Capital Budgeting

The term Capital Budgeting  refers to the long-term planning for proposed capital outlays or expenditure for the purpose of maximizing return on investments. The capital expenditure may be:

1.   Cost of mechanization, automation and replacement.

2.   Cost of acquisition of fixed assets, e.g., land, building and machinery etc.

3.  Investment on research and development.

4.   Cost of development and expansion of existing and new projects.

DEFINITION OF CAPITAL BUDGETING

Capital Budget is also known as “Investment Decision Making or Capital Expenditure Decisions” or “Planning Capital Expenditure” etc. Normally such decisions where investment of money and expected benefits arising therefrom are spread over more than one year, it includes both raising of long-term funds as well as their utilization. Charles T.Horngnen has defined capital budgeting as “Capital Budgeting is long-term planning for making and financing proposed capital outlays.”

In other words, capital budgeting is the decision making process by which a firm evaluates the purchase of major fixed assets including building, machinery and equipment. According to Hamption, John. J., “Capital budgeting is concerned with the firm’s formal process for the acquisition and investment of capital,’’

From the above definitions, it may be concluded that capital budgeting relates of the evaluation of several alternative capital projects for the purpose of assessing those which have the highest rate of return on investment.

Importance of Capital Budgeting

Capital budgeting is important because of the following reasons:

1.  Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.

2.   Capital budgeting involves commitment of large amount of fund.

3.  Capital decisions are required to assessment of future events which are uncertain.

4.  Wrong sale forecast; may lead over or under investment of resources.

5.  In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.

6.   Capital budgeting ensures the selection of right source of finance at the right time.

7.  May firms fail, because they have too much or too little capital equipment.

8.   Investment decision taken by individual concern is of national importance because it deter-mines employment, economic activities and economic growth.

Objectives of Capital Budgeting

The following are the important objectives of capital budgeting:

1.   that the benefits and costs may be measured in terms of cash flow.

2.    Determining the required quantum takes  place as per authorization and To ensure the selection of the possible profitable capital projects.

3.    To ensure the effective control of capital expenditure in order to achieve by

4.   of profit forecasting the long-term financial requirements.

5.    To make estimation of capital expenditure during the budget period and to see

6.   sanctions.

7.    To facilitate co-ordination of inter-departmental project funds among the competing capital projects.

8.    To ensure maximization by allocating the available investment.

Principles or Factors of Capital Budgeting Decisions

A decision regarding investment or a capital budgeting decision involves the following principles or factors:

1.   A careful estimate of the amount to be invested.

2.   Creative search for profitable opportunities.

3.  A careful estimates of revenues to be earned and costs to be incurred in future in respect of the project under consideration.

4.  A listing and consideration of non-monetary factors influencing the decisions.

5.  Evaluation of various proposals in order of priority having regard to the amount available for investment.

6.   Proposals should be controlled in order to avoid costly delays and cost over-runs.

7.  Evaluation of actual results achieved against those budget.

8.   Care should be taken to think all the implication of long range capital investment and working capital requirements.

9.  It should recognize the fact that bigger benefits are preferable to smaller ones ones and early benefits are preferable to latter benefits.  

Capital Budgeting Process

The following procedure may be considered in the process of capital budgeting decisions:

1.   Identification of profitable investment proposals.

2.  Screening and selection of right proposals.

3.   Evaluation of measures of investment worth on the basis of profitability and uncertainty or risk.

4.   Establishing priorities, i.e., uneconomical or unprofitable proposals may be rejected.

5.  Final approval and preparation of capital expenditure budget.

6.   Implementing proposal, i,e., project execution.

7.  Review the performance of projects.

   Types of Capital Expenditure

    Capital Expenditure can be of two types:

1. Capital expenditure increases revenue.

2.  Capital expenditure costs.

 Capital Expenditure Increases Revenue: 

     It is the expenditure which brings more revenue to the firm either by expanding the existing production facilities or development of new production line. 

  Capital Expenditure Reduces Costs:

      Such a capital expenditure reduces the cost of present product and thereby increases the profitability of existing operation. It can be done by replacement of old machine by a new one.

Types of Capital Budgeting Proposals

A firm may have several investment proposals for its consideration. It may adopt after considering the merits and demerits of each of them. For this purpose capital expenditure proposals be classified into:

1.   Independent Proposals

2.  Dependent Proposals or Contingent Proposals

3.  Mutually Exclusive Proposals

   Independent Proposals: 

     These proposals are said be to economically independent which are accepted upon rejected on the basis of minimum return on investment required. Independent proposals do not depend upon each other.

Dependent Proposals or Contingent Proposals: 

     In this case, when the acceptance of one proposal is contingent upon the acceptance of other proposals, it is called as “Dependent or Contingent Proposals.” For example, construction of new building on account of installation of new plant and machinery.

Mutually Exclusive Proposals: 

      Mutually Exclusive Proposals refer to the acceptance of one proposal results in the automatic rejection of the other proposal. Then the two investments are mutually exclusive. In other words, one can be rejected and the other can be accepted. It is easier for a firm to take capital budgeting decisions on such projects.

Methods of Evaluating Capital Investment Proposals

There are of appraisal methods which may be recommended for evaluating the capital investment proposals. We shall discuss the most widely accepted methods. These methods can be grouped into the following categories:

I.  Traditional Methods:

Traditional methods are grouped in to the following:

(      1. Pay-back period method or Payout method.

(I     2. Improvement of Traditional Approach to Pay-back Period Method

a)    Post pay-back profitability Method.

b)   Discounted pay-back Period Method.

c)    Reciprocal Pay-back Method.

(3  Rate of Return Method or Accounting Rate of Return Method.

II.  Time Adjusted Method or Discounted Cash Flow Method

Time Adjusted Method further classified into.

1. Net Present Value Method.

2.  Internal Rate of Return Method.

3.  Profitability Index Method.

I.      Traditional Methods

1.  Pay-back Period Method: Pay-back period is also termed as “Pay-out period” or Pay-off period. Pay out Period Method is one of the most popular and widely recognized traditional method of evaluating investment proposals. It is defined as the number of years required by recover the initial investment in full with the help of the stream of annual cash flows generated by the project.

Calculation of  Pay-back Period: Pay-back period can be calculated into the following two different situations:

A.  In the case of constant annual cash inflows.

B.  In the case of uneven or unequal cash inflows.

(a In the case of constant annual cash inflows: If the project generated constant cash flow the Pay-back period can be computed by dividing cash outlays (original investment) by annual cash inflows. The following formula can be used to ascertain pay-back period: