Corporate Finance

Capital Budgeting: Concept and Analytical Techniques

1. Concept of Capital Budgeting (2 marks)

Capital budgeting is the process of planning, evaluating, and selecting long-term investment projects whose returns are expected to accrue over a period of more than one year. It involves committing substantial funds to fixed assets such as aircraft, buildings, machinery, runways, and technology, where the decision is irreversible or costly to reverse.

Key features:

• Long-term horizon: Benefits extend beyond the current accounting period.
• Large outlay: Involves significant funds relative to the firm's size.
• Irreversibility: Decisions are difficult and expensive to reverse.
• Risk and uncertainty: Future cash flows are estimates, not certainties.
• Wealth maximization: The objective is to select projects that maximize shareholder (or, for CAAN, social) value.

The process typically follows: identification of investment proposals → estimation of cash flows → evaluation using techniques → selection → implementation → post-audit review.

---

2. Analytical Techniques (8 marks)

Capital budgeting techniques are broadly classified into traditional (non-discounting) and modern (discounting) techniques. Two techniques are explained below with suitable examples.

---

(a) Net Present Value (NPV) Method

Concept: NPV is the sum of the present values of all expected future cash inflows minus the present value of cash outflows, discounted at the firm's cost of capital (or required rate of return).

Formula:

$\text{NPV} = \sum_{t=1}^{n} \frac{CF_t}{(1+k)^t} - I_0$

Where:

• $CF_t$ = cash inflow in year $t$
• $k$ = discount rate (cost of capital)
• $n$ = project life
• $I_0$ = initial investment

Decision rule:

• NPV > 0 → Accept
• NPV = 0 → Indifferent
• NPV < 0 → Reject
• Among mutually exclusive projects, choose the one with the highest NPV.

Example:

A project requires an initial investment of Rs 100,000 and is expected to generate cash inflows of Rs 40,000, Rs 50,000, and Rs 30,000 in years 1, 2, and 3 respectively. The cost of capital is 10%.

$\text{NPV} = 100,223 - 100,000 = \text{Rs } 223$

Interpretation: Since NPV is positive, the project should be accepted.

---

(b) Internal Rate of Return (IRR) Method

Concept: IRR is the discount rate at which the NPV of a project equals zero — i.e., the rate at which the present value of cash inflows exactly equals the initial investment. It represents the project's own earning rate.

Formula:

$\sum_{t=1}^{n} \frac{CF_t}{(1+IRR)^t} - I_0 = 0$

Decision rule:

• IRR > cost of capital → Accept
• IRR = cost of capital → Indifferent
• IRR < cost of capital → Reject

Example:

Using the same data — initial investment Rs 100,000; cash inflows Rs 40,000, Rs 50,000, and Rs 30,000 over three years.

At $k = 10\%$, NPV = Rs 223 (positive, from earlier calculation).

Try $k = 11\%$:

$\text{NPV} = 98,552 - 100,000 = \text{Rs } (1,448) \text{ (negative)}$

Interpolation:

$IRR = 10\% + \frac{223}{223 + 1,448} \times (11\% - 10\%)$

$IRR = 10\% + 0.133 \times 1\% = 10.13\%$

Interpretation: Since IRR (10.13%) > cost of capital (10%), the project should be accepted. This agrees with the NPV decision.

---

Summary

NPV is theoretically superior because it uses the cost of capital as the reinvestment rate and gives an absolute measure of value addition, whereas IRR assumes reinvestment at the IRR itself and can give multiple values for non-conventional cash flows.