Edited by Seema Yadav
Capital budgeting is the process that a business uses to determine which proposed fixed asset purchases it should accept, and which should be declined. This process is used to create a quantitative view of each proposed fixed asset investment, thereby giving a rational basis for making a judgment.
According to G.C. Lyrich “Capital budgeting is concerned with the allocation of a firm`s 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 earnings from a project, with the immediate and subsequent streams of expenditure.”
Objectives of Capital budgeting
- Selecting profitable projects: An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.
- Capital expenditure control: Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.
- Finding the right sources for funds: Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.
Features of Capital budgeting
- Capital Budgeting decisions involve a large amount of expenditure on proposed investments.
- Capital Budgeting decisions reflect the future streams of earnings and cost of a business concern and affect their growth, thus it has a long term impact on a business.
- Capital Budgeting decisions once implemented are Irreversible.
- Capital Budgeting decisions are complex as it involves forecasting of future costs and profits.
Capital Budgeting Process
Identifying investment opportunities
An organization needs to first identify an investment opportunity. An investment opportunity can be anything from a new business line to product expansion to purchasing a new asset. For example, a company finds two new products that they can add to their product line.
Evaluating investment proposals
Once an investment opportunity has been recognized an organization needs to evaluate its options for investment. That is to say, once it is decided that new product/products should be added to the product line, the next step would be deciding on how to acquire these products. There might be multiple ways of acquiring them. Some of these products could be:
- Manufactured In-house
- Manufactured by Outsourcing manufacturing the process, or
- Purchased from the market
Choosing a profitable investment
Once the investment opportunities are identified and all proposals are evaluated an organization needs to decide the most profitable investment and select it. While selecting a particular project an organization may have to use the technique of capital rationing to rank the projects as per returns and select the best option available. In our example, the company here has to decide what is more profitable for them. Manufacturing or purchasing one or both of the products or scrapping the idea of acquiring both.
Capital Budgeting and Apportionment
After the project is selected an organization needs to fund this project. To fund the project it needs to identify the sources of funds and allocate it accordingly. The sources of these funds could be reserves, investments, loans or any other available channel.
The last step in the process of capital budgeting is reviewing the investment. Initially, the organization had selected a particular investment for a predicted return. So now, they will compare the investments expected performance to the actual performance. In our example, when the screening for the most profitable investment happened, an expected return would have been worked out. Once the investment is made, the products are released in the market, the profits earned from its sales should be compared to the set expected returns. This will help in the performance review.
Importance of capital budgeting
- It is important as it creates accountability and measurability.
- Long term implication – Capital expenditure decision affects the company’s future cost structure over a long time span. Therefore risk should be minimized through systematic analysis of projects.
- Irreversible decision – Capital investment decisions are not easily reversible without much financial loss to the firm.
- The long-term commitment of funds – Long term investments lead to higher financial risk. Hence careful planning is must to reduce the financial risk.
- Capital budgeting is also vital to a business because it creates a structured step by step process that enables a business to develop and formulate long term strategic goals, Seek out new investment projects, estimates and forecast future cash flows, Facilitate transfer of information