What is capital budgeting?

Capital budgeting is a company’s formal process used for evaluating potential expenditures or investments that are significant in amount. In layman's words, Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long-term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings).

It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders. It involves the decision to invest the current funds for addition, disposition, modification or replacement of fixed assets. The large expenditures include the purchase of fixed assets like land and building, new equipment, rebuilding or replacing existing equipment, research and development, etc. The large amounts spent on these types of projects are known as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future profits since most companies can manage only a limited number of large projects at any one time.

It usually involves calculation of every project’s future accounting profit by period, the flow of cash by period, the present value of cash flows after considering the time value of money. The number of years it takes for a project’s cash flow to pay back the initial cash investment, an assessment of risk, and various other factors.

FEATURES OF CAPITAL BUDGETING:

1. It involves high risk
2. Large profits are estimated
3. The long time between the initial investments and estimated returns

CAPITAL BUDGETING PROCESS:

• Project identification and generation: The first step towards capital budgeting is to generate a proposal for investments. There could be various reasons for taking up investments in a business. It could be the addition of a new product line or expanding the existing one. It could be a proposal to either increase the production or reduce the costs of outputs.
• Project Screening and Evaluation: This step mainly involves selecting all correct criteria to judge the desirability of a proposal. This must match the objective of the firm to maximize its market value. The tool of the time value of money comes in handy in this step. Also, the estimation of the benefits and the costs need to be done. The total cash inflow and outflow along with the uncertainties and risks associated with the proposal must be analyzed thoroughly and appropriate provisioning has to be done for the same.
• Project Selection: There is no such defined method for the selection of a proposal for investments as different businesses have different requirements. That is why the approval of an investment proposal is done based on the selection criteria and screening process which is defined for every firm keeping in mind the objectives of the investment being undertaken. Once the proposal has been finalized, the different alternatives for raising or acquiring funds must be explored by the finance team. This is called preparing the capital budget. The average cost of funds must be reduced. A detailed procedure for periodical reports and tracking the project for the lifetime needs to be streamlined in the initial phase itself. The final approvals are based on profitability, Economic constituents, viability and market conditions.
• Implementation: Money is spent and thus proposal is implemented. The different responsibilities of implementing the proposals, completion of the project within the requisite time period and reduction of cost are allotted. The management then takes up the task of monitoring and containing the implementation of the proposals.
• Performance review: The final stage of capital budgeting involves comparison of actual results with the standard ones. The unfavorable results are identified and removing the various difficulties of the projects helps for future selection and execution of the proposals.

There were some pointers on Capital Budgeting. The need for Capital Budgeting on the day to day investments are as follows:

• A large sum of money is involved which influences the profitability of the firm making capital budgeting an important task.
• Long-term investments, once made, cannot be reversed without a significant loss of invested capital. The investment becomes sunk, and mistakes, rather than being readily rectified, must often be borne until the firm can be withdrawn through depreciation charges or liquidation. It influences the whole conduct of the business for the years to come.
• Investment decisions are the based on which the profit will be earned and probably measured through the return on the capital. A proper mix of capital investment is quite important to ensure an adequate rate of return on investment, calling for the need for capital budgeting.
• The implication of long-term investment decisions is more extensive than those of short-run decisions because of the time factor involved, capital budgeting decisions are subject to the higher degree of risk and uncertainty than a short-run decision.

CAPITAL BUDGETING DECISIONS:

The crux of capital budgeting is profit maximization. There are two ways to it; either increase the revenues or reduce the costs. The increase in revenues can be achieved by expansion of operations by adding a new product line. Reducing costs means representing obsolete return on assets.

Accept / Reject decision – If a proposal is accepted, the firm invests in it and if rejected the firm does not invest. Generally, proposals that yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the others are rejected. All independent projects are accepted. Independent projects are projects that do not compete with one another in such a way that acceptance gives a fair possibility of acceptance of another.

Mutually exclusive project decision – Mutually exclusive projects compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. Only one may be chosen. Mutually exclusive investment decisions gain importance when more than one proposal is acceptable under the accept / reject decision. The acceptance of the best alternative eliminates the other alternatives.

Capital rationing decision – In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process. In that, independent investment proposals yielding a return greater than some predetermined level are accepted. But actual business has a different picture. They have fixed capital budget with large number of investment proposals competing for it. Capital rationing refers to the situation where the firm has more acceptable investments requiring a greater amount of finance than that is available with the firm. Ranking of the investment project is employed on the basis of some predetermined criterion such as the rate of return. The project with highest return is ranked first and the acceptable projects are ranked thereafter.

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