Principles of Capital Budgeting

Capital Budgeting refers to the process of evaluating a project or an investment in terms of the cost associated with the returns expected upon certain rules and principles. The principles of the Capital budgeting are the set of thumb rules that should be followed while evaluating a project.

  • There are five principles of capital budgeting that are as follows:
  1. Incremental Cash Flow (ICF): The decisions regarding a project evaluation should be based on actual cash flow and not on accounting income. It might be possible that between two projects one is having higher incremental cash flow and the other is having higher profit, still the project with higher ICF must be chosen.
  2. Timing of Cash Flow: Time Value of Money is very important, the same amount may vary in value at various points of time, hence it is important to consider the Timing of Cash Flow. All the calculations should be done on the same level of time to get expected results.
  3. Opportunity Costs: Opportunity Cost is the loss of profit when one option is selected over the other. In simple words, there can always be another option which would have been better than the one chosen, the difference between them is the opportunity cost. Hence, while selecting a project the opportunity cost should always be considered.
  4. Tax Considerations: The impact of taxes must be considered and cash flows after considering the impact of taxes must be considered.
  5. Financial Costs: It is evident that any cash flow will have costs associated with it and should be considered, hence the required return incorporates these costs. There is no need to add these costs separately.

Important Terms Associated with Capital Budgeting

Sunk Cost: 

  • Sunk Cost is the expense incurred which cannot be recovered. Such costs do not affect the business decision in a company.
  • E.g. A company has spent Rs. 10000 on market research for the launch of a new product, it does not proceed ahead with the product and hence Rs. 10000 is lost, it is a sunk cost.

Opportunity Cost: 

  • Opportunity cost is the loss of profit when one alternative is chosen over the other.
  • E.g. Ram invests Rs.10000 in bank FD that gives 7% interest, however, he could have invested it in Mutual funds that assure 9% return, here 2% is the opportunity cost.

Incremental Cash Flow: 

  • Incremental Cash Flow is the additional cash flow obtained from a project or an investment after the expected cash flow has been obtained.
  • E.g. Ram invested Rs. 10000 in Insurance Fund, the expected return was of Rs. 12000, however, due to the good performance of the market, the company gave a bonus of Rs. 500 in the returns and Ram got Rs. 12500 as total return, Rs. 500 is the incremental Cash Flow.

Conventional Cash Flow: 

  • If a project has an onetime initial investment and then the returns are expected in cash flow, it is known as Conventional Cash Flow.
  • E.g. Ram invested in a money-back plan wherein he paid Rs. 10000 in the 1st year and then he received Rs. 1000 every year as a return for the next 14 years, this is conventional cash flow.

Non-Conventional Cash Flow: 

  • If a project requires investment in the form of cash flows over a period of time and the returns are in cash flow, it is known as Non-Conventional Cash Flow.
  • E.g. Amit took an insurance plan in which he invests Rs. 5000 every 5 years and the company pays him Rs. 1200 per year, this is non-conventional cash flow.

Externality: 

  • It is the effect on an investment in other aspects of the company other than the investment itself.
  • E.g. Ram has an FD with a bank and receives Rs. 500 as an interest every month, this money he deposits in mutual funds if there is some issue is returns form the bank, it will also have an impact on mutual fund investment, this is an externality.

Independent Projects: 

  • If two or more projects are not related to each other and both can be chosen at the same time, they are independent projects.
  • E.g. Ram can invest Rs. 500 in mutual funds and Rs. 600 in bank deposits, the two investments are unrelated to each other, hence they are independent projects.

Mutually Exclusive Projects: 

  • Two or more projects are said to be mutually exclusive if any of them can be chosen and all of them cannot be chosen.
  • E.g. Ram has Rs. 1000 to invest in, he compares returns in Bank Deposits vs SIP, after comparison he can either choose Deposits in Bank or SIP, hence they are Mutually Exclusive Projects.

Project Sequencing: 

  • When more than 1 project is aligned for investment, such that the company may choose the next project anytime, it is known as project sequencing.
  • E.g. Ram has decided to invest Rs. 10000 in Bank Deposits in this year and has kept the SIP option in the queue, this is a project sequencing where SIP is in sequence after Bank Deposit.

Unlimited Funds: 

  • When an organization has no capping on the amount of investment and is free to invest in all profitable investments, it is said that the company has unlimited funds.
  • E.g. Ram has decided to invest Rs. 10000 each in bank FD, SIP, Insurance, and is also ready if some new deposit scheme is introduced, this is Unlimited Funds.

Capital Rationing: 

  • When a company has a fixed amount of funds to invest in profitable projects, it can only choose projects up to that limit, this is Capital rationing.
  • E.g. Ram has Rs. 100000 to invest either in FD or SIP or Insurance, this is Capital Rationing.
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