07-12-2012, 05:55 PM
CAPITAL BUDGETING
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ABSTRACT
The term Capital Budgeting refers to long term planning for proposed capital outlay and their financial. It includes raising long-term funds and their utilization. It may be defined as a firm’s formal process of acquisition and investment of capital.
Capital budgeting may also be defined as “The decision making process by which a firm evaluates the purchase of major fixed assets”. It involves firm’s decision to invest its current funds for addition, disposition, modification and replacement of fixed assets.
It deals exclusively with investment proposals, which is essentially long-term projects and is concerned with the allocation of firm’s scarce financial resources among the available market opportunities.
Some of the examples of Capital Expenditure are
Cost of acquisition of permanent assets as land and buildings.
Cost of addition, expansion, improvement or alteration in the fixed assets.
R&D project cost, etc.,
INTRODUCTION:
An efficient allocation of capital is the most important finance function in the modern times. It involves decisions to commit the firm’s funds to the long term assets. Such decisions are of considerable importance to the firm since they tend to determine its size by influencing its growth, profitability and risk.
MEANING:
Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaken and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.
capital budgeting is also known as Investment Decision Making, Capital Expenditure Decision, Planning Capital Expenditure and Analysis of Capital Expenditure.
NATURE OF INVESTMENTS:
The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firm’s decisions to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those which affect the firm’s operations beyond the one year period.
CONCEPT OF CAPITAL BUDGETING:
The term capital budgeting refers to long term planning for proposed capital outlays and their financing. Thus, it includes both rising of long term funds as well as their utilization. It is the decision making process by which the firm evaluate the purchase of major fixed assets firm’s decision to invest its current funds of. It involves addition, disposition, modification and replacement of long term or fixed assets. However, it should be noted that investment in current assets necessitated on account of investment in a fixed asset, it also to be taken as a capital budgeting decision.
Capital budgeting is a many folded activity. It includes searching for new and more profitable investment proposals, investigating engineering and marketing considerations predict and making economic analysis to determine the potential of each investment proposal.
CHARACTERISTICS OF CAPITAL BUDGETING:
GROWTH:
A firm’s decision to invest in long term assets has a decisive influence on the rate and the direction of growth. A wrong decision can prove disastrous for the continued survival of the firm. Unwanted or profitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share.
RISK:
A long term commitment of funds may also change the risk complexity of the firm. If the adoption of the investment increases average gain but causes frequent fluctuations in its earnings the firm will become more risky. Thus investment decisions shape the basic risk character of the firm.
FUNDING:
Investment decisions generally involve large amount of funds which make it necessary for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring finances internally or externally.
IRREVERSIBILITY:
Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. Investments decisions once made cannot be reversed or may be reversed but a substantial loss.
NEED AND IMPORTANCE OF CAPITAL BUDGETING
The capital budgeting decisions are often said to be the most important part of corporate financial management. Any decision that requires the use of resources is a capital budgeting decision; thus the capital budgeting cover everything from abroad strategic decisions at one extreme to say computerization of the office, at the other. The capital budgeting decisions affect the profitability of a firm for a long period, therefore the importance of these decisions are obvious. There are several factors and considerations which make the capital budgeting decisions as the most important decisions of a finance manager.
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.
IDENTI FICATION OF INVESTMENT PROPOSALS:
The capital budgeting process begins with the identification of investment proposals. Investment opportunities have to be identified or created; they do not occur automatically. Investment proposal of various types may originate at different levels within a firm. Most proposals, in the nature of cost reduction or replacement or process or product improvement takes place at plant level. The contribution of top management in generating investment ideas is generally confined to expansion or diversification projects. The proposal may originate systematically in a firm. In view of the fact that enough investment proposals should be generated to employ the firm’s funds fully well and efficiently, a systematic procedure for generating proposal may be evolved by a firm. In a number of Indian companies, more than 50% of the investment idea are generated at the plant level. Indian companies uses a variety of methods to encourage idea generation.
SCREENING THE PROPOSALS:
The expenditure planning committee screens the various proposals received from different departments. The committee views these proposals from various angles to ensure that these are in accordance with the corporate strategies, selection criterion of the firm and also do not lead to departmental imbalances.
EVALUATION OF VARIOUS PROPOSALS:
The evaluation of projects should be performed by group of experts who have no axe to grind. For example, the production people may generally interested in having the most modern type of equipment and increased production even of productivity is expected to be low and goods cannot be sold this attitude can bias their estimates of cash flows of the proposed projects.
Similarly, marketing executives may be too optimistic about the sales prospects of goods manufactured, and over estimate the benefits of a proposed new product. It is therefore, necessary to ensure that projects are scrutinized by an impartial group and that objectivity is maintained in the evaluation process.
A company in practice should take all care in selecting a method or methods of investment evaluation. The criterion or criteria selected should be a true measure of evaluating if the investment is profitable(in terms of cash flows), and it should lead the net increase in the company’s wealth(that is, its benefits should exceeds its costs adjusted for time value and risk).
FIXING PRIORITIES:
After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. 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.
FINAL APPROVAL AND PREPARATION OF CAPITAL EXPENDITURE BUDGET:
Proposals meeting the evaluation and criteria are finally approved to be included in the capital expenditure budget. However, proposals involving smaller investment may be decided at the lower for expenditure action. The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.