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Capital Budgeting

Capital budgeting is defined as planning for the purpose of maximizing the long-term profitability of the concern. It needs huge capital investments and hence proper planning and risk analysis are done before the project starts. Its return on investment are realized in future. Capital budgeting is irreversible and long term in nature.

A typical capital budgeting involves following steps.

  1. Identification of various investments proposals
  2. Screening the proposals
  3. Evaluation
  4. Fixing property
  5. Final approval
  6. Implementation
  7. Performance review feedback

Methods of capital budgeting of evaluations

The funds available are always living funds. There are many external market factors are taken into consideration while taking investment decision.

The methods of evaluations are classified as follows:

(A) Traditional methods (or Non-discount methods)

(i) Pay-back Period : Pay-back period is the time required to recover the initial investment in a project.

Payback period= initial investment/ annual cash inflows

(ii) Post Pay-back profitability : Receivable after the pay-back profitability.

Post pay back profitability=Cash inflow (Estimated life – Pay-back period)

(iii) Accounts Rate of Return : The average rate of return or profit taken for considering

the project evaluation.

(B) Modern methods (or Discount methods)

(i) Net Present Value Method : Net present value is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

(ii) Internal Rate of Return Method: It is a rate at which discount cash flows to zero. It is expected by the following ratio:  Cash inflow/Initial investment