Here is a detailed and well-structured explanation of Capital Budgeting including its definition, characteristics, process, importance, limitations, and the main evaluation techniques — Payback Period, Average Rate of Return (ARR), Net Present Value (NPV), and Internal Rate of Return (IRR) — with examples.
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? What is Capital Budgeting?
Capital Budgeting refers to the process of planning and evaluating long-term investments in projects such as new plant setup, expansion, research and development, or replacement of old machinery. The main goal is to determine whether a project will generate returns that justify the initial investment and contribute to the firm’s value over time.
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? Characteristics of Capital Budgeting:
1. Large Investments: Capital budgeting involves large amounts of capital for long-term investments.
2. Long-Term Impact: These decisions affect the business over several years and influence the firm’s future growth.
3. Irreversibility: Once made, capital investment decisions are difficult to reverse without loss.
4. Risk and Uncertainty: Future cash flows are estimated and are subject to economic and market uncertainties.
5. Strategic Decisions: These decisions are aligned with the long-term objectives of the organization.
6. Involves Time Value of Money: Evaluations are based on future cash flows discounted to present values.
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? Importance of Capital Budgeting:
Ensures optimal use of available resources.
Helps in long-term financial planning and growth.
Prevents over-investment or under-investment.
Reduces business risk by evaluating project viability.
Improves shareholder wealth by selecting profitable ventures.
Definition: IRR is the rate at which NPV becomes zero. The project is acceptable if IRR > cost of capital.
Formula:
NPV = 0 =
(Solved using trial and error or financial calculator)
Example:
Initial Investment = ₹1,00,000
Annual inflow = ₹30,000 for 5 years
Try different discount rates to find where NPV = 0.
IRR ≈ 14.87%
Pros:
Considers time value of money.
Gives % return—easy to interpret.
Cons:
Multiple IRRs possible for non-conventional cash flows.
May mislead in mutually exclusive projects.
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⚠️ Limitations of Capital Budgeting:
1. Difficult Cash Flow Forecasting: Future inflows and outflows are based on assumptions.
2. Ignores Qualitative Factors: Like brand image, employee morale, etc.
3. Complex Calculations: Techniques like IRR and NPV need financial understanding.
4. Time-Consuming Process: Requires extensive analysis and data gathering.
5. May Lead to Biased Decisions: If based only on numbers and not strategy.
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✅ Conclusion:
Capital budgeting is an essential process in financial management that ensures wise investment decisions for long-term business sustainability. Techniques like NPV and IRR help evaluate the profitability and feasibility of projects by incorporating risk, time value of money, and return expectations. A successful capital budgeting system boosts investor confidence, resource utilization, and company growth.