B. Com II Sem.

III
Financial Management (SEC)
Chapter II Capital Budgeting

Introduction:
Capital budgeting is the process companies use to decide how to invest their money in
projects that will benefit them in the long run. It’s like planning for a big purchase that will
help the business grow over many years. Companies need to be smart about these decisions
because they involve a lot of money and can impact the company’s future. In capital budgeting,
businesses estimate how much money a project will bring in and how much it will cost. They
use tools like Net Present Value (NPV) and Internal Rate of Return (IRR) to compare different
options and choose the best one. Risk is also a big part of the process; companies think about
what could go wrong and how it might affect the investment. The chosen projects should align
with the company’s overall goals and strategy, ensuring that the money is spent wisely. The
ultimate goal of capital budgeting is to make decisions that will increase the company’s wealth
and ensure long-term success. Through careful planning and analysis, capital budgeting helps
businesses make smart, informed decisions about where to invest their resources for the future.
1. Long-term Planning: Capital budgeting focuses on decisions that will affect the
company for many years.
2. Investment Decisions: It helps companies choose which projects or purchases will
bring the most benefit.
3. Cash Flow Estimation: Companies estimate how much money a project will bring in
and how much it will cost.
4. Evaluation Methods: Tools like Net Present Value (NPV) and Internal Rate of Return
(IRR) are used to compare different investment options.
5. Risk Analysis: Companies also think about what could go wrong and how it might
affect the investment.
6. Strategic Fit: The investment should match the company’s overall goals and direction.
 7. Resource Allocation: Capital budgeting ensures that the company’s money is spent in
the best possible way.
8. Maximizing Returns: The main goal is to invest in projects that will increase the
company’s wealth over time.
9. Long-term Impact: Decisions made through capital budgeting can shape the future of
the company.
In summary, capital budgeting is like planning for a big purchase that will help a company
grow and succeed in the long run.

Definition:
• Ezra Solomon: Capital budgeting is the process of determining which long-term
investments or projects a business should pursue, based on their potential to increase
the company’s wealth.
• James C. Van Horne: Capital budgeting involves evaluating and selecting projects
that require large investments of funds, with the aim of maximizing the firm's value
over time.
• Richard A. Brealey: Capital budgeting is the method by which firms decide on
which long-term investments, such as new machinery or buildings, to finance,
focusing on projects that will increase profitability.
• Charles T. Horngren: Capital budgeting is the process of planning and controlling
large expenditures on assets that will provide benefits over a long period, ensuring
that resources are used effectively.
• I.M. Pandey: Capital budgeting refers to the decision-making process regarding
investments in long-term assets, aiming to ensure that the investments align with
the company’s objectives and yield satisfactory returns.

Nature of capital budgeting:

Nature of capital budgeting can be explained in brief as under:
• Capital expenditure plans involve a huge investment in fixed assets.
• Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in future.
• The future benefits are expected and rate to be realized over a series of years.
• The funds are invested in non-flexible long-term funds.
 • Preparation of capital budget plans involve forecasting of several years’ profits in
advance in order to judge the profitability of projects.
• In view of the investment of large amount for a long period of time, any error in the
evaluation of investment projects, may lead to serious issues, the problem will be
followed many coming years.

Significance of Capital Budgeting

1. Long-term Investment Decisions:
Capital budgeting helps businesses decide on large investments that will impact them
for many years. These decisions, like buying new machinery or expanding operations,
are crucial for the company’s growth and sustainability.
2. Maximizing Shareholder Wealth:
The primary goal of capital budgeting is to choose projects that increase the company's
value, thereby maximizing the wealth of its shareholders. By carefully selecting
profitable investments, the company can ensure a higher return on investment.
3. Efficient Resource Allocation:
Capital budgeting ensures that the company’s resources are used effectively. It helps
prioritize projects that offer the best returns, avoiding wasteful spending on less
profitable ventures.
4. Risk Management:
 By analysing potential risks and uncertainties in long-term investments, capital
budgeting helps companies avoid projects that might lead to financial losses, ensuring
a safer and more stable investment approach.

5. Strategic Alignment:
Capital budgeting ensures that the chosen investments align with the company’s overall
strategy and goals. This helps the company grow in the right direction and supports its
long-term objectives.
6. Cash Flow Management:
Capital budgeting involves estimating future cash inflows and outflows from a project.
This helps in maintaining proper cash flow management, ensuring that the company
has enough funds to operate and grow.
7. Helps in Cost Control:
By evaluating different projects and their costs, capital budgeting helps in controlling
costs and selecting the most cost-effective projects, leading to better financial
management.
8. Competitive Advantage:
Smart capital budgeting decisions can give a company a competitive edge by investing
in technologies, products, or markets that competitors might overlook, leading to
greater market share and profitability.
9. Enhances Financial Planning:
 Capital budgeting provides a structured approach to planning for the future, ensuring
that the company is financially prepared for large expenditures and can handle the costs
associated with long-term projects.
10. Supports Sustainability:
By choosing projects that are not only profitable but also sustainable, capital budgeting
can help companies invest in eco-friendly initiatives, ensuring long-term success in an
increasingly environmentally conscious market.

Process of Capital Budgeting:

In capital budgeting process, main points to be borne in mind how much money will be
needed of implementing immediate plans, how much money is available for its completion and
how are the available funds going to be assigned to various capital projects under consideration.
the financial policy and risk policy of the management should be clear in mind before
proceeding to the capital budgeting process. The following procedure may be adopted in
preparing capital budget.

1. Organization of investment proposal:

The first step in capital budgeting process is the conception of a profit-making idea.
The proposals may come from rank-and-file worker of any department or from any line officer.
The department head collects all the proposals and reviews them in the light of financial and
risk policies of the organization in or to send them to the capital expenditure planning
committee for consideration.
2. Screening of proposals:
In large organizations, a capital expenditure planning committee is established for the
screening of various proposals received by it from the heads of various departments and the
line officers of the company. From the heads of various departments and the line officers of the
company the committee screens the various proposals within the long-range policy-frame work
of the organization. It is to be ascertained by the committee whether the proposals are within
the criterion of the firm, or they do no lead to department imbalances or they are profitable.
3. Evaluation of projects:
The next step in capital budgeting process is to evaluate the different proposals in term
of the cost of capital the expected returns from alternative investment opportunities and the life
of the assets with any of the following evaluation techniques Degree of urgency method
(Accounting rate of return method) Pay-back method Discounted cash flow method
4. Establishing priorities
After proper screening of the proposals, uneconomic or unprofitable proposals are
dropped. The profitable projects or in other words accepted projects are then put in priority. It
facilitates their acquisition or construction according to the sources available and avoids
unnecessary and costly delay and serious and cot-overruns. Generally, priority is fixed in the
following order.
• Current and incomplete projects are given first priority.
• Safety projects and projects necessary to carry on the legislative requirements.
• Projects of maintaining the present efficiency of the firm
• Projects for supplementing the income
• Projects for the expansion of new product.
5. Final approval: -
Proposals finally recommended by the committee are sent to the top management along
with the detailed report, both of the capital expenditure and of the sources of funds to meet
them. The management affirms its final seal to proposals taking in view the urgency,
profitability of the projects and the available financial resources. Project are then sent to the
budget committee for incorporating them in the capital budget.
6 Evaluation: -
Last but not the least important step in capital budgeting process is an evaluation of the
program after it has been fully implemented. Budget proposals and the net investment in the
projects are compared periodically and on the basis of such evaluation, the budget figures may
be reviewer and presented in a more realistic way.
Approaches to Capital Budgeting :

1. Net Present Value (NPV) Approach:

o Description: NPV is a method that calculates the present value of cash flows
generated by a project, minus the initial investment. It helps in determining
whether the project will add value to the company.
o Usage: If the NPV is positive, the project is considered profitable and worth
investing in. A negative NPV indicates that the project will not generate enough
returns to cover the costs.

Example :
 2. Payback Period Approach:
The payback period is the time it takes for a project to recover its initial investment from its
cash inflows. This approach is simple and helps in assessing the risk of an investment. Shorter
payback periods are preferred as they indicate quicker recovery of the investment.