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

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 All of the above
3) High risk project identified when
 Higher investment (initial) has resulted lower variation
 Lower investment (initial) has resulted lower variation
 Higher investment (initial) has resulted higher variation
 Any of the above
4) The sources available for fund raising are
 Preferred stock
 Corporate bond
 Common stock
 None of the above
5) Which is an example of long term investment strategy from the following
 Expansion
 Replacement
 Employee training
 All of the above
Accounting rate of return
Loopholes of payback period overcome through this method. Earning percentage depend on rate
of return for the respective projects. Lifetime of project decide in which asset the investment

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made to enhance the capacity of machinery and capital expenditure made to evaluate average
rate of return. The importance of this method that it does not used any special type of data, only
used general data, measure the profitability of an entire organization.
Accounting rate of return = Average annual net income ÷ Average Investment
A project require initial expenditure of $ 20, 00,000 and the profit for 6 years is 6, 00,000
ARR = $ 6,00,000
6 = $ 1, 00,000 = $ 1,00,000
$ 20,00,000 =5%
Discounted cash flow analysis
Assets life emphasizes the discounted cash flow method in calculation of cash inflow and cash
outflow. This analysis also known as time adjusted method where NPV, IRR and Profitability
index comprised of. By the help of discounting factor discount rates analyzed different
conclusion and ranking in its application and accordingly show the result.
Discounted cash flows examples
NPV (Net Present Value)
One of the methods used extensively for proposed project analysis. The total of cash inflow and
outflow comes to net present value evaluation. This method cash flows statement determines the
time value of money. Net present value often considers present time as per ranks of projects,
signifies the acceptance of project if NPV calculation is higher or equal to zero. It means we

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should carry further the investment if NPV is positive and we should stop to make investment if
NPV comes negative. The economic criteria examine Net Present values evaluation NPV means
the sum of cash inflows and outflows recognized what to add and what to deduct if we takes
place investment in any of the planned project. It is based on the positive and negative aspect if it
becomes positive we should keep further proceeds and if it becomes negative no investment
should made.
Profitability index
Future cash flows present value of capital projects in initial investment represent the ratio of
profitability index. Every technique comprised advantages and disadvantages. Best investment
technique chose to assist capital budgeting process. Different techniques can be selected and
ensure to compare the derived results. Project having profitability index greater than one, the
investment is preferred because firm may earn higher than the investment done. While
profitability index is lower than 1 means firm may seek another opportunities because it would
not recover the invested amount. If the index=zero then it’s called as neutral project.
Internal rate of return
This rate of return at discount reflects the present value cash flows and initial cash outflow to be
equal. Here in this technique the discount rate is unknown then also cash inflow and cash

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outflow are known. Acceptance and rejection of projects IRR depends on its own rate and cut off
rate. The situation define that whenever the IRR is higher than the cut off rate it referred to
project acceptance and in another condition whenever there is IRR is lower than the cut off rate it
referred to project rejection. This is the simple technique in its use and an improved technique
over NPV. IRR preferred often in every firms capital budgeting.
Modified Rate of Return (MIRR)
Modified internal rate of return equal annual cash flows can easily evaluate IRR. By using
discount rate we can calculate internal rate of return and it is identified by the managers for the
same to determine with rates of return. MIRR stands for Modified Internal return measure
investment in an attractive way to solve the difficult situation and used ranking process for
different alternatives. This is the integral techniques we often used over conclusion whether to
find present value of money or whether to execute planning in consideration of various rate of
return with capital generation. A mutually exclusive project comes to vary its existence using
IRR and NPV.
Quiz:
1) Which project is accepted in case profitability index ranking and funds are
 Profitability index > 1, funds unlimited
 Profitability index < 1, funds limited
 Profitability index > 1, funds limited
 Profitability index < 1, funds unlimited
2) Which technique is not used in capital budgeting decision making

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 Internal rate of return
 Net Present Value
 Profitability index
 All of the above
3) After the project have been implemented what are the review of projects called as
 Audit
 Capital budgeting
 All of the above
 None of the above
4) The net present value is preferred when
 NPV is positive
 NPV is negative
 Both (A) and (B)
 NPV is zero
5) What neutral project signifies in profitability index
 Index is greater than one
 Index is lower than one
 Index is equal to one
 Any of the above

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Mutually Exclusive Project
Mutually exclusive projects are combined projects where firm undertake any one project among
them. Firm can consider highest NPV or highest internal rate of return when projects have same
life. Mutually exclusive projects when seems having different life span, we can consider capital
budgeting decision based on NPV Analysis or replacement chain method.
Net present value often considers present time as per ranks of projects. Discount rates analyzed
different conclusion and ranking in its application and accordingly show the result. Replacement
chain method helps to find out common life approach in between. This method determine project
with different life span based on long term projects. Here treating all the projects considering
long term project having equal life. With the help of highest NPV or IRR we can represent the
analysis having same life span.
Example- Among investing companies Project A and Project B. One has a life of 6 years costing
$30 million and generates $10.5 million p.a. Other has a life of 10 years cost $45 million and
generate $11 million p.a. Considering rate of return 10%, evaluate these two projects.
Solution - Project A) NPV = $ 10.5 million ×4.355−$ 30 million=$ 15.72 milliion
Project B) NPV =$ 11million × 6.144−$ 45 million=$ 22million
Conclusion
NPV of Project B has highest value. Project B should be preferable. Change in the capital does
cause a change in the IRR ranking of two such projects. Project having varied term accordingly

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only for shorter or longer term then IRR ranking remain unchanged. NPV is better because it
determine the profitable decision to investors.
Advantages of capital budgeting
1) Time value of money in capital budgeting analysis used discounting for the earning of
proposed investment. The accuracy and reliability represent the data user friendly. The
estimated projects with long term objective ranked and evaluate the position of firm.
2) Value maximization of the company depends on the higher return earns during business.
Returns to shareholder are the major goal of project, good earning returns.
Limitation of capital budgeting
1) Estimation includes every year’s cash flow and economic life of proposed project. The
actual economic life can be varied it may be decreased or increased. Actual cash inflows
per annum either go same or decline than the estimation. Hence capital expenditure
control through capital budgeting can not be exercised.
2) Estimated cash inflows and outflows decision budgeting made through capital budgeting
process. Uncertainty means the future is uncertain, estimated cash flows may not be real.
Sometimes selection of projects may be unreal.

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3) The aspect having non-financial nature does not considered in evaluation of capital
budgeting process whereas they are the major role players in successful organization and
impact on profitability measures. Hence, real profit of planned project cannot be
highlighted.
4) Assumption for solution using mathematical technique is also incorrect to analyze,
accurate technique produce higher returns.
5) Presumption in every technique based on investment proposals mainly to mutually
exclusive projects may not practically correct in some situation.
6) Company’s reputation, goodwill and morale of employees cannot be quantitatively
measured. It is not possible for the capital budgeting implication to influence the
decision.
7) Risk measurement cannot be assumed accurate because the variation and fluctuation
leads to changes in the business environment.
8) For urgent situation and circumstances this technique cannot be used.
9) Known factors considered while applying decisions regarding capital budget. Different
unknown factors cannot be avoided and controlled.
Conclusion
Capital budgeting right decision making can achieve big business heights. Long term investment
in today can provide the value for tomorrow. Hence, capital budgeting is crucial to create value
in financial management. Uncertainty is the only certainty present in capital budgeting analysis.

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So it is concluded that the challenges of an organization is to have uncertain position to possess.
Organization can come to conclusion with each examples discussed earlier in capital budgeting
mechanism. With uncertainty management it is to ensure to manage risk also.
Final Quiz 1:
1. Which project is selected with given payback period?
 Least number of years
 Highest number of years
 Average number of years
 All of the above
2. The projects initial investment made will be recovered by using the technique?
 Undiscounted payback period
 Discounted payback period
 Payback period
 Any of these
3. Which procedure of capital budgeting consider time value of money to recover initial
expenditure?
 Undiscounted payback period
 Discounted payback period
 Payback period
 Any of the above
4. Net Present Value approved which project have _ NPV

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 Positive
 Negative
 Zero
 All of the above
5. Project acceptance under internal rate of return accept the projects have
 IRR= Cost of capital
 IRR>Cost of capital
 Both (A) and (B)
 IRR<Cost of capital
6. Among all defined technique which technique is usually select?
 Payback period
 Profitability index
 Internal rate of return
 Payback period
7. A project profitability index have unlimited funds in case the project
 Accepted
 Rejected
 Both (A) and (B)
 None of the above
8. The project is preferred when
 NPV > Zero
 IRR > cost of capital

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 Profitability index > unity
 Any of these
9. MIRR stands for
 Modified rate of return
 Mutual rate of return
 Mutate rate of return
 All of the above
10. Accounting rate of return refers the formula
 Average net income ÷ average investment
 Average net income ÷ investment
 Net income ÷ average investment
 Net income ÷ investment

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