Capital Budgeting

Capital Budgeting

Meaning of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decisions because the efficient allocation of capital resources is one of the most crucial decisions of financial management. Capital budgeting is budgeting for capital projects. It is significant because it deals with the right kind of evaluation of projects. The exercise involves ascertaining/estimating cash inflows and outflows, matching the cash inflows with the outflows appropriately, and evaluating the desirability of the project. 

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It is a managerial technique of meeting capital expenditure with the overall objectives of the firm. Capital budgeting means planning for capital assets. It is a complex process as it involves decisions relating to the investment of current funds for the benefit to be achieved in the future. The overall objective of capital budgeting is to maximize the profitability of the firm / the return on investment.

Capital Expenditure

Capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in the future. The following are some of the examples of capital expenditure.

  • Cost of acquisition of permanent assets such as land & buildings, plant & machinery, goodwill, etc.
  • Cost of addition, expansion, improvement, or alteration in the fixed assets.
  • Cost of replacement of permanent assets.
  • Research and development project cost etc.
  • Capital expenditure involves non-flexible long term commitment of funds

Definition of Capital Budgeting

“Capital budgeting” has been formally defined as follows.

  • “Capital budgeting is long-term planning for making and financing proposed capital outlay”. – Charles T. Horngreen
  • “The capital budgeting generally refers to acquiring inputs with long-term returns”. – Richards & Greenlaw
  • “Capital budgeting involves the planning of expenditure for assets, the returns form which will be realized in future time periods”. – Milton H. Spencer

The long-term activities are those activities that influence firms operation beyond the one year period. The basic features of capital budgeting decisions are:

  • There is an investment in long term activities
  • Current funds are exchanged for future benefits
  • The future benefits will be available to the firm over a series of years.

Need For Capital Investment

The factors that give rise to the need for capital investments are:

  • Expansion
  • Diversification
  • Obsolescence
  • Wear and tear of old equipment
  • Productivity improvement
  • Learning – curve effect
  • Product improvement
  • Replacement and modernization

The firm’s value will increase in investments that are profitable. They add to the shareholders’ wealth. The investment will add to the shareholders’ wealth if it yields benefits, in excess of the minimum benefits as per the opportunity cost of capital.

It is clear from the above discussion what capital investment proposals involve:

  • Longer gestation period
  • Substantial capital outlay
  • Technological considerations
  • Irreversible decisions
  • Environmental issues

Capital Budgeting – Significance

  • Capital budgeting involves capital rationing. There are the available funds that have to be allocated to competing projects in order of project potential. Normally the individuality of the project poses the problem of capital rationing due to the fact that required funds and available funds may not be the same.
  • Capital budget becomes a control device when it is employed to control expenditure. Because manned outlays are limits to actual expenditure, the concern has to investigate the variation in order to keep expenditure under control.
  • A firm contemplating a major capital expenditure program may need to arrange funds many years in advance to be sure of having the funds when required.
  • Capital budgeting provides useful tools with the help of which the management can reach prudent investment decisions.
  • Capital budgeting is significant because it deals with the right mind of the evaluation of projects. A good project must not be rejected and a bad project must not be selected. Capital projects need to be thoroughly evaluated as to costs and benefits.
  • Capital projects involve investment in physical assets such as land, building plant, machinery, etc. for manufacturing a product against financial investments that involve investment in financial assets like shares, bonds, or mutual funds. The benefits from the projects last for a few too many years.
  • Capital projects involve huge outlay and last for years.
  • Capital budgeting thus involves the making of decisions to earmark funds for investment in long term assets yielding considerable benefits in the future, based on a careful evaluation of the prospective profitability/utility of such proposed new investment.

Capital Budgeting Process

The important steps involved in the capital budgeting process are:

Project Generation. 

Investment proposals of various types may originate at different levels within a firm. Investment proposals may be either proposals to add a new product to the product line or proposals to expand capacity in existing product lines. Secondly, proposals designed to reduce costs in the output of existing products without changing the scale of operations. Investment proposals of any type can originate at any level. In a dynamic and progressive firm, there is a continuous flow of profitable investment proposals.

Project evaluation

Project evaluation involves two steps: i) estimation of benefits and costs and ii) selection of an appropriate criterion to judge the desirability of the projects. The evaluation of projects should be done by an impartial group. The criterion selected must be consistent with the firm’s objective of maximizing its market value.

Project Selection

There is no uniform selection procedure for investment proposals. Since capital budgeting decisions are of crucial importance, the final approval of the projects should rest on top management.

Project Execution

After the final selection of investment proposals, funds are earmarked for capital expenditures. Funds for the purpose of project execution should be spent in accordance with appropriations made in the capital budget.

Factors Influencing Investment Decisions

The main factors which, influence capital investment are:

Technological change

In modem times, one often finds fast obsolescence of technology. New technology, which is relatively more efficient, takes the place of old technology; the latter getting downgraded to some less important applications. However, in taking a decision of this type, the management has to consider the cost of new equipment vis-a-vis the productive efficiencies of the new as well as the old equipment. However, while evaluating the cost of new equipment, the management should not take into, account its full accounting cost (as the equipment lasts for years) but its incremental cost. Also, the cost of new equipment is often partially offset by the salvage value of the replaced equipment.

Competitors ‘strategy

Many a time an investment is taken to maintain the competitive strength of the firm; If the competitors are installing new equipment to expand output or to improve the quality of their products, the firm under consideration will have no alternative but to follow suit, else it will perish. It is, therefore, often found that the competitors’ strategy regarding capital investment plays a very significant role in forcing capital decisions on a firm.

Demand forecast

The long-run forecast of demand is one of the determinants of investment decisions. If it is found that there is a market potential for the product, in the long run, the dynamic firm will have to make decisions for capital expansion.

Type of management

Whether capital investment would be encouraged or not depends, to a large extent, on the viewpoint of the management. If the management is modern and progressive in its outlook, the innovations will be encouraged, whereas conservative management discourages innovation and fresh investments.

Fiscal policy

Various tax policies of the government (like tax concessions on investment income, rebate on new investment, and method of allowing depreciation deduction allowance) also have a favorable or unfavorable influence on capital investment.

Cash flows

Every firm makes a cash flow budget. Its analysis influences capital investment decisions. With its help, the firm plans the funds for acquiring the capital asset. The budget also shows the timing of availability of cash flows for alternative investment proposals, thereby helping the management in selecting the desired project.

Return expected from the investment

In most cases, investment decisions are made in anticipation of increased returns in the future. While evaluating investment proposals, it is therefore essential for the firm to estimate future returns or benefits accruing from the investment.

Kinds of Capital Budgeting Decisions

The overall objective of capital budgeting is to maximize the profitability of a firm or the return on investment. This objective can be achieved either by increasing revenues or by reducing costs. Thus, capital budgeting decisions can be broadly classified into two categories:

  • Those which increase revenue, and
  • Those which reduce costs

The first category of capital budgeting decisions is expected to increase the revenue of the firm through the expansion of the production capacity or size of operations by adding a new product line. The second category increases the earnings of the firm by reducing costs and includes decisions relating to the replacement of obsolete, outmoded, or worn-out assets.

In such cases, a firm has to decide whether to continue with the same asset or replace it. Such a decision is taken by the firm by evaluating the benefit from the replacement of the asset in the form of a reduction in operating costs and the cost/cash outlay needed for the replacement of the asset. Both categories of the above decisions involve investment in fixed assets but the basic difference between the two decisions lies in the fact that increasing revenue investment decisions are subject to more uncertainty as compared to cost-reducing investment decisions.

Further, in view of the investment proposals under consideration, capital budgeting decisions may also be classified as:

  • Accept / Reject Decisions

Accept/reject decisions relate to the independent project which does not compete with one another. Such decisions are generally taken on the basis of minimum return on investment. All those proposals which yield a rate of return higher than the minimum required rate of return or the cost of capital are accepted and the rest are rejected. If the proposal is accepted the firm makes an investment in it, and if it is rejected the firm does not invest in the same.

  • Mutually Exclusive Project Decisions

Such decisions relate to proposals that compete with one another in such a way that acceptance of one automatically excludes the acceptance of the other. Thus, one of the proposals is selected at the cost of the other. For example, a company may have the option of buying a new machine, or a second-hand machine or taking an old machine on hire, or selecting a machine out of more than one brand available in the market. In such a case, the company may select one best alternative out of the various options by adopting some suitable technique or method of capital budgeting. Once one alternative is selected the others are automatically rejected.

  • Capital Rationing Decisions

A firm may have several profitable investment proposals but only limited funds to invest. In such a case, these various investments compete for limited funds and, thus, the firm has to ration them. The firm affects the combination of proposals that will yield the greatest profitability by ranking them in descending order of their profitability.

Summary

Capital budgeting is budgeting for capital projects. It is significant because it deals with the right kind of evaluation of projects. The exercise involves ascertaining/estimating cash inflows and outflows, matching the cash inflows with the outflows appropriately, and evaluating the desirability of the project. It is a managerial technique of meeting capital expenditure with the overall objectives of the firm. Capital budgeting means planning for capital assets.

Capital budgeting involves capital rationing. These are the available funds that have to be allocated to competing projects in order of project potential. Normally the individuality of the project poses the problem of capital rationing due to the fact that required funds and available funds may not be the same. Capital budget becomes a control device when it is employed to control expenditure. Because the estimated cash outlays limits the actual expenditure, the concern has to investigate the variation in order to keep expenditure under control. Capital budgeting provides useful tools with the help of which the management can reach prudent investment decisions.

Capital projects involve huge outlay and long years. The Important factors influencing investment decisions include Technological change, competitors’ strategy, demand forecast, and type of management, fiscal policy, cash flows, and return expected from the investment.