Goseeko blog # What is Capital Budgeting?

Capital budgeting is the process of obtaining the best return on investment by evaluating investments and huge expenses. The management selects projects which give the biggest return as compared to investment made in the project. Each project is ranked on the basis of return, so that the company can select projects.

Capital budgeting is also called investment appraisal. Capital budgeting process includes

• Identifying investment opportunities
• Evaluating investment proposal
• Capital budgeting and apportionment
• Performance review

#### Methods of Capital Budgeting

1. Net present value – Net present value calculates the return on investment by introducing the factor of time element. It recognizes with the fact that rupee earned today is worth more than the same rupee earned tomorrow. The net present values of all inflows and outflows of cash occurring during the entire life of the project is determined separately  for each year by discounting these flows by the firm’s cost of capital.

NPV = present value of inflows – present value of outflows

NPV decision rule,

• If NPV >0 , accept the project
• If NPV = 0, accept or reject the project
• If NPV <0, reject the project
1. Internal rate of return – The internal rate of return is known as time adjusted rate of return, yield method, trial and error yield method. The internal rate of return is defined as the rate of discount at which the present value of cash inflows is equal to the present value of cash outflows.

The accept and reject rule,

• If internal rate of return >required rate of return —— accept
• If internal rate of return  = required rate of return ——– accept
• If internal rate of return  < required rate of return ——– Reject
1. Payback period – It is defined as the number of years required to recover the original cost invested in a project. This method is used when the project is od short duration

When cash flow is constant every year

PBP = Cash outflow/cash inflow

When cash flow is not constant every year

PBP = Completed years +(required inflow/inflow of next year)*12

1. Average rate of return – Under this method, average rate of return is calculated by dividing total net income of the investment by the initial or average investment to derive at the most profitable investment.

ARR on average investment = (average profit after tax/average investment) *100

ARR on initial investment = (average profit after tax/initial investment) *100

1. Profitable index – Profitability Index is the ratio of the present value of future cash flows of the project to the initial investment required for the project.  It is also called as profit investment ratio (PIR) and value investment ratio (VIR). It is very useful in ranking projects.