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Meaning of Capital Budgeting:

Capital Budgeting is the process of making investment decision in capital expenditures. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year. Example: setting up of factories and installing a machinery etc.

Capital budgeting is the process to identify, analysis and select investment projects whose return are expected to extend beyond one year. Dr. S. Bhatt Capital budgeting decision include decisions regarding expansion, modernization and replacement of the long term assets. Milton H. Spencer

Features of Capital Budgeting:

Funds are invested in long term activities. They have a long term and significant effect on the profitability of the concern. They involve generally huge funds.

Why are CAPITAL BUDGETING decisions important:

Long term growth. Large amount of funds involved. Risk involved or risk factor

Process of Capital Budgeting decision:

Project Generation Project Evaluation Project Selection

Review of the Project

Methods of Evaluating Investment Proposals:


Net Present Value Profitability Index Internal Rate of Return

Average Rate of Return

Pay Back

Average Rate of Return Method:

This is also known as Accounting Rate of Return. It is Based upon accounting profit rather than cash inflows. ARR= Average annual profits after taxes * 100 Average Investment

Average annual profits Total of after tax profits of all years After taxes = Number of years Original investment + Salvage value Average Investment = 2

Advantages & Disadvantages:

Advantages: Simple & easy to operate. Based on Accounting profit. Disadvantages: Time value of money not considered. It uses Accounting income rather than Cash flows.

Payback Method:
This method calculates the number of years required to payback the original investment in a project. Initial Investment Payback Period= Annual cash flow Payback Calculation Even Cash Flow Uneven Cash Flow

Even and Uneven Cash Flows Even Cash Flows: Constant cash inflow.
Example: Year 1 2 3 Inflow 10000 10000 10000

Uneven Cash Flow:

Example: Year 1 2 3

Unequal cash inflow.

Inflow 10000 15000 20000

Advantages & Disadvantages

Advantages: Simple & easy to operate. Appropriate for firms suffering from liquidity. Disadvantages: It ignores the time value of money. It ignores the cost of capital.