Financial Management: Capital Budgeting Process

in this article, we will study the capital budgeting and its process which is useful for commerce and management students.

WHAT IS CAPITAL BUDGETING?

Capital budgeting is a company’s formal process used for evaluating potential expenditures or investments that are significant in amount. 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 equipments, rebuilding or replacing existing equipments, research and development, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future profits since most companies are able to manage only a limited number of large projects at any one time.

Capital budgeting usually involves calculation of each project’s future accounting profit by period, the cash flow by period, the present value of cash flows after considering 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.

Capital is the total investment of the company and budgeting is the art of building budgets.

FEATURES OF CAPITAL BUDGETING

1) It involves high risk

2) Large profits are estimated

3) Long time period between the initial investments and estimated returns

Capital Budgeting Process

1. Identification of Potential Investment Opportunities: The first step in the capital budgeting process is to explore the investment opportunities. There is generally a committee that identifies the expected sales from a certain course of action, and then the investment opportunities are identified keeping these targets as a basis.Before initiating the search for the potential investments, there are certain points that need to be taken care of: monitor the external environment on a regular basis to know about the new investment opportunities, define the corporate strategy based on the analysis of the firm’s strengths, weaknesses, opportunities and threats, share the corporate strategy and objectives with the members of capital budgeting process and seek suggestions from the employees.
2. Assembling of Investment Proposals: Once the investment opportunities are identified, several proposals are submitted by different departments. Before reaching the capital budgeting process committee, the proposals are routed through several persons who ensures that the proposals are in line with the requirements and then classify these according to their categories Viz, Replacement, Expansion, New product and Obligatory & welfare investments.This categorization is done to simplify the task of committee members and facilitate quick decision making, budgeting, and control.
3. Decision Making: At this stage, the executives decide on the investment opportunity on the basis of the monetary power, each has with respect to the sanction of an investment proposal.For example, in a company, a plant superintendent, work manager, and the managing director may okay the investment outlays up to the limit of 15,00,000, and if the outlay exceeds beyond the limits of the lower level management, then the approval of the board of directors is required.
4. Preparation of Capital Budget and Appropriations: The next step in the capital budgeting process is to classify the investment outlays into the smaller value and the higher value. The smaller value investments required by, the lower level management, are covered by the blanket appropriations for the speedy actions.And if the value of an investment outlay is higher then it is included in the capital budget after the necessary approvals. The purpose of these appropriations is to evaluate the performance of the investments at the time of the implementation.
5. Implementation: Finally, the investment proposal is put into a concrete project. This may be time-consuming and may encounter several problems at the time of implementation.For expeditious processing, the capital budgeting process committee must ensure that the project has been formulated and the homework in terms of preliminary studies and comprehensive formulation of the project is done beforehand.
6. Performance Review:Once the project has been implemented the next step is to compare the actual performance against the projected performance. The ideal time to compare the performance of the project is when its operations are stabilized.Through a review, the committee comes to know about the following: how realistic were the assumptions, was the decision making efficient, what were the judgmental biases and were the desires of the project sponsors fulfilled.

FACTORS AFFECTING CAPITAL BUDGETING:

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.