The resources of a business firm is invested in current and fixed assets. Current assets are acquired for the smooth running of business whereas fixed assets are purchased for generating revenue. The profitability of a firm depends upon the productive capacity of the fixed assets. Furthermore, the decision of investing in fixed assets has far-reaching impact because it requires huge capital for long period. The failure of any project may lead the firm in the door of liquidation. Therefore, the cost, benefit and probable risk of the proposed project should be analyzed systematically before making the investment.
Capital budgeting decision comprises of three words ‘Capital’, ‘Budgeting’ and ‘Decision’. Capital means the fund or resource available for investing. Budgeting is the numerical aspect of planning. Decision or decision making is the process of deciding whether alternative action is to be undertaken or not. In this way, capital budgeting decision is the process under which different investment alternatives are evaluated and the best alternative is selected. In other words, capital budgeting decision is concerned with the long-term investment decision i.e. making capital expenditure. The expenditure on fixed asset such as land and building, furniture and fixtures, plant and machinery etc. is called capital expenditure. The life of these fixed assets is more than one year. So, capital budgeting decision is concerned with long-term planning. Capital budgeting is also decision making process for an investment which includes the process of investment, evaluating, planning and financing major investment project of an organization.
Therefore, it can be said that capital budgeting is concerned with the allocation of the firm’s financial resources among the available investment alternatives. It is a part of long-term planning and comprises the evaluation and selection of investment projects.
Need And Importance Of Capital Budgeting
Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of the firm. The need and importance of capital budgeting has been explained as follows:
1. Long-term Implication
Capital expenditure decision affects the company’s future cost structure over a long time span. The investment in fixed assets increases the fixed cost of the firm which must be recovered from the benefit of the same project. If the investment turns out to be unsuccessful in future or give less profit than expected, the company will have to bear the extra burden of fixed cost. Such risk can be minimized through the systematic analysis of projects which is the integral part of investment decision.
2. Irreversible Decision
Capital investment decision are not easily reversible without much financial loss to the firm because there may be no market for second-hand plant and equipment and their conversion to other uses may not be financially viable. Hence, capital investment decisions are to be carried out and performed carefully and effectively in order to save the company from such financial loss. The investment decision which is undertaken carefully and effectively can save the firm from huge financial loss aroused due to the selection of unfavorable projects.
3. Long-term Commitments Of Funds
Capital budgeting decision involves the funds for the long-term. So, it is long-term investment decision. The long-term commitment of funds leads to the financial risk. Hence, careful and effective planning is must to reduce the financial risk as much as possible.
Capital Budgeting Processes
The extent to which the capital budgeting process needs to be formalized and systematic procedures established depends on the size of the organization, number of projects to be considered, direct financial benefit of each project considered by itself, the composition of the firm’s existing assets and management’s desire to change that composition, timing of expenditures associated with the that are finally accepted.
The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm’s fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase.
This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple pay back method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances.
Considering the returns and risk associated with the individual project as well as the cost of capital to the organization, the organization will choose among projects so as to maximize shareholders wealth.
When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.
The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.
When a project terminates, or even before, the organization should review the entire project to explain its success or failure. This phase may have implication for forms planning and evaluation procedures. Further, the review may produce ideas for new proposal to be undertaken in the future.
In brief, capital budgeting processes include:
A. Estimation of initial investment
B. Estimation of cash inflows
C. Evaluation of projects
D. Selection of projects
3 thoughts on “Methods of Capital Budgeting”