Capital Budgeting

    CAPITAL BUDGETING

DEFINITION: It is the process through which different projects are evaluated. It is the process of making investment decision in fixed assets or capital expenditure. Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time. Capital budgeting is the process of analysing and ranking proposed projects to determine which ones are deserving of an investment. The result is intended to be a high return on invested funds.

ADVANTAGES OF CAPITAL BUDGETING:

• It helps a company to understand various risks involved in an investment opportunity and how these risks affect the returns to the company.
• It helps the company to estimate which investment option would yield the best possible return.
• It helps the company to make long-term strategic investments.
• It helps to make an informed decision about an investment taking into consideration all possible options.
• It offers adequate control on expenditure for projects.
• It allows management to abstain from over investing and under investing.
• It helps to estimate whether an investment would increase the company’s value or not.
• It contributes towards increase in shareholders wealth and give the company an edge in the market.

DISDVANTAGES OF CAPITAL BUDGETING:

• It is a long term decision which is mostly irreversible.
• The techniques of capital budgeting are purely based on the estimations and assumptions as

future would always remain uncertain.

• A wrong capital budgeting decision taken can affect the long term durability of the company and hence it needs to be done judiciously by professionals who understands the project well.
• It involves risk factor as well as the discounting factor.
• A wrong capital budgeting decision taken can affect the long term durability of the company and hence it needs to be done judiciously by professionals who understands the project well.[pic 1]

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TRADITIONAL METHODS OF CAPITAL BUDGETING:

• PAY-BACK PERIOD (PBP) - Payback period is a non-discounted cash flow method that strictly focuses on the time required to recover the initial amounts of capital invested in fixed assets. This method is unrealistic because it does not account for the time value of money, i.e., future changes in the value of money. If we have to compare and choose one project out of the ones being offered, we will calculate the PBP of all the projects individually and the one having the lowest will be taken into consideration. The riskiness of the project can be tackled as it may ensure guarantee against loss and it gives an insight to the liquidity of the project. But it fails to take account of the cash inflows earned after the payback period and may give a rise to administrative difficulties.

               PBP = INITIAL OUTLAY (after depreciation and tax)[pic 16]

                          ACTUAL REVENUE

• AVERAGE RATE OF RETURN (ARR) - This method uses the accounting information to measure the profit-abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.

Average rate of return= average of profit (after depreciation and tax) X 100

                                      Net initial investment[pic 17]

Return per unit of investment method= total profit (after depreciation and tax) X 100[pic 18]

                                                               Net initial investment

Return on average investment method= total profit (after depreciation and tax) X 100[pic 19]

                                                                Average of Net initial investment

Average return on

average investment method= average of profit (after depreciation and tax) X 100

                                               average of net initial investment[pic 20]