UNIT 3

Capital Budgeting: Techniques &

Importance
CAPITAL BUDGETING TECHNIQUES /
METHODS
There are different methods adopted for capital budgeting. The
traditional methods or non discount methods include: Payback
period and Accounting rate of return method. The discounted
cash flow method includes the NPV method, profitability index
method and IRR.

 Payback period method:

As the name suggests, this method refers to the period in which

the proposal will generate cash to recover the initial investment
made. It purely emphasizes on the cash inflows, economic life
of the project and the investment made in the project, with no
consideration to time value of money. Through this method
selection of a proposal is based on the earning capacity of the
project. With simple calculations, selection or rejection of the
project can be done, with results that will help gauge the risks
involved. However, as the method is based on thumb rule, it
does not consider the importance of time value of money and
so the relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash
inflow
Example
Project Project
   
A B
Cost 1,00,000   1,00,000
Expected
future cash
flow
Year 1 50,000   1,00,000
Year 2 50,000   5,000
Year 3 1,10,000   5,000
Year 4 None   None
TOTAL 2,10,000   1,10,000
Payback 2 years   1 year
Payback period of project B is shorter than A, but project
A provides higher returns. Hence, project A is superior to
B.

Need Guidance? Ask from Experts!

 Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the

payback period method. The rate of return is expressed as a
percentage of the earnings of the investment in a particular
project. It works on the criteria that any project having ARR
higher than the minimum rate established by the management
will be considered and those below the predetermined rate are
rejected.
This method takes into account the entire economic life of a
project providing a better means of comparison. It also ensures
compensation of expected profitability of projects through the
concept of net earnings. However, this method also ignores
time value of money and doesn’t consider the length of life of
the projects. Also it is not consistent with the firm’s objective of
maximizing the market value of shares.
ARR= Average income/Average Investment

 Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow

and outflow through the life of an asset. These are then
discounted through a discounting factor. The discounted cash
inflows and outflows are then compared. This technique takes
into account the interest factor and the return after the payback
period.

 Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital

investment proposals. In this technique the cash inflow that is
expected at different periods of time is discounted at a
particular rate. The present values of the cash inflow are
compared to the original investment. If the difference between
them is positive (+) then it is accepted or otherwise rejected.
This method considers the time value of money and is
consistent with the objective of maximizing profits for the
owners. However, understanding the concept of cost of capital
is not an easy task.
The equation for the net present value, assuming that all cash
outflows are made in the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of
capital, C is the cost of the investment proposal and n is the
expected life of the proposal. It should be noted that the cost of
capital, K, is assumed to be known, otherwise the net present,
value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs

 Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the
investment is zero. The discounted cash inflow is equal to the
discounted cash outflow. This method also considers time
value of money. It tries to arrive to a rate of interest at which
funds invested in the project could be repaid out of the cash
inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay
and proceeds associated with the project and not any rate
determined outside the investment.
It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept
If IR < k = reject

 Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the
required rate of return to the initial cash outflow of the
investment. It may be gross or net, net being simply gross
minus one. The formula to calculate profitability index (PI) or
benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital
expenditures are long term investments which involve more
financial risks. That is why proper planning through capital
budgeting is needed.
2) Huge investments and irreversible ones: As the
investments are huge but the funds are limited, proper planning
through capital expenditure is a pre-requisite. Also, the capital
investment decisions are irreversible in nature, i.e. once a
permanent asset is purchased its disposal shall incur losses.
3) Long run in the business: Capital budgeting reduces the
costs as well as brings changes in the profitability of the
company. It helps avoid over or under investments. Proper
planning and analysis of the projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial
management
 Capital budgeting provides a wide scope for financial
managers to evaluate different projects in terms of their
viability to be taken up for investments
  It helps in exposing the risk and uncertainty of different
projects
 It helps in keeping a check on over or under investments
 The management is provided with an effective control on
cost of capital expenditure projects
 Ultimately the fate of a business is decided on how
optimally the available resources are used

Example of Capital Budgeting:

Capital budgeting for a small scale expansion involves three
steps: recording the investment’s cost, projecting the
investment’s cash flows and comparing the projected earnings
with inflation rates and the time value of the investment.
For example, equipment that costs $15,000 and generates a
$5,000 annual return would appear to "pay back" on the
investment in 3 years. However, if economists expect inflation
to rise 30 percent annually, then the estimated return value at
the end of the first year ($20,000) is actually worth $15,385
when you account for inflation ($20,000 divided by 1.3 equals
$15,385). The investment generates only $385 in real value
after the first year.
Capital Budgeting is an interesting concept and a high in
demand skill among organizations globally. Learning capital
budgeting requires professional guidance to cover the
complexities of the topic well. There are courses that are
focused on cost accounting and budgeting and cover the topic
extensively. Pursuing a course in Management Accounting also
trains the candidate on capital budgeting. Below are two
courses that can be pursued to learn capital Budgeting in
depth: 
US CMA – Certified Management Accountant 
The US CMA course is offered by IMA, an institute based in the
United States. US CMA course covers Management
Accounting as the major domain in accounting. Management
Accounting being different than generic accounting is a
specialized domain and requires specialized training.
For details on the US CMA course like US CMA course
eligibility, US CMA course scope, US CMA course duration,
contact our counsellors. 
ACCA – Chartered Certified Accountants
The ACCA course is offered by an accounting body in the
United Kingdom. The ACCA course is a great combination of
general accounting and management accounting. That means
a candidate gets to learn and excel in every domain of
accounting, including financial accounting and management
accounting. The ACCA course also defines exemptions for
certain exams and levels depending on the academic and work
background of the candidate.
For details on the ACCA course like ACCA course eligibility,
ACCA course scope, ACCA course duration, contact our
counsellors. 

Conclusion:
According to the definition of Charles T. Hrongreen, “Capital
Budgeting is a long-term planning for making and financing
proposed capital outlays.”
One can conclude that capital budgeting is the attempt to
determine the future.

Social Cost-Benefit Analysis

The following points highlight the top four things to know
about Social Cost-Benefit Analysis. The things are: 1.
Criteria for Social Cost-Benefit Analysis 2. Identifying
Benefits and Costs 3. Valuation of Costs and Benefits 4.
Social Rate of Discount.
Social Cost-Benefit Analysis: Thing # 1. Criteria for Social Cost-
Benefit Analysis:
The objective function of CBA is the establishment of net social
benefit (NSB) which can be expressed as NSB = Benefits – Costs.

There are four benefit-cost criteria. They are ‘В — С/I’, ‘∆В /∆С’, ‘В
— С’ and ‘B/C’, where В and С refer to benefits and costs
respectively, I relates to direct investment and Δ is incremental or
marginal.

Of these, the formula В – C/1 is “for determining the total annual

returns on a particular investment to the economy as a whole
irrespective of to whom these accrue.” Here I does not include the
private investment that may have to be incurred by the beneficiaries
of the project, such as the cultivators from an irrigation project.

If the private investment happens to be very large, even a high value

of В – С/I may be less beneficial to the economy. Thus this criterion
would not give satisfactory results.

The criterion of ∆В/∆С = 1 is meant to determine the size of a

project that has already been selected and is not for selecting a
project. The adoption of the В – C. criterion would always favour a
large project, and make small and medium size projects less
beneficial. Thus this criterion can only help in determining the scale
of the project on the basis of the maximisation of the difference
between В and C.

But the best and the most reliable criterion for project evaluation is
B/C. In this criterion, the benefit-costs ratio is the measure for the
evaluation of a project. If B/C = 1, the project is marginal. It is just
covering its costs. If B/C > 1, the benefits are more than costs and it
is beneficial to undertake the project.

f B/C < 1, the benefits is less than costs and the project cannot be
undertaken. The higher the benefit-cost ratio, the higher will be the
priority attached to a project.
Social Cost-Benefit Analysis: Thing # 2. Identifying Benefits and
Costs:
Identifying benefits and costs is essential for the
evaluation of benefits and costs of a project:
(a) Identifying Benefits:
A project is evaluated on the basis of the benefits accruing from it.
Benefits refer to the addition to the flow of income accruing from a
project. A project is beneficial to the extent it tends to increase the
income of the people, increase in income being measured by the
actual increase in production and consumption. Benefits may be
real or nominal and direct or indirect.

Real or Nominal Benefits:

In CBA, we are concerned with the real benefits rather than with the
nominal benefits flowing from a project. A river valley project may
increase irrigational facilities to the cultivators. But if at the same
time the state leaves heavy betterment levy on them, the benefit is
nominal. For, whatever benefit accrues from the project it goes to
the treasury. But if the same project, besides increasing irrigational
facilities, raises the productivity of land per acre and leads to a
number of other external economies whereby, the level of real
income of the farmers raises then it leads of real benefits.

Direct and Indirect Benefits:

Direct benefits are those benefits which are immediately and
directly obtainable from a project. They are the values of the
immediate products and services for which direct costs are
incurred. A number of direct and immediate benefits flow from a
multipurpose river valley project such as flood control, irrigation,
and navigation facilities, the development of fisheries, power, etc. A
project may also lead to certain indirect or external benefits. These
are the benefits to the non-users of the project.

For instance, the construction of the Bhakra Nangal Project has led
to the construction of a new railway line connecting Nangal
township and the Bhakra Dam with the rest of the country. New
roads have been laid. A new town, Nangal, has come up.
A fertilizer factory has been started there which is the harbinger of
more factories. The Bhakra-Nangal Dam has been developed into a
tourist resort, thereby augmenting income. Usually external
benefits are nonmonetary, but sometimes they may result in direct
financial benefits.

Tangible and Intangible Benefits:

A project may also lead to tangible or intangible benefits. Tangible
benefits are those which can be computed and measured in terms of
money while intangible benefits cannot be measured in monetary
terms. For example, benefits flowing from the Bhakra-Nangal
Project are tangible and can be computed.

Intangible benefits enter into individual evaluations for which there

is neither a market nor a price. They may be positive or negative.
The former are the scenic beauty and recreational value of the
Bhakra Dam while the latter refer to the uprooting of the people as a
result of the Dam.

Identifying Costs:
Just as there are various forms of benefits, so there are various
types of costs

Project Costs:
They are the value of the resources used in constructing,
maintaining and operating the project. They relate to the cost of
labour, capital, intermediate goods, natural resources, foreign
exchange, etc., including allowance for induced adverse effects.

Indirect or Secondary Costs:

They are the value of goods and services incurred to provide indirect
benefits of a project, viz., houses, school, hospital, etc., or the people
working at the project site. They also include the costs of processing
the immediate products of the project.

Real and Nominal or Pecuniary Costs:

Costs may be real or nominal. If a Block Samiti borrows from the
people of the area for digging a canal, it is a case of nominal costs.
For no real sacrifice is involved on the part of the people, money
having been transferred to the Block Samiti from the people. But if
the people of the block are asked to dig the canal themselves, it
would be real cost for them.

Primary or Direct Costs:

In cost-benefit analysis, we are concerned more with primary or
direct costs. These are costs properly incurred for the construction,
maintenance and execution of a project.

External Costs:
There are of two types:
(i) Monetary Costs:
That relate to the loss of profits to competitors. In the case of Delhi
Metro, external monetary costs would include the loss of profits to
other transport operators such as three wheelers, buses, taxis, etc.

(ii) Non-monetary Costs:
These include pollution and other types of inconveniences to local
residents. Construction of an airport may lead to externalities
resulting from its operation, such as noise.

Conclusion:
Thus in evaluating a project, we are to identify, compute and
compare its total direct benefits and total direct costs. If it is found
that the benefits are expected to be more than the costs, it will be
beneficial to undertake the project, otherwise not costs.

Social Cost-Benefit Analysis: Thing # 3. Valuation of Costs and

Benefits:
In the valuation of social costs and benefits of a public project, the
shadow prices of inputs and outputs of the project are used instead
of actual market prices. Shadow prices reflect true values of goods
and services, including the factors of production.

Their money values are computed on the basis of price indices in

different markets, giving weights to inflationary and deflationary
situations. Economists estimate three such prices: shadow wage
rate, shadow interest rate and shadow exchange rate. However, for
many items of social costs and benefits, there may not be any
shadow price at all.

Social Cost-Benefit Analysis: Thing # 4. Social Rate of Discount:

The B/C formula usually used for evaluating social costs and
benefits does not take into account the time horizon of the project.
As a matter of fact, future benefits and costs cannot be treated at
par with present benefits and costs. Therefore, the appraisal rule for
a public project requires discounting of future benefits and costs
because society prefers the present to the future.

For this purpose, economists use a social rate of discount for

discounting all benefits and costs. It is a rate of discount that
reflects society’s preference for present benefits over future benefits.
The social discount rate is used to calculate the net present value
(NPV) of a time stream of benefits and costs of a project where its
NPV is calculated as

NPV = Σt (Bt-Ct/(1 + i)t)

Bt is the expected gross benefit of the project at time t, C, is the
expected gross cost of the project at time I, and i is the social
discount rate at time t.
If the government chooses a high rate, the future net benefits will
discount mere. As a result, the project with a long life will be-less
beneficial than a project which yields a quick’s return. It is,
therefore, advisable to choose a relatively low discount rate.

Economic Rate of Return

All businesses need a way to measure the success of their various
investments, strategies and decisions. This is done by capturing
the return from any investment: the additional profits and value the
investment has been able to bring to the company. The most
reasonable way to look at the success of previous investments and to
compare the potential of future investments is to calculate a rate of
return for these types of projects. What Is the Rate of Return?

The rate of return can also be called the return on investment (ROI) or internal rate
of return (IRR). These names can mean slightly different things. As a concept,
rates of return are calculated by comparing the current value of the investment with
the initial cost of the investment, given as a percentage of the initial cost. The rate
of return formula is as follows:

[ (Current Value - Cost) / Cost ] x 100 = %RR

Calculating the current value of the investment includes any income received
resulting from the investment as well as any capital gains that have been realized.
The rate of return is usually calculated using value created over a period of time,
thus representing the net gain or loss over that time period. It’s comparing two
snapshots of value: the cost of the capital and the gains it has provided.

This can be a critical part of the analysis. For example, a high rate of return means
something different over two years than it does over 20 years.

Applying Economic Rate of Return

The rate of return can be used to judge the success of a project. Obviously, a
higher rate of return is desirable, whereas a negative rate of return represents a net
loss on the investment within that specific time period.

As rate of return is usually calculated at the end of an investment’s useful life, rates
of different investments can be compared with each other. This information can be
used to drive future investments by revealing which types of investment provide
net gain and which are unsuccessful. A higher ROI represents a better return on
the investment, but it should be taken into consideration that ROI looks at a time
period without making many adjustments for the change in the value of money over
time.

To understand this ERR economics concept, consider investing in the general

sense (rather than specifics like capital projects, stocks or bonds). Having $100
today is worth more than having $100 in five years, namely because that $100
could be invested somewhere and collect interest, meaning that in five years it will
in fact be worth more than $100. This assumes a generic interest rate is available
for that $100 to be invested, which is often an industry standard.
Economic Rate of Return Example

Consider a company that invests $100 into three different projects. Each project
ends up being worth $300 at the end of its life, meaning each project would have
the same ROI. However, if project X returned $300 in two years, project Y returned
$300 in five years and project Z returned $300 in 10 years, then that’s a significant
difference in project performance that isn’t necessarily captured in the ROI. This is
why businesses use the internal rate of return as well.

Return on Investment

Rate of return and return on investment are often used interchangeably; internal

rate of return, or IRR, is a measure often used to gauge the attractiveness of
future investments. IRR is designed to capture the rate where the net present
value of the positive (profits, etc.) and negative (costs, etc.) cash flows reach zero.
This calculation involves a discount rate, which is a tool investors use to judge how
the value of money changes over time due to inflation and other factors. This
discount rate represents the minimum rate of return that’s acceptable to the
investor; most companies set a minimum discount rate, and the calculated IRR is
compared to this discount rate to determine the attractiveness of the project.

The calculation of the IRR involves many iterations, so it’s best to use a tool like
Excel to obtain this value. The concept involves calculating over a number of time
periods (for example, years) the discount rate at which the profits and losses during
that time period — discounted for the future value of that time period — net to zero.
This sounds confusing, so consider IRR as a number whose value is most
important in comparison to other ones.

If a project has an IRR of 20% and other investments the company can make are
only expected to yield 5% over the same time period, then that investment project
looks favorable as opposed to the alternatives. The higher the IRR, the more
potential that project has to be a good company investment as compared to other
investments. This can help a company choose its types of investment strategies.

Difference Between IRR and ROI

With this in mind, the difference in IRR and ROI is that ROI looks at two snapshots
and does not account for the change in the value of money over time, while IRR
offers an understanding of a comparable “interest rate” the investment may pay
back.

IRR may seem more representative, but ROI is easily calculated and offers a
straightforward capture of the value produced by the investment. IRR can be
difficult to calculate, although most software like Excel offers ways to solve the
iteration sum formula for the IRR.
How to Use Rates of Return

The standard rate of return or return on investment calculations can be used

to evaluate previous investments which may have reached the end of their useful
life. This lets management know which investments were worthwhile and gives
them a starting point from which they can develop an understanding of why some
investments work out and others don’t.

The rate of return can also be used to compare potential future projects, which
will require estimation of the project’s lifespan, revenues to be gained over this set
timeline and the potential cost of the project in capital. This is one of the values
often used when management creates the capital budget for a company.

The internal rate of return is usually used against some benchmark determined by
company executives as a minimum desired discount rate. Since IRR looks at the
decreasing value of money over time, IRR can capture comparisons that won’t
appear in ROI.

Example Using Rates of Return

A company is considering two potential investments, A and B. They may have

similar returns on investment, but if A is a five-year project and B is a 10-year
project, that same ROI now means two different things if you take into
consideration the way the value of money changes over time. Companies that are
on accelerated timetables may even require projects to break even in periods of
two to three years. These analyses look at both ROI and IRR.

Use of ROI and IRR Values

Companies use these values in two different ways: to evaluate previous

investments and to make decisions about future ones. It’s easier to calculate
ROI and IRR for projects that have already been completed, of course, than it is to
make estimations in the future. Project managers and accounting analysts can sift
through the project’s costs and its revenue streams over time and provide this kind
of information to management.

This is usually done at project close, but often, a company will look at investments
over the last five to 10 years to evaluate which sorts of projects were the most
successful. The information gained from this type of analysis becomes a part of the
next step, which is making investment decisions to establish a capital budget
projection for the company’s future.

Making Investment Decisions

Normally, a company will have a desired value for both ROI and IRR, and the
departments tasked with estimating capital costs and future returns will compare
their projections to the targets in question. Investments with tangible products —
new equipment, facilities, production units, improvements and so on — are often
the responsibility of an engineering department that can use industry standards and
best practices to estimate initial costs, ongoing costs and potential revenues.

Investments with intangible products — marketing campaigns, trainings and so on

—often fall within the purview of accounting, marketing and/or sales. These
departments have their own tools that can help predict future revenues as well as
direct costs. The decision to invest capital in stock, bonds or other financial
investments is one that is made at the executive board level.

These values are then used to determine where to spend limited capital. It’s rare
that a company has enough capital to invest in every single potential project on its
list. Therefore, these values are part of the decision-making process. Keep in mind
that there are other factors to consider when looking at potential investments.

Examples of Investment Decisions

For example, some capital projects are unavoidable — replacing old equipment or
investing in new software — no matter what the ROI or IRR might be. The
managers of the capital budget should be able to consider these factors to make
sure that the overall rate of return stays positive.

Likewise, a project with an incredibly high IRR might come with too high of a price
tag for the board of directors to approve. There are limitations in every company’s
resource pool.

Benefits of Certain Investments

There can also be benefits of investments that can’t necessarily be seen in cash.
For example, a targeted marketing campaign may also help the company’s brand
image and perception within its marketplace, which may not translate into a dollar
figure but still represents intangible value to the company. Likewise, investments in
research and development often don’t directly affect the company’s bottom line —
they may, in fact, increase costs — but the value of research and development is
difficult to capture directly.

Those types of investments may appear to have a poor rate of return but offer
opportunities for the research and development team to explore new areas, which
may lead to new product lines or additional improvements in the future. Another
example is investment in intangible efficiency creators, like online software suites
or data management programs. These types of services can improve record
retention and data analysis, none of which has a direct impact financially but
definitely has value within the company.

All of these factors then become a part of the decision-making process for a
business. However, since a company is often driven by its financial success, values
like ROI and IRR are usually significant. For any investor, it’s important to
understand how these numbers are calculated so that good financial choices can
be made. A business’s future is decided by the way investments are made in the
past and present. It’s critical to consider the rates of return as a big portion of the
decision-making process.