Capital budgeting: meaning, importance, process, payback and ARR
Financial Management · Unit IV · Topic 13 of 16 · 4 min read
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1. Meaning and features
Capital budgeting is the process of evaluating and selecting long-term investments: new plant, replacement of machinery, expansion, new products, research. It is long-term planning for making and financing capital outlays whose benefits come over several years. Features: a large outlay now, benefits spread over several years, decisions hard to reverse, and high risk because the future is uncertain.
Kinds of decision: accept–reject (independent projects), mutually exclusive (choose one of several, as machine A or B), and capital rationing (rank projects when funds are limited).
2. Importance (benefits)
- Large sums are committed for long periods; a wrong decision is costly to reverse.
- The decisions decide the firm’s future growth, capacity and competitive position.
- They fix the firm’s cost structure (fixed costs, hence business risk).
- Funds are scarce; a systematic method allocates them to the best projects.
- Discounted methods link decisions to the goal of wealth maximisation.
- The process forces careful forecasting, review and post-audit, improving control.
3. The process
- Identification of investment opportunities (from departments, market study).
- Screening and estimation of the outlay and the cash flows after tax over the project’s life.
- Evaluation by payback, ARR, NPV, IRR or PI, with risk analysis.
- Selection and approval, within the capital budget.
- Implementation: funds released, project carried out on time and within cost.
- Performance review (post-audit): actual results compared with estimates.
4. Building cash flows after tax
Profit before depreciation and tax (CFBT) − depreciation = profit before tax; − tax = profit after tax (PAT); + depreciation = cash flow after tax (CFAT). Depreciation is added back because it is a non-cash charge; it matters only because it saves tax. Add scrap value and release of working capital in the last year.
5. Payback period
The time taken for cumulative cash inflows to recover the outlay. Equal flows: outlay ÷ annual CFAT. Unequal flows: add year by year and interpolate. Accept if shorter than a target; prefer the shorter.
Worked problem (January 2026, C and S company). Outlay Rs. 2,00,000; depreciation 20% of cost = Rs. 40,000 a year; tax 40%; income after depreciation before tax as given.
| Year | PBT | Tax 40% | PAT | + Dep. | CFAT | Cumulative |
|---|---|---|---|---|---|---|
| 1 | 1,00,000 | 40,000 | 60,000 | 40,000 | 1,00,000 | 1,00,000 |
| 2 | 1,00,000 | 40,000 | 60,000 | 40,000 | 1,00,000 | 2,00,000 |
| 3 | 80,000 | 32,000 | 48,000 | 40,000 | 88,000 | 2,88,000 |
| 4 | 80,000 | 32,000 | 48,000 | 40,000 | 88,000 | 3,76,000 |
| 5 | 50,000 | 20,000 | 30,000 | 40,000 | 70,000 | 4,46,000 |
Cumulative CFAT reaches Rs. 2,00,000 at the end of year 2: payback period = 2 years. (The NPV of this project is worked in the next note.)
Merits: simple; stresses liquidity; a rough guard against risk in uncertain industries. Demerits: ignores the time value of money and all flows after the payback year; not a measure of profitability. The discounted payback uses present values to meet the first objection.
6. Accounting (average) rate of return
ARR = average annual PAT ÷ average investment × 100, where average investment = (cost − scrap) ÷ 2 + scrap (some texts use original investment; state which).
C and S company: PAT total 2,46,000; average 49,200; average investment 2,00,000 ÷ 2 = 1,00,000. ARR = 49.2% (24.6% on original investment).
Worked problem (February 2025, ABC Ltd). Cost Rs. 1,00,000, life 5 years, no salvage, depreciation Rs. 20,000; tax 40%.
| Year | CFBT | − Dep. | PBT | Tax 40% | PAT | CFAT |
|---|---|---|---|---|---|---|
| 1 | 15,000 | 20,000 | −5,000 | −2,000 | −3,000 | 17,000 |
| 2 | 16,000 | 20,000 | −4,000 | −1,600 | −2,400 | 17,600 |
| 3 | 18,500 | 20,000 | −1,500 | −600 | −900 | 19,100 |
| 4 | 26,600 | 20,000 | 6,600 | 2,640 | 3,960 | 23,960 |
| 5 | 27,000 | 20,000 | 7,000 | 2,800 | 4,200 | 24,200 |
| Total | 1,860 | 1,01,860 |
Average PAT = 1,860 ÷ 5 = 372; average investment 50,000. ARR = 0.74% (0.37% on original investment): far too low, and the project should be rejected.
Merits of ARR: simple; uses accounting data; considers the whole life. Demerits: uses profit, not cash flow; ignores the time value of money; different definitions of investment give different answers.
How this is examined
The 10-mark Unit IV problem always needs the CFAT table in section 4 first; payback and ARR then take two lines each, and the discounted methods follow in the next note. The theory essay or note is sections 1–3.
Now try the real questions: Financial Management past question papers.