Capital budgeting is about long-term investment decisions like purchasing machinery, launching a new project, or expanding capacity. These decisions involve:
Therefore, managers evaluate projects using TVM (time value of money) based methods like NPV and IRR.
Capital budgeting is the process of evaluating and selecting long-term investment projects.
Examples:
Importance:
Capital budgeting uses cash flows, not accounting profit.
Reasons:
Common cash flows:
TVM means:
So future cash flows must be converted to present value using discounting.
Where r = discount rate, n = number of years.
Payback period is the time required to recover the initial investment from cash inflows.
Decision idea:
Merits:
Access the complete note and unlock all topic-wise content
It's free and takes just 5 seconds
Managerial economics is a stream of management studies which emphasises solving business problems and decision-making by applying the theories and principles of microeconomics and macroeconomics. It is a specialised stream dealing with the organisation's internal issues by using various economic theories.
Get instant access to notes, practice questions, and more benefits with our mobile app.
Download this note as PDF at no cost
If any AD appears on download click please wait for 30sec till it gets completed and then close it, you will be redirected to pdf/ppt notes page.
Capital budgeting is about long-term investment decisions like purchasing machinery, launching a new project, or expanding capacity. These decisions involve:
Therefore, managers evaluate projects using TVM (time value of money) based methods like NPV and IRR.
Capital budgeting is the process of evaluating and selecting long-term investment projects.
Examples:
Importance:
Capital budgeting uses cash flows, not accounting profit.
Reasons:
Common cash flows:
TVM means:
So future cash flows must be converted to present value using discounting.
Where r = discount rate, n = number of years.
Payback period is the time required to recover the initial investment from cash inflows.
Decision idea:
Merits:
Limitations:
Discounted payback improves payback by discounting cash flows first, but still ignores cash flows after payback.
NPV is the difference between the present value of cash inflows and the present value of cash outflows.
Formula:
Interpretation:
Merits:
IRR is the discount rate at which NPV becomes zero.
Meaning:
Decision:
Limitations:
Useful when funds are limited (capital rationing).
FV=₹10,000 after 2 years, r=10%:
Investment=₹50,000; annual inflow=₹10,000:
If PV of inflows = ₹60,000 and investment = ₹50,000:
Step flow (NPV):
Estimate cash flows → choose discount rate → compute PV of inflows → NPV = PV inflows − investment → decision
Quick formula table:
From this topic
Capital budgeting is important because it:
Hence firms evaluate projects carefully using NPV/IRR methods.
Capital budgeting uses cash flows, not accounting profit.
Therefore project evaluation is based on cash inflows/outflows.
Capital budgeting is the process of evaluating and selecting long-term investment projects such as new plant, machinery, expansion and replacement.
Identify project → Estimate cash flows → Choose discount rate (cost of capital)
→ Evaluate (NPV/IRR/Payback) → Select/Reject → Implement & Review
Thus, firms use capital budgeting to achieve profitability and growth in the long run.