The process of determining a project to be initiated by a company is known as capital budgeting. It is a method of making long term planning decisions for capital investments.

The management plans different kinds of project that will give them return in the future period. The Company look into those projects that have potential and increase the shareholder’s value. A firm needs to commit funds now to receive a return in the coming years.

There are basically two types of investment decision :-

• Selecting new facilities or expanding existing facilities.

• Replacing existing facilities with the new the facilities.

**Tools of Capital Budgeting**

**Payback Period **-The time required to recover the total investment for a particular project is known as payback period. Payback period is calculated by dividing the cost of the project by annual cash inflow. Future income and time value of money is not considered while evaluating payback period. These are the two drawbacks of payback period.

**Accounting Rate of Return**-It is a rate of return derived from the average annual profits divided by average income. This rate reflects a quick estimation of projects worth. The major disadvantage of this tool is that it fails to present true value of return.

Net Present Value-Net Present Value is derived from the difference between the present value of the cash inflow and cash outflow. This helps in analyzing the profitability of a company.

**Internal Rate of Return** – Internal Rate of Return is a rate at which the project is expected to grow. The internal rate of return helps to compare the profitability of investments. Equating present value of cash flow from a particular project to zero derives IRR.

**Profitability Index**- Profitability Index is derived from the present value of future cash flow divided by initial investment.

The indications of PI are:-

PI is greater than 1- Accept the project

PI is less than 1 - Reject the project.

Capital expenditure requires large amount of funds. A company requires best methods to fund the above requirements. Therefore, Capital Budgeting is an important process for the management.