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Methods of capital budgeting

Methods of capital budgeting

01/July/2025 00:51    Share:   

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.
 
 
 
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⚙️ Capital Budgeting Process:
 
1. Project Identification: Finding potential investment opportunities.
 
 
2. Project Evaluation: Estimating future cash flows and returns.
 
 
3. Project Selection: Choosing projects that meet financial criteria.
 
 
4. Capital Budgeting Techniques Application: Using tools like NPV, IRR, etc.
 
 
5. Project Implementation: Allocation of funds and execution.
 
 
6. Performance Review: Monitoring actual performance against expected results.
 
 
 
 
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? Capital Budgeting Techniques:
 
1. ✅ Payback Period Method
 
Definition: It is the time required to recover the original investment from the project’s cash inflows.
 
Formula:
 
\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}
 
Example: Investment = ₹1,00,000, Annual cash inflow = ₹25,000
Payback Period = 1,00,000 / 25,000 = 4 years
 
Pros:
 
Simple and easy to calculate.
 
Emphasizes liquidity.
 
 
Cons:
 
Ignores time value of money.
 
Ignores cash flows after payback period.
 
 
 
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2. ✅ Average Rate of Return (ARR)
 
Definition: Measures average annual return as a percentage of the investment.
 
Formula:
 
\text{ARR} = \left( \frac{\text{Average Annual Profit}}{\text{Initial Investment}} \right) \times 100
 
Example: Initial Investment = ₹1,00,000, Average annual profit = ₹20,000
ARR = (20,000 / 1,00,000) × 100 = 20%
 
Pros:
 
Uses accounting profit.
 
Simple and easy to understand.
 
 
Cons:
 
Ignores time value of money.
 
Based on accounting profit, not cash flows.
 
 
 
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3. ✅ Net Present Value (NPV)
 
Definition: NPV is the present value of future cash inflows minus the initial investment. If NPV is positive, the project is acceptable.
 
Formula:
 
NPV = \sum \left( \frac{C_t}{(1 + r)^t} \right) - C_0
 
Where:
 
 = Cash inflow at time t
 
 = Discount rate
 
 = Initial investment
 
 
Example: Initial Investment = ₹50,000, Yearly inflow = ₹20,000 for 3 years, Discount rate = 10%
NPV = (20,000/1.1) + (20,000/1.21) + (20,000/1.331) – 50,000
NPV ≈ 18,182 + 16,529 + 15,030 – 50,000 = –259
 
Pros:
 
Considers time value of money.
 
Measures profitability in absolute terms.
 
 
Cons:
 
Complex for non-finance managers.
 
Requires proper estimation of discount rate.
 
 
 
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4. ✅ Internal Rate of Return (IRR)
 
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.
 


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