantage.

 Useful in Long-Term Commitment of Fund:

Capital Budgeting Decisions Typically Involve Significant Financial Commitments Over a Long
Period, Requiring Careful Planning and Allocation.
  Irreversibility of Purchasing or Acquiring Assets:
Once an Investment Is Made in Assets, It Is Often Not Possible to Reverse the Decision Without
Incurring Significant Costs.

 Long-Term Effect on Profitability:

The Impact of Capital Investments on the Company’s Profitability in the Long Run, Considering
Factors Like Depreciation, Maintenance, and Operational Efficiency.

Pakistan’s International Airline (PIA) Failure due to Poor Capital

Budgeting & Poor Financial Management

PIA's failure can be attributed to poor capital budgeting decisions:

 Outdated Fleet: Increased maintenance costs and inefficiency due to an old fleet.
 Insufficient Technology Investment: High costs and inefficiencies from lack of
technological upgrades.
 Poor Route Planning: Financial losses from expanding into unprofitable routes.
 Inefficient Fuel Management: High fuel costs from not investing in fuel-efficient aircraft
and systems.
 Outdated Airport Infrastructure: Increased maintenance costs due to lack of
modernization.
 Inadequate Safety and Maintenance Investment: Increased costs and safety concerns
from insufficient investment.
 Poor Capital Structure: Financial struggles from high debt and low equity.
These factors combined led to PIA's decline. If they recognize the need of Capital Budgeting
with these aspects they will Improve.

IMPORTANCE OF CAPITAL BUDGETING

1.Long-Term Investment Decisions:

It focuses on long-term investments that shape the future direction of the company.

2.Resource Allocation:
Ensures that limited financial resources are used effectively.

3.Risk Management:
Capital budgeting involves assessing the risks associated with large investments and helps in
planning for potential uncertainties. This includes financial risks, market risks, operational risks,
and other uncertainties.

4.Financial Performance:
Projects are evaluated based on their potential to generate cash flows and profitability. It also
ensures that investment decisions are economically sound, align with strategic goals, manage
risks effectively, and contribute to the company’s long-term financial health and shareholder
value.

5.Strategic Planning:
Aligns investment decisions with the company’s overall strategic goals.

Example:
Suppose a company, XYZ Inc., has two investment opportunities:
Project A: Requires an initial investment of $100,000 and is expected to generate annual cash
flows of $30,000 for five years.
Project B: Requires an initial investment of $50,000 and is expected to generate annual cash
flows of $20,000 for three years.
Using capital budgeting techniques like Net Present Value (NPV) or Internal Rate of Return (IRR),
XYZ Inc. can evaluate and compare the two projects, selecting the one that generates the
highest returns or meets its investment criteria.
By applying capital budgeting principles, XYZ Inc. can make an informed decision, allocating its
resources to the most profitable project and maximizing shareholder value.
“One country known for effectively using capital budgeting is the United States.”

TECHNIQUES OF CAPITAL BUDGETING

 Payback Period
The payback period is the length of time it takes to recover the cost of an investment or the
length of time an investor needs to reach a breakeven point.

Decision Criteria:
1. Accept the project if the payback period is less than or equal to a predetermined maximum
payback period (e.g., 3 years).

2. Reject the project if the payback period is greater than the predetermined maximum payback
period.

Example:

An industry is considering investment in a project which cost Rs. 600,000.

Cash inflows are Rs.120,000, Rs.140,000, Rs.180,000, Rs.200,000

Rs.250,000.

Calculate Payback period.

 Years Cash flows Cumulative C.F
0 (600,000) (600,000)
1 120,000 (480,000)
2 140,000 (340,000)
3 180,000 (160,000)
4 200,000 40,000
5 250,000 -

Formula:-
Payback period= year before + unrecovered cost at the ÷ C.f during

full recovery. start of the year. the year.

= 3 + 160,000÷ 200,000

= 3 + 0.8

Payback period= 3.8 years.

Internal Rate of Return

IRR, or internal rate of return, is a metric used in financial analysis to estimate the profitability
of potential investments. IRR is a discount rate that makes the net present value (NPV) of all
cash flows equal to zero.

Pros:

1. Easy to understand: IRR is a simple and intuitive concept, expressing returns as a

percentage.
2. Comparative analysis: IRR allows for easy comparison between projects or investments.
3. Commonly used: IRR is a standard metric in finance, making it easy to communicate
with stakeholders.

Cons:

1. Ignores cash flow patterns: IRR focuses on returns, neglecting the timing and size of
cash inflows and outflows.
2. May prioritize short-term gains: IRR favors projects with high initial returns, potentially
overlooking long-term value.
3. Ignore risk: IRR doesn’t consider the risk associated with the project, which can be
significant factor in investment decision.
 Modified Internal Rate of Return
Modified Internal Rate of Return (MIRR) is a financial metric that calculates the return on an
investment or project, taking into account the cost of capital and the net present value (NPV) of
cash inflows and outflows. It’s a variation of the Internal Rate of Return (IRR) that provides a
more accurate and robust measure of investment performance.

Formula:

MIRR= (FVCF ÷ PVCF) ^(1/n) -1

Difference:

MIRR IRR

MIRR assumes reimbursement IRR assumes reinvestment at the

at a specified rate. same rate.
It considers the cost of capital. It doesn’t.

May return only one solution. May return two solutions.

NET PRESENT VALUE

• This method is also called Excess present value or Net gain method.
• This method considered the time value of money and attempts to calculate the return
on investment by introducing the factor of time element.
• All cash flows (cash inflows & cash outflows) are discounted at a given rate and their
present values are ascertained.
• This method is used when management has already determined a minimum rate of
return (cut off rate or discounted rate) as their policy.

BASIC PRINCIPLES OF CAPITAL BUDGETING

Capital budgeting has a rich history and sometimes employs some sophisticated
procedures.Fortunately, capital budgeting relies on just a few basic principles and typically uses
the following assumptions:
 1. Decisions are based on cash flows: The decisions are not based on accounting concepts,
Such as net income. Furthermore, intangible costs and benefits are often ignored
because, If they are real, they should result in cash flows at some other time.
2. Timing of cash flows is crucial: Analysts make an extraordinary effort to detail precisely
when cash flows occur.
3. Cash flows are based on opportunity costs: What are the incremental cash flows that
occur with an investment, compared to what they would have been without the
investment?
4. Cash flows are analyzed on an after-tax basis: Taxes must be fully reflected in all capital
budgeting decisions.
5. Financing costs are ignored: This may seem unrealistic, but it is not.

Most of the time, Analysts want to know the after-tax operating cash flows that result from a
capital investment. Then these after-tax cash flows and the investment outlays are discounted
at the Required rate of return to find the net present value (NPV). Financing costs are reflected
In the required rate of return. If we included financing costs in the cash flows and in the
Discount rate, we would be double-counting the financing costs. So. Even though a project may
be financed with some combination of debt and equity, we ignore these costs, Focusing on the
operating cash flows and capturing the costs of debt (and other capital) In the discount rate.

Formula:

NPV= Present value of cash inflow – Present value of cash outflow

Decision criteria:

So, if result is:

• More than zero I.E Positive NPV =>Project Accept.

• Less than zero I.E Negative NPV=>Project Reject.
• Equal to zero I.E Nil NPV => Neutral.

Example:

Imagine you are considering investing in a project that will cost $10,000 today. Over the next
five years, you expect to receive cash inflows of $3,000 at the end of each year. To calculate the
NPV of this project, you would discount each cash inflow back to the present value using a
discount rate, let’s say 5%.

Calculation:
Step # 1 & 2:
 Years Cash Flows Present value Sum of PV
1 $3000 3000/ (1+0.05)^1 $ 2857.14
2 3000 3000/ (1+0.05)^2 2730.37
3 3000 3000/ (1+0.05)^3 2605.59
4 3000 3000÷(1+0.05)^4 2482.37
5 3000 3000÷(1+0.05)^5 2360.90
= 13,036.47

Formula of Present value:

PV= FV/(1+i) ^n

Step # 3:

Putting the values in formula:

$13,036.47 - $10,000 = $3,036.47

Decision:

So, in this example, the NPV of the project is $3,036.47, which means the project is profitable
because the NPV is positive.

Profitability Index
The Profitability Index (PI) is a financial metric used to evaluate the attractiveness of a project or
investment.

Interpretation:

 PI > 1: The project is profitable and generates more value than its cost.
 PI = 1: The project breaks even, and the present value of cash flows equals the initial
investment.
 PI < 1: The project is not profitable and generates less value than its cost.

Advantages:

1. Simple to calculate.
2. Easy to understand.
3. Useful for comparing projects with different lifetimes and cash flow patterns.

Limitations:

1. Ignores the time value of money (if not using discounted cash flows).
2. Favors projects with high upfront returns.
 3. Does not consider risk or uncertainty

Formula:

PV of cash inflow / PV of cash outflow

Calculation:

= 3036.47 / 10000

=0.30

Conclusion
In conclusion, capital budgeting is a vital tool for businesses to make informed investment
decisions that drive growth, profitability, and long-term success. By integrating capital budgeting
into their decision-making process, businesses can achieve sustainable growth, improve
profitability, and maintain a competitive edge in the market.