Capital Budgeting Techniques

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Capital Budgeting Technique

1. Introduction to Capital Budgeting

Capital Budgeting refers to the process of evaluating and selecting long-term investment projects that require large capital expenditure and provide benefits over several years.

Examples

  • Purchase of machinery
  • Expansion of business
  • Construction of a new building
  • Launch of a new product

2. Importance of Capital Budgeting

Capital budgeting is important because it:

  • Involves huge financial commitment
  • Affects long-term profitability
  • Helps in efficient allocation of resources
  • Reduces investment risk
  • Ensures wealth maximization of owners

3. Uses of Capital Budgeting

  • Selection of profitable projects
  • Long-term financial planning
  • Control over capital expenditure
  • Comparison of alternative investments
  • Strategic decision-making

4. Capital Budgeting Techniques

Capital budgeting techniques are divided into:

A. Non-Discounting Techniques

  1. Payback Period (PBP)
  2. Accounting Rate of Return (ARR)

B. Discounting Techniques

  1. Net Present Value (NPV)
  2. Internal Rate of Return (IRR)
  3. Profitability Index (PI)

1. Payback Period (PBP)

Meaning

Payback Period is the time required to recover the initial investment from cash inflows.

Formula


Decision Rule

  • Shorter payback period is preferred

Solved Numerical – 1

Initial Investment: Rs. 100,000
Annual Cash Inflow: Rs. 25,000


✅ Investment will be recovered in 4 years

Solved Numerical – 2

Initial Investment: Rs. 200,000
Annual Cash Inflow: Rs. 40,000


✅ Payback period = 5 years

Merits

  • Simple and easy
  • Useful for liquidity analysis

Demerits

  • Ignores time value of money
  • Ignores profit after payback

2. Accounting Rate of Return (ARR)

Meaning

ARR measures profitability based on accounting profit.

Formula


Decision Rule

  • Higher ARR is preferred

Solved Numerical – 1

Initial Investment: Rs. 100,000
Annual Profit: Rs. 20,000


Solved Numerical – 2

Initial Investment: Rs. 150,000
Annual Profit: Rs. 30,000


Merits

  • Uses accounting data
  • Easy to calculate

Demerits

  • Ignores cash flows
  • Ignores time value of money

3. Net Present Value (NPV)

Meaning

NPV is the difference between the present value of cash inflows and initial investment.

Formula


Decision Rule

  • Accept project if NPV > 0

Solved Numerical – 1

Initial Investment: Rs. 100,000
PV of Cash Inflows: Rs. 130,000


✅ Project is acceptable

Solved Numerical – 2

Initial Investment: Rs. 200,000
PV of Cash Inflows: Rs. 180,000


❌ Project should be rejected

Merits

  • Considers time value of money
  • Best technique for wealth maximization

Demerits

  • Requires discount rate
  • Difficult for beginners

4. Internal Rate of Return (IRR)

Meaning

IRR is the discount rate at which NPV becomes zero.

Decision Rule

  • Accept project if IRR > Cost of Capital

Solved Numerical – 1

Cost of Capital: 12%
IRR: 18%

✅ Since 18% > 12%, project is accepted

Solved Numerical – 2

Cost of Capital: 15%
IRR: 10%

❌ Since 10% < 15%, project is rejected

Merits

  • Easy to understand
  • Considers time value of money

Demerits

  • Complex calculation
  • Multiple IRRs possible

5. Profitability Index (PI)

Meaning

PI shows the value created per rupee invested.

Formula


Decision Rule

  • Accept project if PI > 1

Solved Numerical – 1

PV of Inflows: Rs. 150,000
Initial Investment: Rs. 100,000


✅ Project is acceptable

Solved Numerical – 2

PV of Inflows: Rs. 90,000
Initial Investment: Rs. 100,000


❌ Project is rejected

6. Conclusion

Capital budgeting techniques help businesses:

  • Choose profitable projects
  • Minimize risk
  • Maximize shareholder wealth
  • Plan long-term growth effectively

 

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