**Meaning of Capital Budgeting or Investment Decision**

The term capital budgeting or investment decision means planning
for capital assets. Capital budgeting decision means the decision as to whether
or not to invest in long-term projects such as setting up of a factory or
installing a machinery or creating additional capacities to manufacture a part
which at present may be purchased from outside and so on. It includes the
financial analysis of the various proposals regarding capital expenditure to
evaluate their impact on the financial condition of the company for the purpose
to choose the best out of the various alternatives.

According to Milton “Capital budgeting involves planning of
expenditure for assets and return from them which will be realized in future
time period”.

According to I.M Pandey “Capital budgeting refers to the total
process of generating, evaluating, selecting, and follow up of capital
expenditure alternative”

Capital budgeting decision is thus, evaluation of expenditure
decisions that involve current outlays but are likely to produce benefits over
a period of time longer than one year. The benefit that arises from capital
budgeting decision may be either in the form of increased revenues or reduced
costs. Such decision requires evaluation of the proposed project to forecast
likely or expected return from the project and determine whether return from
the project is adequate.

**Nature / Features of Capital budgeting decisions**

a) Long
term effect: Such decisions have long term effect on future profitability and
influence pace of firms growth. A good decision may bring amazing returns and
wrong decision may endanger very survival of firm. Hence capital budgeting
decisions determine future destiny of firm.

b) High
degree of risk: Decision is based on estimated return. Changes in taste,
fashion, research and technological advancement leads to greater risk in such
decisions.

c)
Huge funds: Large funds are required and sparing
huge funds is problem and hence decision to be taken after proper care .

d)
Irreversible decision: Reverting back from a
decision is very difficult as sale of high value asset would be a problem.

e)
Most difficult decision: Decision is based on
future estimates/uncertainty. Future events are affected by economic, political
and technological changes taking place.

f)
Impact on firms future competitive strengths: These
decisions determine future profit or cost and hence affect the competitive
strengths of firm.

g)
Impact on cost structure – Due to this vital
decision, firm commits itself to fixed costs such as supervision, insurance,
rent, interest etc. If investment does not generate anticipated profit, future
profitability would be affected.

**Techniques used in Investment decision making**

Most commonly used technique in investment decision making are
given below:

**1) Payback period Method:**It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. Here, cash inflow means profit after tax but before depreciation.

**Merits of Payback period Method**

a) This method of evaluating proposals for capital budgeting is
simple and easy to understand, it has an advantage of making clear that it has
no profit on any project until the payback period is over i.e. until capital
invested is recovered. This method is particularly suitable in the case of
industries where risk of technological services is very high.

b) In case of routine projects also, use of payback period method
favours projects that generates cash inflows in earlier years, thereby
eliminating projects bringing cash inflows in later years that generally are
conceived to be risky as this tends to increase with futurity.

c) By stressing earlier cash inflows, liquidity dimension is also
considered in selection criteria. This is important in situations of liquidity
crunch and high cost of capital.

d) Payback period can be compared to break-even point, the point
at which costs are fully recovered but profits are yet to commence.

e) The risk associated with a project arises due to uncertainty
associated with cash inflows. A shorter payback period means that uncertainty
with respect to project is resolved faster.

**Limitations of payback period**

a) It stresses capital recovery rather than profitability. It does
not take into account returns from the project after its payback period.

b) This method becomes an inadequate measure of evaluating 2
projects where the cash inflows are uneven.

c) This method does not give any consideration to time value of
money, cash flows occurring at all points of time are simply added.

d) Post-payback period profitability is ignored totally.

**2) Accounting rate of return (Average rate of return – ARR):**ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects. It is calculated with the help of the following formula:

ARR=Average Profit / Investment

**Merits of ARR**

a) It
is simple, common sense oriented method.

b) Profits
of all years taken into account.

c) It
considers actual net profit of the project.

**Demerits of ARR**

a) Time
value of-money is not considered

b) Risk
involved in the project is not considered

c) Annual
average profits might be same for different projects but accrual of profits
might differ having significant implications on risk and liquidity

d) The
ARR has several variants and that it lacks uniform understanding.

**3) Net present value (NPV) method:**The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.

**Merits of NPV method:**

1) NPV method takes into account the time value of money.

2) The whole stream of cash flows is considered.

3) NPV can be seen as addition to the wealth of shareholders.
The criterion of NPV is thus in conformity with basic financial objectives.

4) NPV uses discounted cash flows i.e. expresses cash flows
in terms of current rupees. NPV's of different projects therefore can be
compared. It implies that each project can be evaluated independent of others
on its own merits.

**Limitations of NPV method:**

1) It involves different calculations.

2) The application of this method necessitates forecasting
cash flows and the discount rate. Thus accuracy of NPV depends on accurate
estimation of these 2 factors that may be quite difficult in reality.

3) The ranking of projects depends on the discount rate.