What Is Capital Budgeting? The word Capital refers to be the total investment of a company of firm in money, tangible and intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to be the art of building budgets. Budgets are a blue print of a plan and action expressed in quantities and manners.
The examples of capital expenditure:
- Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
- The expenditure relating to addition, expansion, improvement and alteration to the fixed assets.
- The replacement of fixed assets.
- Research and development project.
Definitions
According to the definition of Charles T. Hrongreen, “capital budgeting is a long-term planning for making and financing proposed capital out lays.According to the definition of G.C. Philippatos, “capital budgeting is concerned with the allocation of the firms source financial resources among the available opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earning from a project, with the immediate and subsequent streams of expenditure”.
According to the definition of Richard and Green law, “capital budgeting is acquiring inputs with long-term return”.
According to the definition of Lyrich, “capital budgeting consists in planning development of available capital for the purpose of maximizing the long-term profitability of the concern”.
It is clearly explained in the above definitions that a firm’s scarce financial resources are utilizing the available opportunities. The overall objectives of the company from is to maximize the profits and minimize the expenditure of cost.
Need and Importance of Capital Budgeting
- Huge investments: Capital budgeting requires huge investments of funds, but the available funds are limited, therefore the firm before investing projects, plan are control its capital expenditure.
- Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks involved in the investment decision are more. If higher risks are involved, it needs careful planning of capital budgeting.
- Irreversible: The capital investment decisions are irreversible, are not changed back. Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose off those assets without involving huge losses.
- Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in long-term and will bring significant changes in the profit of the company by avoiding over or more investment or under investment. Over investments leads to be unable to utilize assets or over utilization of fixed assets. Therefore before making the investment, it is required carefully planning and analysis of the project thoroughly.
Capital Budgeting Process
Capital budgeting is a difficult process to the investment of available funds. The benefit will attained only in the near future but, the future is uncertain. However, the following steps followed for capital budgeting, then the process may be easier are.Identification of various investments proposals
The capital budgeting may have various investment proposals. The proposal for the investment opportunities may be defined from the top management or may be even from the lower rank. The heads of various department analyse the various investment decisions, and will select proposals submitted to the planning committee of competent authority.Screening or matching the proposals
The planning committee will analyse the various proposals and screenings. The selected proposals are considered with the available resources of the concern. Here resources referred as the financial part of the proposal. This reduces the gap between the resources and the investment cost.Evaluation
After screening, the proposals are evaluated with the help of various methods, such as pay back period proposal, net discovered present value method, accounting rate of return and risk analysis. Each method of evaluation used in detail in the later part of this chapter. The proposals are evaluated by.- Independent proposals
- Contingent of dependent proposals
- Partially exclusive proposals
Fixing property
After the evolution, the planning committee will predict which proposals will give more profit or economic consideration. If the projects or proposals are not suitable for the concern’s financial condition, the projects are rejected without considering other nature of the proposals.Final approval
The planning committee approves the final proposals, with the help of the following:Profitability
- Economic constituents
- Financial violability
- Market conditions.
Implementing
The competent autherity spends the money and implements the proposals. While implementing the proposals, assign responsibilities to the proposals, assign responsibilities for completing it, within the time allotted and reduce the cost for this purpose. The network techniques used such as PERT and CPM. It helps the management for monitoring and containing the implementation of the proposals.Performance review of feedback
The final stage of capital budgeting is actual results compared with the standard results. The adverse or unfavourable results identified and removing the various difficulties of the project. This is helpful for the future of the proposals.Kinds of Capital Budgeting Decicions
The overall objective of capital budgeting is to maximize the profitability. If a firm concentrates return on investment, this objective can be achieved either by increasing the revenues or reducing the costs. The increasing revenues can be achieved by expansion or the size of operations by adding a new product line. Reducing costs mean representing obsolete return on assets.Methods of Capital Budgeting of Evaluation
By matching the available resources and projects it can be invested. The funds available are always living funds. There are many considerations taken for investment decision process such as environment and economic conditions.Risk and Uncertainly In Capital Budgeting
Capital budgeting requires the projection of cash inflow and outflow of the future. The future in always uncertain, estimate of demand, production, selling price, cost etc., cannot be exact. For example: The product at any time it become obsolete therefore, the future in unexpected. The following methods for considering the accounting of risk in capital budgeting. Various evaluation methods are used for risk and uncertainty in capital budgeting are as follows:- Risk-adjusted cut off rate (or method of varying discount rate)
- Certainly equivalent method.
- Sensitivity technique.
- Probability technique
- Standard deviation method.
- Co-efficient of variation method.
- Decision tree analysis.
Source: What Is Capital Budgeting?