International Review of Business and Economics
Volume 4, Special Issue No.1, July 2020 338
53. EFFECTIVE CAPITAL BUDGETING
DECISIONS BY FIRMS
Mr. MANJUNATH M.S., Lecturer, Department of Commerce,Government
First Grade College, N R Pura, Mail: manjunathms567@gmail.com
Cell: 9972160567
Mr. PRAVEEN B, Assistant Professor, Department of Commerce &
Management,PES Institiute of Advanced Management Studies, Shivamogga.
Mail: brppraveen1@gmail.com Cell: 9611650036
ABSTRACT
Finance is the life blood of business. Finance is said to be the circulatory
system of the economy body, making
possible the required cooperation
between the innumerable units of
activity. Finance guides and regulates
investment decisions and expenditure
of administers economic activities.
Capital budgeting means planning
for capital assets. Capital budgeting
decisions are complex process of
paramount importance in financial
decisions, because efficient allocation
of capital resources is one of the
most crucial decisions of financial
management. Capital budgeting is
budgeting for capital projects.Because
the long-term profitability of most
enterprises depends on the nature
and quality of their capital project
investments, appropriate planning,
evaluation, and implementation
of high-return capital projects are
imperative. Capital budgeting helps
managers plan for the acquisition of
capital projects that promise high
returns.
It is a managerial technique of meeting
capital expenditure with the overall
objectives of the firm. The research
findings are expected to be useful to
the financial institutions, managers
as well as practitioners in the area
of investment decision-making.
As there are various methods and
criteria available, the research studies
undertaken so far suggest that by and
large decision-makers tend to select
methods ignoring time value of money.
KEYWORDS
Capital Budgeting, Risk, Capital
Expenditure.
Capital budgeting.:It is decisionmaking process concerned with
“whether or not (i) the firm should
invest funds in an attempt to make
profit?” and (ii) how to choose among
competing projects.
Risk:Refers to a situation in which there
are several possible outcomes, each
outcome occurring with a probability
that is known to the decision-maker.
Capital Expenditure: A capital
expenditure is an expenditure incurred
for acquiring or improving the fixed
assets, the benefits of which are
expected to be received over a number
of years in future.
INTRODUCTION
A number of researchers in finance and
accounting have examined corporate
capital budgeting practices. Many
of these articles survey corporate
managers and report the frequency
with which various evaluation methods,
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One Day Online International Conference Organised by IRBE Publications, Denver, USA 339
such as payback, internal rate of
return (IRR), net present value (NPV),
discounted payback, profitability index
(PI), or average return on book value
are used.
The process of budgeting resources
for the future of an organization’s
long termplans. Capital planning for
a business would include budgeting
for new and replacement machinery,
research and development and the
production of new products, new plants
and other major capital expenditures.
Capital budgeting is a managerial
technique of meeting capital
expenditure with the overall objectives
of the firm. There are two fundamental
types of financial decisions that the
finance team needs to make in a
business: investment and financing.
The two decisions boil down to how
to spend money and how to borrow
money. A business needs to make
investments in various projects. As
a normal practice, a business entity
invests the money in the acquisition of
fixed assets, such as, machinery, land
or building.
OBJECTIVES OF THE STUDY
The following objectives were set out
for the study:
1. To determine the types of capital
investments undertaken and the
methods of appraisal used.
2. To analyze the problems faced to
estimate the cash flows associated with
each capital investment accurately.
3. To analyze how ‘Uncertainty’ in
the future estimates in investment
projects is being taken care of.
4. To study the preferences between
Net Present Value (NPV) and Internal
Rate of Return (IRR) methods.
METHODOLOGY
For the present study descriptive
analysis method is applied and it
is based on the secondary sources
of data which have been collected
from various articles, books, reports,
documents journals, newspaper etc.
Why do firms follow Capital budgeting
decision?
1.Capital budgeting involves capital
rationing
2.Capital budget becomes a control
device when it is employed to control
expenditure
3.A firm contemplating a major capital
expenditure programme may need to
arrange funds many years in advance
to be sure of having the funds when
required.
It calls for the effective decision making
process in terms of the acquisition
of fixed assets, modification of fixed
assets and replacement of fixed assets.
Therefore, it is not only important to
determine the capital expenditure of
a business entity but also evaluate
the results while considering various
factors, such as, economic and social
and technological etc.
KINDS OF CAPITAL BUDGETING
DECISION FOLLOWING BY FIRMS
(i) Mutually Exclusive Projects:
It means if a firm accepts one project,
it may rule out the necessity for others
i.e., the alternatives are mutually
exclusive and only one is to be chosen.
(ii)Accept-Reject
Acceptance Rule:
Decisions
or
The proposals which yield a higher
rate of return in comparison with a
certain rate of return or cost of capital
are accepted and, naturally, the others
are rejected.
(iii) Capital Rationing Decision:
Capital rationing is normally applied to
situations where the supply of funds
to the firm is limited in some way. As
such, the term encompasses many
different situations ranging from that
where the borrowing and lending rates
faced by the firm differ, to that where
the funds available for investments
are strictly limited.
International Review of Business and Economics
Volume 4, Special Issue No.1, July 2020 340
Techniques of capital budgeting
PAYBACK PERIOD
The Payback Period helps to determine
the length of time required to recover
the initial cash outlay in the project.
Simply, it is the method used to
calculate the time required to earn back
the cost incurred in the investments
through the successive cash inflows.
The formula to calculate it:
Payback Period = Initial Outlay/Cash
Inflows
Accept-Reject Criteria: The projects
with the lesser payback are preferred.
AVERAGE RATE OF RETURN
Definition: The Average Rate of Return
or ARR, measures the profitability of
the investments on the basis of the
information taken from the financial
statements rather than the cash flows.
It is also called as Accounting Rate of
Return.
The formula for calculating the average
rate of return is:
Average Rate of Return = Average
Income / Average Investment over
the life of the project
Where, Average Income = Average of
post-tax operating profit
Average Investment = (Book value of
investment in the beginning + book
value of investments at the end) / 2
Accept-Reject Criteria: The projects
having the rate of return higher than
the minimum desired returns are
accepted.
Net Present Value
The Net Present Value or NPV is
a discounting technique of capital
budgeting wherein the profitability of
investment is measured through the
difference between the cash inflows
generated out of the cash outflows or
the investments made in the project.
The formula to calculate the Net
Present value is:
Net present value = n∑t=1 Ct / (1+r)t – C0
Where, Ct = cash inflow at the end of
year t
n= life of the project
r= discount rate or the cost of capital
C
o
= cash outflow
Accept – Reject Criteria: If the NPV is
positive, the project is accepted.
INTERNAL RATE OF RETURN
Definition: The Internal Rate of Return
or IRR is a rate that makes the net
present value of any project equal
to zero. In other words, the interest
rate that equates the present value of
cash inflow with the present value of
cash outflow of any project is called as
Internal Rate of Return.
Unlike the Net present value method
where we assume that the discount
rate is known, in the case of internal
rate of return method, we put the
value of NPV zero and then find out
the discount rate that satisfies this
condition.
The formula to calculate IRR is:
CF
o
= n∑
t=1 Ct / (1+r)t
Where, CFo = Investment
C
t = Cash flow at the end of year t
r = internal rate of return
n= life of the project
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One Day Online International Conference Organised by IRBE Publications, Denver, USA 341
Accept- Reject criteria: If the project’s
internal rate of return is greater than
the firm’s cost of capital, accept the
proposal.
PROFITABILITY INDEX
Definition: The Profitability Index
measures the present value of returns
derived from per rupee invested. It
shows the relationship between the
benefits and cost of the project and
therefore, it is also called as, BenefitCost Ratio.
The profitability Index helps in giving
ranks to the projects on the basis of
its value, the higher the value the top
rank the project gets. Therefore, this
method helps in the Capital Rationing.
The formula to calculate the Profitability
Index is:
PI = Present value of future cash
inflows/ Present value of cash outflows
Accept-Reject Criteria: The project is
accepted when the value of PI exceeds
1. If the value is equal to 1, then the
firm is indifferent towards the project
and in case the value is less than 1 the
proposal is rejected.
MODIFIED INTERNAL RATE OF
RETURN
Definition: The Modified Internal
Rate of Return or MIRR is a distinct
improvement over the internal rate
of return that assumes the cash
flows generated from the project are
reinvested at the firm’s cost of capital
rather that at the company’s internal
rate of return.
The formula to calculate the Modified
Internal Rate of Return is:
Where, n= no. of periods
Terminal value is the future net cash
inflows that are reinvested at the cost
of capital.
Accept-Reject Criteria: If the project’s
MIRR is greater than the firm’s cost
of capital, accept the proposal.
DIFFERENT CATEGORIES OF CAPITAL
BUDGETING
1. Replacement and Repair of
Existing Equipment
Equipment that wears out or breaks
down must be replaced. When you
spend more time and money fixing
equipment, it’s usually best to replace
it, because the costs end up exceeding
the resources you need to purchase
new equipment. Improvements on
your workspace also may be included
in the replacement category of your
capital budget. Repairs and other
maintenance costs that exceed your
normal operating budget also go into
the more long-term outlay projected
in a capital budget. Replacements
usually don’t require the same level of
analysis and consideration you put into
additions to your business.
2. Regulatory Requirements
Mandatory additions, adjustments,
improvements or repairs required by
state or city government codes serve to
form another category of your capital
budget plan. Federal regulations or
environmental industry changes must
be included in your planning so that
you can stay in business and avoid fines
and shutdowns. Any requirements your
insurance carriers mandate go into the
mandatory requirement category of
the budget. This category is another
step that can’t be ignored or debated
and includes those costs that are not
recurring in your operational budget.
3. Expansions and Improvements
Before adding new services or products
to your business, expansions and
improvements of existing equipment
and facilities must be considered.
The category in the capital budget
is reserved for adding onto existing
product lines and increasing the
purchasing levels of those products
proving to be most successful. This
category might include renovations to
International Review of Business and Economics
Volume 4, Special Issue No.1, July 2020 342
your building or converting existing
space to be more functional. It includes
those expenditures that make your
business better without adding new
structures, equipment or products.
Unlike repairs, replacements and
government requirements, expansions
and improvements require extensive
consideration before adding them to
your capital budget.
4. Additions and Acquisitions
Making additions to your buildings,
adding new product lines and the
equipment needed to produce it, and
creating additional services are all
part of the capital budget for growth.
This category includes acquisition of
new land and buildings. Additions to
your business require resources and
planning and should coincide with your
strategic growth plans. The capital
budget process allows you to consider
all the ramifications of growth that
includes the costs associated with the
additional resources you’ll need to
achieve that growth. According to the
website Reference for Business, the
capital budgeting process does not just
include making list of your additional
needs, but considering how those
additions fit in with your strategic goals.
CONCLUSION
A large number of empirical studies
have been undertaken to examine the
methods of capital budgeting used by
industries in India and abroad. The
main purpose was to study the practices
of capital budgeting but it seems
that there is no research conducted
recently to study the methods used
currently by industries. Trends towards
sophisticated techniques and sound
capital budgeting decisions have. The
findings of this research, decades of
teaching experience of the authors
and the literature reviewed have been
utilized to evaluate current practices
and suggest possible improvements in
decision making (through a normative
framework).
REFERENCES
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Management accounting practices, April-
2015, Vol-7, Num-3.
2.V. Shanmugsundaram and Dr. V
Balakrishnan, “ Investment Decisions”,
Indian Journal of Finance.
3.Financial Management- I M Pandey,
10th Edition , Vikas Publishing House pvt.,
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Practice- G. Sudarshana Reddy,
3rd Revised Edition, Himalaya publishing
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United Publishers- first Edition [unit 11, pp
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G B Baligar- 6th Edition- Ashok Prakashan.
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Reproduced with permission of copyright owner. Further reproduction
prohibited without permission.
