The capital budgeting is one of the important decisions of the financial management of the enterprise. The decisions pertaining to the financial management of the firm are following
Why the capital budgeting is considered as most important decision over the others
The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets. The importance of the capital budgeting is only due to the benefits of the long term assets stretched to many number of years in the future. It is a tool of analysis which mainly focuses on the quality of earning pattern of the fixed assets.
The capital budgeting decision is a decision of capital expenditure or long term investment or long term commitment of funds on the fixed assets. Charles T. Horngreen “A long-term planning for making and financing proposed capital outlays”.
To make rational investment: The study of capital budgeting on capital expenditures
evades not only over capitalization but also under capitalization. The long-term investment
normally demands heavy volume of investment which is met out by the firm either through
external or internal source of financing. Hence, the amount of capital raised by the firm
should neither greater nor lesser than the investment.
Locking up of capital: The amount invested is requiring longer gestation to recover.
The longer gestation is connected with future horizon in getting back the investment.
The future is uncertain unlike the present. If the longer is the gestation in the future leads
to greater risk involved.
Effect on the profitability of the enterprise: The profitability of the enterprise is mainly
depending on the proper planning of the capital expenditure.
Nature of Irreversibility: The improper/ unwise capital expenditure decision cannot be
immediately corrected as soon as it was found. Once it is invested is invested which
cannot be reversed. The poor investment decision will require the firm either to keep it
as an idle in the form of investment or to unnecessarily meet out fixed commitment
charge of the capital which excessively raised more than the requirement.
The methods are the nothing but the instruments of the capital budgeting to study the
quality of the investments/fixed assets. The investments are studied by the firms in the
following angles:
Based on the number of years taken for getting back the investment – Pay Back
Period Method
Based on the profits accrued out of the investment – Accounting Rate of Return/
Average Rate of Return
Based on the timing of benefits – Present value of future benefits of the investment
–Discounted cash flow methods
Based on the comparison in between the cash outlay and receipts discounted
with the help of minimum rate of return - Net present value method
Based on the identification of maximum rate of return, in between the initial
cash outlay and discounted expected future receipts - Internal Rate of return
Based on the ration in between the present values of cash inflows and outflows
– Present value index method.
Pay Back Period Methethod
The pay back period is the period taken by the firm to get back the investment. The pay
back period is nothing but number of years/months/days required by the firm to get back
its investment invested in the project.
To find out the pay back period, the following are two important covenants required:
Initial outlay / Initial investment/ Original investment
Cash inflows
How the pay back period is calculated?
The pay back period is calculated by way of establishing the relationship between the
volume of investment and the annual earnings
While calculating the pay back period, the nature of annual earnings should be identified.
The nature of the annual earnings can be classified into two categories:
Cash flows are equivalent or constant
Cash flows are not equivalent or constant
If the cash flows are equivalent, How the pay back period is to be calculated ?
The cost of the project is Rs.1,00,000. The annual earnings of the project is Rs.20,000.
Calculate the pay back period.
It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 Capital Budgeting years time period to get back the original volume of the investment.
If the cash flows are not equivalent, How the pay back period is to be calculated ?
The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows
Discounted Cash Flows Method
The discounted cash flows method is the only method nullifies the drawbacks associated
with the traditional methods viz Pay back period method and Accounting rate of return
method. The underlying principle of the method is time value of money. The value of 1
Re which is going to be received on today bears greater value than that of 1 Re expected
to receive on one month or one year later. The main reason is that "Earlier the benefits
better the principle". It means that the benefits whatever are going to be accrued during
the present will be immediately reinvested again to maximize the earnings, so that the
earlier benefits are weighed greater than the later benefits. The later benefits are expected
to receive only during the future which is connected with the future i.e., future is uncertain.
It means that there is greater uncertainty involved in the receipt of the benefits connected
with the future.
Why the time value of money concept is inserted on the capital budgeting tools?
The main reason is that the capital expenditure is expected to extend the benefits for
many number of years. The 1 Re is expected to receive one year later cannot be treated
at par with the 1 Re of 2 years later. This is the only method considers the profitability as
well as the timing of benefits. This method gives an appropriate qualitative consideration
to the benefits of various time periods.
The time value of money principle is used for an analysis to study about the quality of the
investments in receiving the future benefits.
There are general classifications which are as follows
Net present value method
Present value index method
Internal rate of return method
Under this method, the initial outlay or initial investment available in terms of present
value is compared with the present value of future earnings of the enterprise.
Why the present value of the future earnings are found out?
The ultimate reason to find out the present value future earnings is that the comparison
in between inflows and outflows should be meaningful as well as effective. The present
value of the initial outlay cannot be converted into the future value for comparison, even
otherwise the conversion takes place, the comparison cannot be meaningful. To be
meaningful comparison, the future earnings are converted into the present value which
is known as discounting process through the discount rate. The rate at which the future
earnings are discounted is known as required rate of return.
Selection criterion of Net present value method
If the present value of future cash inflows are greater than the present value of initial
investment ; the proposal has to be accepted.
If the present value of future cash inflows are lesser than the present value of initial
investment ; the proposal has to rejected.

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