Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the goal of investors’ wealth maximization. When a business makes a capital investment (assets such as equipment, building, land etc.) it incurs a cash outlay in the expectation of future benefits. The expected benefits generally extend beyond one year in the future. Out of different investment proposals available to a business, it has to choose a proposal that provides the best return and the return equals to, or greater than, that required by the investors. In simple Capital Budgeting involves:-
•Evaluating investment project proposals that are strategic to business overall objectives •Estimating and evaluating post-tax incremental cash flows for each of the investment proposals •Selection an investment proposal that maximizes the return to the investors However, Capital Budgeting excludes certain investment decisions, wherein, the benefits of investment proposals cannot be directly quantified
PURPOSE OF CAPITAL BUDGETING
The capital budgeting decisions are important, crucial and critical business decisions due to following reasons: (i).Substantial expenditure: Capital budgeting decisions involves the investment of substantial amount of funds. It is therefore necessary for a firm to make such decisions after a thoughtful consideration so as to result in the profitable use of its scarce resources. The hasty and incorrect decisions would not only result into huge losses but may also account for the failure of the firm. (ii).Long time period: The capital budgeting decision has its effect over a long period of time. These decisions not only affect the future benefits and costs of the firm but also influence the rate and direction of growth of the firm.
(iii).Irreversibility: Most of the investment decisions are irreversible. Once they are taken, the firm may not be in a position to reverse them back. This is because, as it is difficult to find a buyer for the second-hand capital items. (iv).Complex decision: The capital investment decision involves an assessment of future events, which in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision.
CAPITAL BUDGETING PROCESS
The extent to which the capital budgeting process needs to be formalised and systematic procedures established depends on the size of the organisation; 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 projects that are finally accepted 1)Planning: 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. 2)Evaluation: This phase involves the determination of proposal and its investments, inflows and outflows.
Investment appraisal techniques, ranging from the simple payback 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. 3)Selection: Considering the returns and risks associated with the individual projects as well as the cost of capital to the organisation, the organisation will choose among projects so as to maximise shareholders’ wealth.
4)Implementation: When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project. 5)Control: 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. 6)Review: When a project terminates, or even before, the organisation should review the entire project to explain its success or failure. This phase may have implication for firms planning and evaluation procedures. Further, the review may produce ideas for new proposals to be undertaken in the future.