CAPITAL BUDGETING
One of the important decisions to be taken by a financial manager is: How should limited resources of the firm be allocated to get maximum values for the firm? This refers to investment decisions that deal with the investment of a firm's resources in fixed assets and current assets or capital budgeting decisions and working capital management. Capital budgeting is mainly a decision-making process for investment in assets that have long-term implications, affect the future growth and the profitability of the firm, and the basic composition and assets mix of the firm. In effect, it comprises the following:
Measuring the benefit and costs associated with each alternative option of incremental cash flows.
Evaluating different t proposals in the light of the different maximizing returns expected by the investors of the firm and the return promised by the proposal.
Applying different techniques to select an alternative with the objective of the value of the firm.
Definition of Capital Budgeting
The term 'capital budgeting' refers to the allocation of investible funds to different long-term assets A capital budgeting decision denotes a decision situation where lump sum funds are invested in the initial stages of a project. This involves the entire process of decision-making relating to the acquisition of long-term assets whose returns are expected to arise over a period beyond one year. Capital budgeting decisions may be related to various fields such as buying land. building or plant. or to undertake a program on research and development of a product etc.
In other words, the system of capital budgeting is employed to evaluate expenditure decisions that involve current outlays but are likely to produce benefits over a period of me longer than one year. Capital bud the getting assets the getting, therefore, includes addition, disposition, modification, and replacement of fixed assets.
capital budgeting is more or less a continuous process and is carried out by different functional areas of management such as production, marketing, engineering, etc. So, it plays a very important role in a growing concern.
Objectives of Capital Budgeting
The basic objective of capital budgeting is to select long-term investment projects that are expected to make the maximum contribution to the wealth of shareholders in the long run. Some of the important definitions of capital budgeting are as follows
The capital budgeting is essentially a list of what management believes to be worthwhile projects for the acquisition of new capital assets together with the estimated cost of the project." - Robert N. Anthony
"Capital budgeting consists of planning the development of available capital for the purpose of maximizing the long-term profitability (return on investment) of the firm." -R.M. Lynch
"Capital budgeting is long-term planning for making and financing proposed capital outlays." - Charles T. Hangmen
"The capital expenditure budget represents the plans for the appropriations and expenditures for fixed assets during the budget period." -Keller and Ferrara
"Capital budgeting involves the planning of expenditures for assets, the returns form which will be realized in future time periods." - Milton H. Spencer
On the basis of the above definitions, we can conclude that capital budgeting is a management technique that is used for maximizing the profits of the firm by investing the firm's funds in such assets that generate income for a number of years.
FEATURES OF CAPITAL BUDGETING
Capital budgeting is a multifarious activity. It includes searching for new and more profitable investment proposals, investigating, engineering and marketing considerations to predict the consequences of accepting the investment, and making an economic analysis to determine the profit potential of each investment proposal, Its basic features are as follows
Evaluation of proposals
Capital budgeting gives an opportunity for management to evaluate various capital expenditure proposals and helps them to make correct decisions.
The tool of control
In order to control various capital expenditures, capital budgeting is considered a good tool. With the help of this, we can recognize deviation* between actual and standard expenditure.
Optimal selection
With the help of capital budgeting. management is able to choose the best alternative from a number of projects.
Helps to maintain coordination
Capital budgeting helps to maintain good coordination between various capital expenditures in many projects.
Capital expenditure decisions
The success or failure of a firm usually depends on capital expenditure decisions. This is one of the most important works of management
Proper management of finance
Capital expenditure requires a large investment in different projects. How much amount is to be obtained and from what sources are required to be successfully decided by the management?
To avoid and reduce losses: Expenditure on current assets is fixed and can not be taken without loss from the project. So, in order to avoid and reduce losses, it is essential to consider capital budgeting.
Consideration of other factors: The decision to capital expenditure had a long-lasting effect for a number of years. There are more uncertainty and risk in capital expenditure decisions. So, for the analysis of risk, capital budgeting is necessary.
IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting decisions are often said to be the most important part of corporate financial management. Any decision that requires the use of resources is a capital budgeting decision. Capital budgeting decisions affect the profitability of a firm for a long period, and therefore, the importance of these decisions is obvious. The importance of capital budgeting can be summarized as follows:
Long-term effects: Capital budgeting decisions have long-term effects on the risk and return composition of the firm. These decisions affect the future position of the firm to a considerable extent.
Affect the capacity and strength to compete
Capital budgeting decisions involve a largely irreversible commitment of ent of resources effect objected commitment effect to an of significant degree risk. These decisions have far-reaching effects on the profitability of a firm. A firm may lose competitiveness if the decision to modernize is delayed. So, capital budgeting decisions affect the capacity and strength of a firm to face the competition.
Irreversible decisions: Capital budgeting decisions should be taken only after considering and evaluating each and every minute detail of a project. Most capital budgeting decisions are irreversible. Once taken, the firm may not be in a position to revert back unless it is ready to absorb heavy losses which may result in abandoning the project midway.
Substantial commitments: Capital budgeting involves a large commitment of funds, and As a result, substantial portions of capital funds are blocked in capital budgeting decisions. So, more attention is required in capital budgeting decisions, otherwise, he may suffer heavy capital losses in times to come.
Most difficult to make
Capital budgeting requires an assessment of future events. which are uncertain. It is really a difficult task to estimate the probable future events, probable benefits et., because of economic, political, social, and technological changing factors.
Determine the future growth of an organization: As capital budgeting decisions
have a long-term effect on the capacity and return of an organization, have a substantial initial capital outlay, are irreversible in nature, and are most difficult to make, these decisions significantly determine the future growth and stability of an organization.
Types of Capital Budgeting Decisions
A capital, budgeting decision is a specific decision in a given situation, for a given farm, and with given parameters. Even if the same decision is being considered by the same firm at two different points in time, decision considerations may change as a result of a change in any of the variables. There are some projects which affect other projects, which the firm is considering and analyzing. The projects may be classified as revenue-generating projects or cost-reducing projects. So, capital budgeting decisions can be classified as under:
Expansion Project Decision: When an organization wants to expand its existing capacity, expansion decisions are required to be taken. In such a case, the finance manager is required to evaluate the expansion program of the firm in terms of marginal costs and marginal benefits.
Replacement Project Decision: The continuous use makes machines worn out. worn outback means Sometimes machines are not worn-out but due to the coming of new machines in the market, these become obsolete. In such a case, an outback replacement decision is considered,
New Firm: A newly incorporated firm is required to take different capital budgeting decisions such as the selection of plants to be installed, capacity utilization at initial stages, etc.
Existing Firm: An existing firm may also be required to take various capital budgeting decisions from time to time to meet the challenges of competition.
Diversification: This is also known as a revenue-increasing alternative efficiency decision. Sometimes the firm may be interested to diversify into new product lines, new markets, production of spare parts, etc.
Modernization Decision: If an existing plant is to be replaced because it has become technologically outdated decision may be known as a modernization decision. In this case, the objective is to increase alternative efficiency and reduction of costs
Research and Development Project Decision The research and development work done in different operating sectors of an undertaking is included in the research and development project decision.
Housekeeping Projects Decision: These are the projects in which there is no direct return on investment but with this investment, the productivity and morale of the employee increase, which ultimately benefits the firm in the form of increased production and/or decreased costs.
Capital Budgeting Decisions
Mutually Exclusive Decisions: The mutually exclusive decision situation occurs when the firm has more alternative but competitive proposals before it. In this situation acceptance of one alternative results in an automatic rejection of all their proposals. The selection of one location out of different feasible locations is a mutually exclusive decision.
Contingent Decisions: Sometimes, a capital budgeting decision is contingent on some other decision. For example, the utilization of a bank branch may require not only air- conditioning but also the transfer of some staff members to other branches. The contingent decision, if any, must be considered and evaluated simultaneously.
Accept-Reject Decisions: Accept-reject decisions occur when a proposal is independently accepted or rejected without regard to any other alternative proposal. This is usually made when: (a) Rosal's cost and benefit neither affects nor is affected by the cost and benefit of other proposals, (b) different proposals being considered are not competitive, and (c) accepting or rejecting a proposal has no impact on the desirability of other proposals.
PROCESS OF CAPITAL BUDGETING
There is no common and widely accepted method of preparation for capital budgeting. The process of capital budgeting differs from one organization to another. Generally, the following steps are used for capital budgeting in a big firm:
(1) Origin of investment proposals - The first step in the preparation of a capital budget starts with the origin of investment proposals. The investment proposal can originate at any level of management. For example, a suggestion for improvement in the production process may be given by a foreman. Some proposals are also made by top management.
Process of Capital Budgeting
Origin of investment proposals
Presentation of proposals
Screening the proposal
An economic evaluation of the proposals
Project Selection
The final decision on the projects
Formulation of the capital budget
Authorization of capital expenditure
Project execution
Feedback
(2) Presentation of proposals - When the origin of investment proposals has taken place, then the presentation of proposals is to be made in a well-organized form before appropriate officers. Ordinarily, the head of the department decides the capital expenditures of his department and presents them in a proper form or budget to the budget committee. Generally, the following information is provided in investment proposals
Date of Request,
Project identification number,
Description of the project;
Purpose of and risks for the project,
Estimated total costs;
Estimated starting and completion dates;
The estimated amount and the timing of expenditure;
Estimated cost savings or other economic or financial justifications; and
Estimates of the amount and timing of income from project approvals.
(3) Screening the proposals - When different departments send the proposals to the planning committee or budget committee then the committee screens the 'proposals. This screening is done on the basis of standards set up by the top management and budget committee. The committee looks into the proposals and finds, whether these are in line with the long-term development programmers or not. lf these are found suitable then further economic evaluation of these proposals is done.
(4) Economic evaluation of the proposals - Those proposals which after economic Scrutiny by the budget committee found suitable for consideration are primarily evaluated. In this evaluation, the cost of every project and its economic benefits are taken into consideration.
(5) Project Selection - When the evaluation of various projects is completed then those projects are left out which are not viable or not profitable. The film selects those profitable projects which are within the present and future financial resources of the firm and suits the priorities of the firm.
(6) Final decision on the projects -The budget committee evaluates different projects and chooses suitable projects and sends those projects with detailed recommendations to the Board of Directors. The Board of Directors gives its final decision keeping in view the necessity of profitability and resources. After acceptance by the Board of Directors, the project is included in the capital budget of the firm.
(7) Formulation of the capital budget - The funds are planned after approval of the board of directors. The planning of funds is called the capital budget. The finance committee makes a capital budget and allocates resources for different projects.
(8) Authorisation of capital expenditure-When various projects are included in the capital budget then the different heads of departments are authorized for the implementation of projects for their departments. This authorization is done on the basis of requests received from heads and this function is performed by the financial controller.
(9) Project execution - When the expenses for the projects are authorized then the execution of projects is done in different stages.
(10) Feedback - During the process of implementation the comparison of actual expenditures is done with budgeted expenditures and when the deviation is more than the permitted limit, then this deviation is analyzed and cost estimates are revised, or effective steps are taken for cost control.
Capital budgeting Techniques
Capital budgeting is about techniques wont to decide which investments to form in projects. There are a variety of capital budgeting techniques available, which include the following:
Discounted cash flows. Estimate the quantity of all cash inflows and outflows related to a project through its estimated useful life, then apply a reduced rate to those cash flows to work out their present value. If this value is positive, accept the funding proposal.
Internal rate of return. Determine the discount rate at which the cash flows from a projected net to zero. The project with the very best internal rate of return is chosen.
Constraint analysis
Examine the impact of a proposed project on the bottleneck operation of the business. If the proposal either increases the capacity of the bottleneck or routes works around the bottleneck, thereby increasing throughput, then accept the funding proposal.
Break-Even Analysis
Determine the specified sales level at which a proposal will end in positive income. If the sales level is low enough to be reasonably attainable, then accept the funding proposal.
Discounted payback. Determine the quantity of your time it'll deem the discounted cash flows from a proposal to earn back the initial investment. If the amount is sufficiently short, then accept the proposal.
Accounting rate of return. This is often the ratio of an investment’s average annual profits to the quantity invested in it. If the result exceeds a threshold value, then the investment is approved.
Real options. specialize in the range of profits and losses which will be encountered over the course of the investment period. The analysis begins with a review of the risks to which a project is going to be subjected, then models for every one of those risks or combinations of risks. The result could also be greater care in placing large bets on one likelihood of probability.
Example of Capital Budgeting
Capital budgeting for a dairy expansion involves three steps: recording the investment's cost, projecting the investment's cash flows, and comparing the projected earnings with inflation rates and therefore the value of the investment. for instance, dairy equipment that costs $10,000 and generates a $4,000 annual return would seem to "pay back" on the investment in 2.5 years.
However, if economists expect inflation to rise 30 percent annually, then the estimated return value at the top of the primary year ($14,000) is really worth $10,769 once you account for inflation ($14,000 divided by 1.3 equals $10,769). The investment generates only $769 in real value after the primary year.
Limitations of Capital Budgeting
The economic life of the project and annual cash inflows are only an estimation. The particular economic lifetime of the project is either increased or decreased. Likewise, the particular annual cash inflows could also be either more or but the estimation. Hence, control over cost can't be exercised.
The appliance of capital budgeting techniques is predicated on the presumed cash inflows and cash outflows. Since the longer term is uncertain, the presumed cash inflows and cash outflows might not be true. Therefore, the choice of profitable projects could also be wrong.
The capital budgeting process doesn't take into consideration various non-financial aspects of the projects they play a crucial role in the successful and profitable implementation of them. Hence, truth profitability of the project can't be highlighted.