The process of evaluating and selecting long-term investment projects based on their potential to generate returns above the cost of capital.
Capital Budgeting (also called Investment Appraisal) involves analyzing whether large expenditures on projects, equipment, or expansion are financially worthwhile. Methods include: NPV (Net Present Value — most theoretically sound), IRR (Internal Rate of Return — return percentage), Payback Period (time to recover investment — simplest), Profitability Index (return per rupee invested), and Discounted Payback. Decisions are irreversible (you can't easily un-buy a factory), involve large sums, and impact business for years. Capital rationing occurs when a company has more good projects than available funds.
Company evaluates 3 projects (budget: ₹50,00,000): Project A: Cost ₹30L, NPV ₹8L, Payback 2.5 years. Project B: Cost ₹25L, NPV ₹6L, Payback 2 years. Project C: Cost ₹35L, NPV ₹12L, Payback 3.5 years. Under capital rationing (can't do all): Choose A + B (₹55L cost? No, exceeds budget). Choose B + one more? Best combo: A + B gives total NPV ₹14L but exceeds ₹50L budget. Final: Project C alone (₹12L NPV, within budget) or Project B (if risk-averse).
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NPV is theoretically superior because it: gives absolute value creation (₹ amount), considers time value of money, and aligns with shareholder wealth maximization. However, use multiple methods together — NPV for the go/no-go decision, IRR to communicate return to management, and Payback Period for risk assessment (shorter = less risky). Never use Payback alone.
Capital Budget: Long-term investment decisions (buying machinery, building factory, acquiring company). One-time, large, irreversible. Operating Budget: Short-term recurring expenses (salaries, materials, utilities). Annual, routine, adjustable. Capital budgets use discounting techniques; operating budgets use incremental/zero-based approaches.
The difference between the present value of future cash inflows and the initial investment, used to evaluate the profitability of a project.
A financial metric that measures the profitability of an investment by comparing the net profit to the cost of the investment, expressed as a percentage.
The minimum rate of return a company must earn on its investments to satisfy its debt holders and equity shareholders.
Funds spent by a business to acquire, upgrade, or maintain long-term physical assets such as property, equipment, or technology infrastructure.
The point at which a business's total revenue equals total costs, resulting in neither profit nor loss.
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