Capital Budgeting Techniques and Project Evaluation (Finance)

This report provides a comprehensive overview of capital budgeting, a crucial function in financial management, focusing on investment decision-making and project evaluation. The report delves into various methods like Net Present Value (NPV), Internal Rate of Return (IRR), and payback period, emphasizing their application to real-world scenarios and cash flow analysis. It covers key topics such as decision-making under uncertainty, option pricing, depreciation, and working capital investments. The report also discusses capital budgeting processes, including identifying and evaluating investment opportunities, along with the functions and essential elements of budget. It examines factors influencing capital budgeting decisions and the scope of capital budgeting projects, such as mechanization, expansion, machinery replacement, and product innovation. The report emphasizes the importance of cash flow analysis, risk assessment, and the goal of maximizing shareholder value through sound investment choices. The report is designed to help students learn and apply capital budgeting techniques in a practical context.

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Overview
Capital budgeting is belonging to the main function in financial management. Capital budgeting
explains investment decision making, most important process for corporate finance. Capital
budgeting determine the task whether to undertake an investment or not. Investment involves
company’s long term investment. Firm performance reflects the success or failure. This course
focuses on managing firm’s financial suggestion.
The aim of following course is to evaluate which project is beneficial for the long term
investment and set out the firm’s future cash flows and also help in risk understanding. The
major strength of this course is its techniques applying on project of real companies, used on a
daily basis. The core content of this course focus on the examples, the application of methods
and also tried to mention cash flow analysis that allows those methods to provide practical
aspect. After two to three section quiz helps to examine the course examples. Important topics,
examples, formulas are given throughout the techniques evaluation.
This course will study the different methods Net Present Value, Internal Rate of Return and
Payback Period. Assets involved in business define company’s management. For example, a
soap company’s a soap company because it runs through soap manufacturing appliances. The
investment making is an important task than other financial decisions, where to raise fund from
loan financing or how to deal with working capital.
Apart from survival correct decision making and company’s success is also important for
company’s growth and competitiveness based on continuous new product ideas, output
productivity at low cost and existing product to perform better.

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Considering the standards, capital budgeting standard set out the criteria to calculate Net Present
Value and Internal Rate of Return, most widely rules for decision. The covered topics examine
how to make cash flow analysis, discounted factor application and estimated projects. After
knowing the application of different methods like payback period, account rate of return, Net
Present Value and Internal rate of return the next motive is to cover the evaluation of estimated
projects. Each topic given in this course examined the examples for proper understanding. After
every two or three section quiz section inserted ends with an interpretation that highlights the key
topics from the course.
Introduction
Capital budgeting emphasizes the planning of major project for the company’s long term
investment. Investment involves company’s long term investment strategy, machinery
replacement, new product, new capital assets, projects regarding research and development.
Capital budgeting is also called as investment appraisal. Allocation of capital to several projects
involves planning and funding of cash. Intention behind every investment budgeting strategy is
to facilitate higher return.
To understand every stage organization need to go through them whether it is of decision making
knowledge, position establishment by using option pricing analysis and also discounted cash
flow analysis. Usually different approaches compared the projects performance and one of the
non- discount methods are accounting rate of return and payback analysis.
Ranking projects is also the task execute through capital budgeting where large amount of
investment proposal takes in consideration. The purpose is to serve the budgeting to ensure

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capital expenditures and revenues. A framework of this particular model analyzes the
performance of business and plans according to forecasting measure. To carry actual operation in
capital budgeting manager considers the following conditions arise in an event.
Decision making
Uncertainty is the main reason in modern world decision making strategy. Proposed capital
projects with management can take overall decisions and count the possible outcomes of existing
market circulation. Decision tree implementation ensure that using different software’s like
expert choice and decision pro to gain knowledge regarding decision. Decision tree provided
trade included private trade building to help. Different opinions and ideas, group and team
execution are much better due to decision tree.
Option pricing
Uncertainty is an important factor while considering option pricing also. First stage provide
knowledge through decision tree whereas second stage ascertain the option offered by customers
where producing company have options to change according to suitable option for the project to
go through. Options can be taken in various ways: postponement, alteration, changes etc. How to
recognize the project with the options values organization need to manage capital projects.
Financial management in accounting studies the present values of assets. Inflation is main cause
to reduce the cost of asset over the useful life. Future perspective involves uncertainty and sunk
cost of money recognized the respective time value of money.

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Discounted rate of return consists of net present value, IRR and profitability index. The key
element decision making usually examine these method. The entire company goes through the
purpose only to generate profitability. Operating expenses involves in every sales and to increase
the performance in order to profitability. Profit throughout the whole system obligated to pay this
operating expenses. The primary component of capital budgeting is making proposal in order to
maximize the growth for through put to operate favorably. Cost reduction is less important.
Payback analysis decisions determined time period and revenue generation.
Cash flows determination after tax consider in capital budgeting. Some risk involvements are in
its adjustment. After considering decision tree knowledge for decision is making and also options
building for company’s projects. Different factors comprised its scope are as:
1) Compensate the risk engagement in projects
2) Acknowledge the risk for foreign projects.
3) Adjustment in capital budgeting for expected results.
Economic life of planning projects can evaluate through stages of capital budgeting whereas
calculation is another level to examine capital projects.
Depreciation
Assets including capital assets are associated with depreciation, estimated life of an asset helps to
calculate the depreciable value of asset. Depreciation is a non-cash item in cash flow statement.
Application of depreciation deducted to measure taxes on project revenues payment and also
added depreciation to bring cash flow.
Working Capital

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Investment basic requirement is to increase working capital. New production consumes more
working capital that often needs stock and salaries to pay. Change in working capital means
mainly leads to company’s project. End in project evaluation brought reverse mechanism in
projects.
Overhead:
Moreover planned projects involved in allocated overheads to increase proportion often. There is
no difference happens with nature of allocation. For relevancy of cost there is need to access the
overhead implemented in respective project associated with more capital investment.
Financing Costs:
To funding a capital project financing is needed. To cover additional cash flows need to plan the
capital project in its best way double cost effect possibility eliminates due to financing cost
deduction from it. Discount rates included in financing cost from our capital project.
Capital budgeting decisions influenced by the different factors:
 Funding for the business projects
 Capital criteria
 Investment and replacement
 Government intervention
 Economic life criteria
 Engagement of risk
 Location of an organization
 Predictions of market performance

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 Performance level of an organization
 Generation of favorable returns
Total money involved in projects show the profit of firm. Once investment made in long capital
project cannot be reversed, capital budgeting help and provide advice to decrease sunk cost and
ignore the investment in non planned investment. Since companies should make decision
properly. Profit earning capacity based always on investment decision the right decision impact
on whole organization. Continuation of project needs large funding whereas retained earning can
help in project investment.
In capital budgeting capital rationing is a one of the process where the funds require in larger
proportion than the available resources for the investment. At this situation NPV is preferable
because for wealth maximization selection of investment plan of NPV provide highest present
value to shareholders value to increase.
Scope of capital budgeting
Mechanization project:
Replacement of manual process in production takes place through mechanization of this process.
The main aspect is to ensure that this change helps to decrease cost. Lower cost operation
resulted in savings for the investment on future cash inflows.
Project expansion:

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Increased production and sales in business can expand its operation. In concise, company can
allocate new assets such as machinery, building, acquisition and take over of other businesses
where huge funding requires for future earning.
Machinery replacement:
Replacement also takes place in old machinery to new machinery with advanced technology
resulted in less operating expenses and more over productivity. Savings done due to application
of new machinery, the volume of production also increased in additional amount.
Lease or buy:
Capital assets can be purchased or acquired through lease. Higher amount of funding required for
initial purpose or investment. Same asset can be acquired on lease, used on lease base and future
benefits can be made from mutually exclusive alternatives.
Choice of equipment:
Two machines performed similar work and each machine cost differently. Advantages and
disadvantages of machineries in product line are analyzed and best option selected in between.
Capital budgeting helps during such selection.
Product innovation:
Innovation takes place in new product. Research and development staff finds out innovative new
products. Every process require higher amount of funding for implementation and this process
also do so. Net cash inflow and cash outflow are too useful for the comparative analysis of
projects.

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Housekeeping:
Every projects legal requirement is to implement and boost up the morale of employees in an
organization, motivates them. Safety measures, healthy environment, welfare projects, training
and information development, research and development, status level projects all are the basic
requirements during housekeeping project execution. Quantity, financial aspects, sources and
profitability are not considered while implement this project.
Capital budgeting process
Identifying investment opportunities: The first task of an organization is to identify a strategy to
select the opportunity of investment plan. It includes various purposes where it can be any of the
product line, expansion of project and new asset allocation. For example company adds two new
product to product lines for evaluation to derive profits, current investment fund with future
benefit.
Evaluating investment purpose: After identification and selection next process has been
evaluated more options for investment purpose. Whenever new products add in product line,
next step is of decision making for acquiring that new product. Various ways are available for
acquiring new products:
1) In house manufacture
2) Outsourcing of manufacturing processes

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3) Purchase new product from the market segment
Performance review: This step is last and review the performance level an organization. This
process has impact on cash flows, initial investment made for forecast situation associated with
the return. Comparison of estimated investments and actual performance of business look by an
organization.
Functions
 Essential functions of budget provide measures to control initial investment,
communication of plans and motive of organization to evaluate performance and provide
visibility. Capital budgeting mainly focus on capital investment for long term purpose.
Ranking of capital projects could reward the organization. Fund raising for capital
projects means to determine the sources available with the corporation to trade in
preferred stock, corporate bonds, common stock and.
 Managers involved in financial management ensure the risk related to funding. Corporate
bonds have low risk rather other bonds have that’s why it is preferable in financial
managements risk to ascertain. Preferred stocks also have no risk as such whereas
dividends in relation to arrears with dividend must pay to them before distribution among
shareholders. Capital budgeting influences profits where the total investment indulged at
larger amount and the decisions are more effective against short term decisions as to
cover the various factors impact and risk involvement and most importantly the future
uncertainty. The goal behind capital budgeting is ranking its project.

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 Cash flows in accounting require updated understanding for every feature to affect
particularly the processes involving, tracking the cash inflows and outflows. Assets and
liabilities in balance sheet are the determinant for resources implication. Cash flow
analysis include rate of return, net present value are the core equipments in capital
budgeting and it is based on investing, operating and financing activities.
Key words
NPV -This key word is stands for net present value used in capital budgeting for profitability
analysis. MIRR - A term used for finance, modified version of internal rate of return. IRR-
internal rate of return is a metric for strong investment to estimate profits.
Techniques of capital budgeting
To access organization in selection of investment for long term there are different types of
techniques available to ensure compared data of cash flows and cash outflows.
Payback period (traditional approach)
This method analyzes the proposed period and reduces risk, consider the earning to expand
project. This period preferred to recover initial investment. What to select and reject is organized
for risk measurement, based on certain calculations done. Time value of money is not considered
and will circulate cash for the initial stages, investment done in an organization. While in
discounted payback period time value of money required to recover initial investment. It’s also a
capital budgeting procedure break the given number of years from initial investment by

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discounting the future cash flows. Time value of money determines the importance of money
today than tomorrow’s money. The importance of this method is to estimated quotation of
informed investment to get back the investment cost. Time period of a project directly linked to
the project risk involvement. Project with lower payback period are preferred usually.
Payback period = Initial capital expenditure ÷ Expected cash flow after deducting tax
Payback reciprocal: Average annual cash flow ÷ Initial capital expenditure
For example, project costing $ 30, 00,000 for initial capital expenditure and expected cash flow
after deducted tax is $ 6, 00,000.
$ 30,00,000
$ 6,00,000 = 5years
Hence n = 5 years
1) In given projects cash flow:
Initial capital expenditure =$ 4, 00,000 and expected cash flow after deducted tax is $
20,000. What is the payback period?
 4 years
 2 years
 3 years
 1 year
2) Scope of capital budgeting include from the following
 Choice of equipment
 Lease or buy
 Product innovation