Capital budgeting tries to determine the capital investment requirements of the business, e.g., acquisition of machinery, building, etc. The plans of the business to modernize or go in for additions of long-term investment will influence the cash budget in the current year. Therefore, capital expenditure decisions must be anticipated in advance and integrated into the Master Budget.
Capital budgeting is the planning of expenditure whose return will mature after a year or so. Thus, it is a process of deciding whether or not to commit resources to a project whose benefit would be spread over the years. The object of capital budgeting is to rank the various investment opportunities according to the prospective earnings, they will yield. The total capital (long/short term) of a company is employed in Fixed Assets and Current Assets of the firm. Fixed Assets are those which are not meant for resale such as Land and Building, Plant and Machinery Furniture, etc.
It is a challenging task for management to take a judicious decision regarding capital expenditure (Investment in fixed Assets) so that the amount invested in Fixed Assets should not be locked up in capital goods which may have for researching effect on the success or failure of an enterprise.
A capital Asset once acquired cannot be disposed off without substantial loss and if these are acquired on credit basis a continuous liability is incurred over a long period of time. It is, therefore, required long-range planning while taking the decision regarding investment in capital expenditure is known as Capital Budgeting.
Definitions of Capital Budgeting
The following are the important definitions of capital budgeting:
1. Charles T. Harngreen. “Capital budgeting is long term planning for making and financing proposed capital outlay”.
2. Richards and Green Law. “The capital budgeting generally refers to acquiring inputs with long-run returns”
3. G.C. Philiphatos. Capital budgeting is concerned with the allocation of a firm’s scarce financial resources amongst available market opportunities. The consideration of the expected future streams of earnings from a project, with the immediate and subsequent streams of expenditure for it.”
The capital budget is prepared separately from the operating budget and lists projects for the acquisition of, new assets. Each proposal needs justification. A lump sum is often included in the capital budget for projects that are not large enough to warrant individual consideration.
The Capital budgeting represents the plans for appropriations of expenditure for fixed Assets during the budget period.
Capital budget projects will generally be classified under the following headings:
- new asset acquisition
- cost reduction and replacement
- expansion of existing product lines
- new products
- health and safety
- legal requirements-
Approval of capital projects in principle does not mean authority to proceed. Some worthwhile projects may not be approved because funds are not available.
Follow-ups on capital expenditures include checks on the spending itself and comparison of how near the estimates of cost and returns were to actual. If there are wide variances, then a revised capital budget may be necessary to provide additional resource appropriation.
Nature of Capital Budgeting
It can be explained as :
1. Huge Investment. Capital expenditure is a huge investment plan for acquiring or expanding fixed Assets.
2. Long Term Investment. Capital Expenditure is not only a huge investment plan but also long term investment whose return will be available after a considerable gap of time.
3. Futuristic Investment. Capital budgeting is a futuristic investment. It is a forecasting of several years profitability of several years.
4. Effect Wrong Selection. Any error in the evaluation of proposal may lead to serious consequences.
5. Permanent Commitment of Funds. The funds involved in capital expenditure are not only huge but also long term decision. The longer the time the longer are the risks involved.
6. Investment Decision. The long term capital expenditure decisions are always complicated. The long term decisions are always associated with risk and uncertainty. The management should make judicious decisions.
7. Wealth Maximisation. The capital expenditure has a direct impact on the economic life of the company, the aim ought to be avoid over-investment and under-investment in Fixed Assets. The careful management must select those proposals whose profitability are more thus, they can maximize the wealth of shareholders which is the basic object of each company.
Need and Importance of Capital Budgeting
The selection of most profitable capital expenditure proposal can be considered a most judicious function of Financial Manager. As said earlier these are long term huge capital investments with the intention of earning more and more profits in the coming years. The need of capital budgeting can be highlighted as:
1. Heavy Investment. All capital expenditures are always for long term investment and also involve huge sum which are collected from various external and internal sources. Thus, these funds pose a serious problem of capital investment planning.
2. Permanent Commitment of Funds. Capital budgeting is a long term decision which has far-reaching effects. A wrong capital expenditure decision may results unnecessary heavy operating costs.
3. Guard against Risk and Uncertainty. The capital expenditure decision is more sophisticated in nature carry more risk and uncertainty on the other, the acquiring capital assets is a continuous process thus, the management is always careful in taking judicious decisions.
4. Irreversible Decisions. Capital expenditure not only involves heavy investment but also irreversible decisions too, the amount invested cannot be taken back without heavy financial losses.
5. Ranking of Investment Programmes. Capital expenditure needs huge investment which is not easy state of affair thus, it involves cash forecasts carefully so that the financial requirement can be met out at the right time.
6. Wealth Maximisation. Capital Expenditure is a long term financial planning which benefits the shareholder’s interest. It checks over and under the investment of Fixed Assets. Here most profitable projects are selected. There is every possibility that shareholder will get the maximum benefit which in turn result in wealth maximization.
7. Useful for Sound Depreciation Policy. Capital Expenditure planning is a very useful technique of depreciation policy and replacement of Fixed Assets.
8. Cost-Reduction. Capital budgeting is useful for cost reduction. The most modern machine is purchased whose capacity is more than the old one thus per unit cost of output is drop.
9. Replacement of Men by Machines. In the modern set up all forms of Government are giving more importance to the labor force then the due under changing the economic environment it is useful to replace manual work by machine (Capital Expenditure).
Procedure of capital budgeting or step in capital budgeting
The procedures of Capital Budgeting are as:
1. Selection of Profitable Proposals. The starting point of Capital Expenditure planning is the conception of a profit-making idea. Such a proposal may come from the low level or from a high level. All proposals are studied with the seriousness with regard to investment and risk. These proposals with ranks are sent to the Capital Expenditure Planning Committee for consideration.
2. Screening the Proposal. In all big organisation, Capital Expenditure Planning Committee is formed for screening the proposals which are received from various heads of department or top executives. The committee studies these proposals with long-range and send these proposals to Board of Directors for final approval.
3. Evaluations of Proposals. The next important point in capital budgeting is to evaluate different proposals in reference to investment, period of return, life of the proposal Assets, etc. Following are the techniques for evaluation of capital budgeting:
(i) Degree of urgency method.
(ii) Payback period method.
(iii) Return on investment method.
(iv) Discount cash flow method.
4. Ranking/Priority. Once the screening process is over the uneconomical or non-profitable proposals are dropped. Profitable projects are selected and ranked. The best criteria of priority are:
(a) Current and incompleted projects are given top priority.
(b) Projects of safety as prescribed by state laws be given priority.
(c) Projects for maintaining the present efficiency of the firm.
(d) Projects of additions to income be given priority.
(e) Projects for expansion of new product.
5. Final approval. Proposals finally recommended by the committee are sent to the top management with detailed report with regard to Capital Investment and how to financial the same. These are sent to the budget committee for incorporating them in the Capital Budgeting.