Capital budgeting in decision making

NAME – Rith Mondal

ROLL – 35105019020
REG. no – 028539 of 2019-20
Sub- Financial management

1
 Capital Budgeting

Meaning of Capital Budgeting:

Capital expenditure budget or capital budgeting is a process of making

decisions regarding investments in fixed assets or capital assets such as land,
building, machinery or furniture. Normally capital expenditure is one which is
intended to benefit in the future period of time i.e. more than one year.

Capital budgeting is the planning process used to determine whether an

organization's long term investments such as purchase of new machinery,
replacement of old machinery, Purchase of new plants, Introduction of new
products, and research development projects are worth pursuing. It is a
budget for major capital expenditures.

The word ‘investment’ refers to the expenditure which is required to be made in

connection with the acquisition and the development of long-term or fixed
assets. It refers to process by which management selects those investment
proposals which are worthwhile for investing available funds. For this purpose,
management is to decide whether or not to acquire, or add to or replace fixed
assets in the light of overall objectives of the firm.

Capital budgeting is an extremely important aspect of a company's financial

management. If a company makes a mistake in its capital budgeting process,
then it has to live with that mistake for a long period of time as it cannot be
reversed.

Nature of Capital Budgeting

Nature of capital budgeting can be explained in brief as under Capital

expenditure plans involve a huge investment in fixed assets. Capital expenditure
once approved represents long-term investment that cannot be reserved or
withdrawn without sustaining a loss. Preparation of coital budget plans involve
forecasting of several years profits in advance in order to judge the
profitability of projects. It may be asserted here that decision regarding capital
investment should be taken very carefully so that the future plans of the company
are not affected adversely.

Importance/Need of Capital Budgeting

2
Capital budgeting decisions are of paramount importance in financial decision.
So it needs special care on account of the following reasons:

Long-term Implications:

A capital budgeting decision has its effect over a long time span and inevitably
affects the company’s future cost structure and growth. A wrong decision can
prove disastrous for the long-term survival of firm. On the other hand, lack of
investment in asset would influence the competitive position of the firm. So the
capital budgeting decisions determine the future destiny of the company.

Involvement of large amount of funds:

Capital budgeting decisions need substantial amount of capital outlay. This

underlines the need for thoughtful, wise and correct decisions as an incorrect
decision would not only result in losses but also prevent the firm from earning
profit from other investments which could not be undertaken.

Irreversible decisions:

Capital budgeting decisions in most of the cases are irreversible because it is

difficult to find a market for such assets. The only way out will be scrap the
capital assets so acquired and incur heavy losses.

Risk and uncertainty:

Capital budgeting decision is surrounded by great number of uncertainties.

Investment is present and investment is future. The future is uncertain and
full of risks. Longer the period of project, greater may be the risk and
uncertainty. The estimates about cost, revenues and profits may not come
true.

Difficult to make:

Capital budgeting decision making is a difficult and complicated exercise for the
management. These decisions require an over all assessment of future events
which are uncertain. It is really a marathon job to estimate the future benefits
and cost correctly in quantitative terms subject to the uncertainties caused by

3
economic-political social and technological factors.

Kinds of capital budgeting decisions:

Generally the business firms are confronted with three types of capital budgeting
decisions.

Accept-Reject Decisions;

Mutually Exclusive Decisions; and (iii) Capital Rationing

Decisions.

Accept-Reject Decisions: Business firm is confronted with

alternative investment proposals. If the proposal is
accepted, the firm incur the investment and not
otherwise. Broadly, all those investment proposals
which yield a rate of return greater than cost of capital
are accepted and

the others are rejected. Under this criterion, all the independent proposals are
accepted.

Mutually Exclusive Decisions: It includes all those

projects which competewith each other in a way that
acceptance of one precludes the acceptanceof other or
others. Thus, some technique has to be used for selecting
the best among all and eliminates other alternatives.

Capital Rationing Decisions: Capital budgeting decision

is a simple process in those firms where fund is not the
constraint, but in majority ofthe cases, firms have fixed
capital budget. So, large amount of projects compete for
these limited budgets. So the firm rations them in a
manner so as to maximize the long run returns. Thus,
capital rationing refers to the situations where the firm
has more acceptable investment requiring greater
amount of finance than is available with the firm. It is
concerned with the selection of a group of investment
out of many investment proposals ranked in the
descending order of the rate or return.

Procedure of Capital Budgeting

Capital investment decision of the firm have a pervasive influence on the entire
spectrum of entrepreneurial activities so the careful consideration should be
regarded to all aspects of financial management.

4
In capital budgeting process, main points to be borne in mind how much
money will be needed of implementing immediate plans, how much money is
available for its completion and how are the available funds going to be assigned
tote various capital projects under consideration. The financial policy and
risk policy of the management should be clear in mind before proceeding to the
capital budgeting process. The following procedure may be adopted in preparing
capital budget:

Organisation of Investment Proposal

The first step in capital budgeting process is the conception of a profit

making idea. The proposals may come from rank and file worker of any
department or from any line officer. The department head collects all the
investment proposals and reviews them in the light of financial and risk policies
of the organisation in order to send them to the capital expenditure planning
committee for consideration.

Screening the Proposals

In large organisations, a capital expenditure planning committee is established

for the screening of various proposals received by it from the heads of various
departments and the line officers of the company. The committee screens the
various proposals within the long-range policy-frame work of the
organisation. Itis to be ascertained by the committee whether the proposals are
within the selection criterion of the firm, or they do no lead to department
imbalances or they are profitable

Evaluation of Projects

The next step in capital budgeting process is to evaluate the different

proposals in term of the cost of capital, the expected returns from alternative
investment opportunities and the life of the assets with any of the following
evaluation techniques:

Pay-Back Period Method

Accounting Rate of return Method

Net Present Value Method

Profitability-Index Method

5
Internal Rate of Return Method

Establishing Priorities

After proper screening of the proposals, uneconomic or unprofitable

proposals are dropped. The profitable projects or in other words accepted
projects are then put in priority. It facilitates their acquisition or construction
according to the sources available and avoids unnecessary and costly delays and
serious cotoverruns. Generally, priority is fixed in the following order.

Current and incomplete projects are given first priority.

Safety projects ad projects necessary to carry on the

legislative requirements.

Projects of maintaining the present efficiency of the firm.

Projects for supplementing the income.

Projects for the expansion of new product.

Final Approval

Proposals finally recommended by the committee are sent to the top

management along with the detailed report, both o the capital expenditure and of
sources of funds to meet them. The management affirms its final seal to
proposals taking in view the urgency, profitability of the projects and the
available financial resources. Projects are then sent to the budget committee
for incorporating them in the capital budget

Evaluation

Last but not the least important step in the capital budgeting process is an
evaluation of the programme after it has been fully implemented. Budget
proposals and the net investment in the projects are compared periodically
and

6
on the basis of such evaluation, the budget figures may be reviewer and presented in a more
realistic way.

Significance of capital budgeting

The key function of the financial management is the selection of the most profitable assortment of
capital investment and it is the most important area of decision-making of the financial manger
because any action taken by the mangerin this area affects the working and the profitability of the
firm for many years to come. The need of capital budgeting can be emphasized taking into
consideration the very nature of the capital expenditure such as heavy investment in capital
projects, long-term implications for the firm, irreversible decisions and complicates of the
decision making. Its importance can be illustrated well on thefollowing other grounds:

Indirect Forecast of Sales

The investment in fixed assets is related to future sales of the firm during the life time of the assets
purchased. It shows the possibility of expanding the production facilities to cover additional sales
shown in the sales budget. Any failure to make the sales forecast accurately would result in over
investment or under investment in fixed assets and any erroneous forecast of asset needs may lead
the firm to serious economic results

Comparative Study of Alternative Projects

Capital budgeting makes a comparative study of the alternative projects for the replacement of assets
which are wearing out or are in danger of becoming obsolete so as to make the best possible
investment in the replacement of assets. For this purpose, the profitability of each project is
estimated.

Timing of Assets-Acquisition

Proper capital budgeting leads to proper timing of assets-acquisition and improvement in quality
of assets purchased. It is due to ht nature of demand and supply of capital goods. The demand of
capital goods does not arise until sales impinge on productive capacity and such situation
occurs only intermittently. On the other hand, supply of capital goods with their availability is
one of the functions of capital budgeting.

7
Cash Forecast

Capital investment requires substantial funds which can only be arranged by making determined
efforts to ensure their availability at the right time. Thus it facilitates cash forecast.

Worth-Maximization of Shareholders

The impact of long-term capital investment decisions is far reaching. It protects the interests of
the shareholders and of the enterprise because it avoids over- investment and under-investment
in fixed assets. By selecting the most profitable projects, the management facilitates the wealth
maximization of equity share-holders.

Other Factors

The following other factors can also be considered for its significance:

It assists in formulating a sound depreciation and assets replacement

policy.

It may be useful n considering methods of coast reduction.

8
9
10
11
A reduction campaign may necessitate the consideration of purchasingmost up-to—date
and modern equipment.
The feasibility of replacing manual work by machinery may be seen fromthe capital
forecast be comparing the manual cost an the capital cost.
The capital cost of improving working conditions or safety can beobtained through capital
expenditure forecasting.
It facilitates the management in making of the long-term plans an assistsin the
formulation of general policy.
It studies the impact of capital investment on the revenue expenditure ofthe firm such as
depreciation, insure and there fixed assets.

Limitations of Capital Budgeting

The limitations of capital budgeting are as follows:

It has long term implementations which can't be used in short term and it is used as operations
of the business. A wrong decision in the early stages can affect the long-term survival of the
company. The operating cost getsincreased when the investment of fixed assets is more
than required.
Inadequate investment makes it difficult for the company to increase it budget and the
capital.
Capital budgeting involves large number of funds so the decision has to be taken carefully.
Decisions in capital budgeting are not modifiable as it is hard to locate the market for
capital goods.
The estimation can be in respect of cash outflow and the revenues/saving and costs
attached which are with projects.

A reduction campaign may necessitate the consideration of purchasingmost up-to—date

and modern equipment.
The feasibility of replacing manual work by machinery may be seen fromthe capital
forecast be comparing the manual cost an the capital cost.
The capital cost of improving working conditions or safety can beobtained through capital
expenditure forecasting.
It facilitates the management in making of the long-term plans an assistsin the
formulation of general policy.
It studies the impact of capital investment on the revenue expenditure ofthe firm such as
depreciation, insure and there fixed assets.

Limitations of Capital Budgeting

The limitations of capital budgeting are as follows:

It has long term implementations which can't be used in short term and it is used as operations
of the business. A wrong decision in the early stages can affect the long-term survival of the
company. The operating cost getsincreased when the investment of fixed assets is more
than required.
Inadequate investment makes it difficult for the company to increase it budget and the
capital.
Capital budgeting involves large number of funds so the decision has to be taken carefully.
Decisions in capital budgeting are not modifiable as it is hard to locate the market for
capital goods.
The estimation can be in respect of cash outflow and the revenues/saving and costs
12
attached which are with projects.

13
14
A reduction campaign may necessitate the consideration of purchasing most up-to—
date and modern equipment.
The feasibility of replacing manual work by machinery may be seen from the capital
forecast be comparing the manual cost an the capital cost.
The capital cost of improving working conditions or safety can be obtained through
capital expenditure forecasting.
It facilitates the management in making of the long-term plans an assists in the
formulation of general policy.
It studies the impact of capital investment on the revenue expenditure of the firm such
as depreciation, insure and there fixed assets.

Limitations of Capital Budgeting

The limitations of capital budgeting are as follows:

It has long term implementations which can't be used in short term and it is used as
operations of the business. A wrong decision in the early stages can affect the long-term
survival of the company. The operating cost gets increased when the investment of fixed
assets is more than required.
Inadequate investment makes it difficult for the company to increase it budget and the
capital.
Capital budgeting involves large number of funds so the decision has to be taken carefully.
Decisions in capital budgeting are not modifiable as it is hard to locate the market for
capital goods.
The estimation can be in respect of cash outflow and the revenues/saving and costs
attached which are with projects.

15