Question

briely describe capital budgeting

Answer 1

Meaning of Capital Budgeting: Capital Budgeting is the process of making investment decision in purchase of  fixed assest whether it shoud accept or reject. There are number of methods to evaluate fixed assets under a formal capital budgeting system.

For example: Your factory machine is stopped working. Now, you have two choices: Either buy a new one or get the same machinery repaired. Here, you may conclude that the costs of repairing the machinery  the life of the machinery. However, there could be a possibility that the cost to buy a new machine would be lesser than its repair costs. So, you decide to replace your cell phone and you proceed to look at different phones that fit your budget.

Objectives of capital Budegting: Capital expenditures are huge and have a long-term effect. So while performing a capital budgeting analysis an organization must keep the following objectives in mind:

1. Selecting profitable projects: An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth

2.Right source of fund: There are various source available to raise capital.  Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.

Methods of capital Budeting: There are various methods which are explained with help of example:

The discount rate for discounted cashflow (DCF) calculation is 12 per cent. Accounting profits are the same
as cashflow except that the initial expenditure should be depreciated over 4 years; there is no resale value at
year 4.

Year	Cash flow
0	(30000)
1	4000
2	10000
3	20000
4	11000

1. Pay back period method: In this technique, the entity calculates the time period required to earn the initial investment of the project or investment

Year	Cash flow	Cumulative cash flow
0	(30000)	..................
1	4000	4000
2	10000	14000(10000+4000)
3	20000	34000
4	11000	45000

Pay back period: 2 (16/20*12)=2.8 years

2. Net present value:The net present value is calculated by taking the difference between the present value of cash inflows and the present value of cash outflow over a period of time. The investment with a positive NPV will be considered. In case there are multiple projects, the project with a higher NPV is more likely to be selected.

Year	Cash flow	Discount@ 12%	PV
0	(30000)	1.0	(30000)
1	4000	0.8929	3572
2	10000	0.7972	7972
3	20000	0.7118	14236
4	11000	0.6355	6991
NPV			2771

NOTE: Caculation of discount rate

12/100=0.12

1+0.12= 1.12

1/1.12= 0.8929........

Then press = in caclcy u will get another 0.7972

3. Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or average investment to derive at the most profitable investment.

Annual depreciation: 30000/4= 7500

Year	Cash flow
1	4000-7500 = (3500)
2	10000-7500= 2500
3	20000-7500= 12500
4	11000-7500= 3500
	15000

Average profits: 15000/4= 3750

ARR= 3750/30000*100= 12.5%

Internal rate of Return: For NPV computation a discount rate is used. IRR is the rate at which the NPV becomes zero. The project with higher IRR is usually selected

16% is assumed:

Year	Cash flow	Discount@ 16%	PV
0	(30000)	1.0	(30000)
1	4000	0.8621	3448
2	10000	0.7432	7432
3	20000	0.6407	12814
4	11000	0.5523	6075
NPV			(231)

IRR= 12%+2771/2771+231*4%)= 15.7%

Features of Capital Budgeting:

1.Capital budgeting involves the investment of funds currently for getting benefits in the future.

2.Generally, the future benefits are spread over several years.

3.The long term investment is fixed

4.The long term investment is fixed

Limitations of Capital Budgeting:

1.The application of capital budgeting technique is based on the presumed cash inflows and cash outflows. Since the future is uncertain, the presumed cash inflows and cash outflows may not be true. Therefore, the selection of profitable project may be wrong.

2.Only known factors are considered while applying capital budgeting decisions. There are so many unknown factors which are also affecting capital budgeting decisions. The unknown factors cannot be avoided or controlled

3.It is also not correct to assume that mathematically exact techniques always produce highly accurate results

4.The economic life of the project and annual cash inflows are only an estimation. The actual economic life of the project is either increased or decreased.

Conclusion: Capital budgeting is important function of management. Right decisions taken can lead the business to great heights. However, a single wrong decision can inch the business closer to shut down due to the number of funds involved and the tenure of these projects