Define Capital budgeting ? Explain the needs and process of capital budgeting decisions?

The word Capital refers to be the total investment of a company of firm in money, tangible and intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to be the art of building budgets. Budgets are a blue print of a plan and action expressed in quantities and manners. Investment decision is the process of making investment decisions in capital expenditure. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. The examples of capital expenditure:

1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.

2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets.

3. The replacement of fixed assets.

4. Research and development project.

MEANING

The process through which different projects are evaluated is known as capital budgeting. Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of capital. It involves firm’s decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets”.

DEFINITION

Capital budgeting (investment decision) as, “Capital budgeting is long term planning for making and financing proposed capital outlays.” ----- Charles T.Horngreen

“Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern” – Lynch

“Capital budgeting is concerned with the allocation of the firm source financial resources among the available opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earning from a project, with the immediate and subsequent streams of expenditure”. ---- G.C. Philippatos

NEED AND IMPORTANCE OF CAPITAL BUDGETING

The reasons that make the capital budgeting decisions most crucial for finance managers are as

follows:

1. These decisions involve large outlay of funds in anticipation of cash flows in future, for

example, investment in plant and machinery. The economic life of such assets has long

periods. The anticipated projections of cash flows involve forecasts of many financial

variables of which the most crucial variable is the sales forecast.

2. Sometimes, long time investments of the funds may change the risk profile of the firm.

3. Most of the capital budgeting decisions involve huge outlay. The funds required during the

phase of execution must be synchronised with the flow of funds. Failure to achieve the

required coordination between the inflow and outflow may cause time over-run and cost

over-run.These two problems of time overrun and cost overrun have to be prevented from occurring

in the beginning of execution of the project. Quite a lot of empirical examples are there in

public sector in India in support of this argument that cost overrun and time overrun can

make a company’s operation unproductive.

4. Capital budgeting decisions involve assessment of market for company’s product and

services, deciding on the scale of operations, selection of relevant technology and finally

procurement of costly equipment.

If a firm were to realise after committing itself to considerable sums of money in the process

of implementing the capital budgeting decisions taken that the decision to diversify or

expand would become a wealth destroyer to the company, then the firm would have

experienced a situation of inability to sell the equipments bought. Loss incurred by the firm

would be heavy if the firm were to scrap the equipments bought specifically for

implementing the decision taken. Sometimes these equipments will be specialised costly

equipments. Therefore, capital budgeting decisions are irreversible. All capital budgeting

decisions involve three elements. These three elements are:

o cost

o quality

o timing

Decisions must be taken at the right time which would enable the firm to procure the assets

at the least cost for producing products of required quality for the customer. Any lapse on

the part of the firm in understanding the effect of these elements on implementation of

capital expenditure, will strategically affect the firm’s profitability.

6. Liberalisation and globalisation gave birth to economic institutions like world trade

organisations. General Electrical can expand its market into India snatching away the share

that was enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of GE to

sell its products in India at a rate lesser than the rate, at which Indian companies sell, cannot

be ignored.

Therefore, the growth and survival of any firm in today’s business environment demands it

to be pro-active. Pro-active firms cannot avoid the risk of taking challenging decisions of

capital budgeting for growth.

7.The social, political, economic and technological forces generate high level of uncertainty in

future cash flow streams associated with capital budgeting decisions. Thes e factors make

these decisions highly complex.

8.Capital budgeting decisions are very expensive. To implement these decisions, firms will

have to tap the capital market for funds. The composition of debt and equity must be

optimal keeping in view the expectations of investors and risk profile of the selected project.

Therefore, capital budgeting decisions for growth have become an essential characteristic of

successful firms today.

The complexities involved in capital budgeting decisions. Capital expenditure decision involves

forecasting of future operating cash flows. Forecasting the future cash flows demands certain

assumptions about the behaviour of costs and revenues in future

However, there are complexities involved in capital budgeting decisions. They are as follows:

A. Estimation of future cash flows

B. Commitment of funds on long-term basis

C. Problem of irreversibility of decisions

CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefit to the achieved in future and the future is always uncertain. However the following procedure may be adopted in the process of capital budgeting:

Step 1 and 2 = Project generation,

Step3 = Project evaluation

Step4 and 5 =project selection

Step 6 = project execution.

PROJECT GENERATION

1. Identification of Investment Proposals:

The capital budgeting process begins with the identification of investment proposals. The proposal or the idea about potential investment opportunities may originate from the top management or may come from the rank and file worker of any department or from any officer of the organization. The departmental head analyses the various proposals in the light of the corporate strategies and submits the suitable proposals to the capital expenditure planning committee in case of large organizations or to the officers concerned with the process of long-term decisions.

2. Screening the Proposals:

The expenditure planning committee screens the various proposals received from different departments. The committee views these proposals from various angels to ensure that these are in accordance with the corporate strategies or a selection criterion’s of the firm and also do not lead to departmental imbalances.

PROJECT EVALUATION

3. Evaluation of Various Proposals:

The next step in the capital budgeting process is to evaluate the profitability of various proposals. There are many methods which may be used for this purpose such as payback period method, rate of return method, net present value method, internal rate of return method etc. All these methods of evaluating profitability of capital investment proposals have been discussed in detail separately in the following pages of this chapter.

It should, however, be noted that the various proposals to the evaluated may be classified as:

(I) Independent proposals

(ii) Contingent or dependent proposals and

(iii) Mutually exclusive proposals.

Independent proposals are those which do not compete with one another and the same may be either accepted or rejected on the basis of a minimum return on investment required. The contingent proposals are those whose acceptance depends upon the acceptance of one or more other proposals, eg., further investment in building or machineries may have to be undertaken as a result of expansion programmed. Mutually exclusive proposals are those which compete with each other and one of those may have to be selected at the cost of the other.

PROJECT SELECTION

4. Fixing Priorities:

After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight ways. But it may not be possible for the firm to invest immediately in all the acceptable proposals due to limitation of funds. Hence, it is very essential to rank the various proposals and to establish priorities after considering urgency, risk and profitability involved therein.

5. Final Approval and Preparation of Capital Expenditure Budget:

Proposals meeting the evaluation and other criteria are finally approved to be included in the Capital expenditure budget. However, proposals involving smaller investment may be decided at the lower levels for expeditious action. The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.

PROJECT EXECUTION

6. Implementing Proposal:

Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorize to go ahead with the implementation of the project. A request for authority to spend the amount should further be made to the Capital Expenditure Committee which may like to review the profitability of the project in the changed circumstances.

Further, while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as PERT and CPM can also be applied to control and monitor the implementation of the projects.

7. Performance Review:

The last stage in the process of capital budgeting is the evaluation of the performance of the project. The evaluation is made through post completion audit by way of comparison of actual expenditure of the project with the budgeted one, and also by comparing the actual return from the investment with the anticipated return.The unfavorable variances, if any should be looked into and the causes of the same are identified so that corrective action may be taken in future.

DEVOLOPING CAH FLOW DATA (cash inflow and cash outflow)

Before we can compute a project’s value, we must estimate the cash flows both current and future associated with it. We therefore begin by discussing cash flow estimation, which is the most important and perhaps the most difficult, step in the analysis of a capital project. The process of cash flow estimation is problematic because it is difficult to accurately forecast the costs and revenues associated with large, complex projects that are expected to affect operations for long periods of time

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