Capital budgeting is a method of analyzing and comparing substantial future investments and expenditures to determine which ones are most worthwhile. In other words, it’s a process that company management uses to identify what capital projects will create the biggest return compared with the funds invested in the project. Each project is ranked by its potential future return, so the company management can choose which one to invest in first.
Most business’ future goals include expanding their operations. This is difficult to do if the company doesn’t have enough capital or fixed assets. That is where capital budgeting comes into play.
Capital budgets or capital expenditure budgets are a way for a company’s management to plan fixed asset sales and purchases. Usually these budgets help management analyze different long-term strategies that the company can take to achieve its expansion goals. In other words, the management can decide what assets it might need to sell or buy in order to expand the company. To make this decision, management typically uses these three main analyzes in the budgeting process: throughput analysis, discounted cash flows analysis, and payback analysis.
Obviously, capital budgeting involves difficult decisions. In most cases buying fixed assets is expensive and cannot be easily undone. The management has to decide to spend cash in the bank, take out a loan, or sell existing assets to pay for the new ones. Each one of these decisions comes with the eternal question: will they receive the proper return on investment? Because when you think about it, buying new fixed assets is no different than putting money any other investment. The company is buying equipment hoping that is will pay off in the future.
That is why many managers used the present value of future cash flows when deciding what to buy. Present value dollars will help them analyze the current and future cash inflows and outflows equally to come up with the best plan for the future.
Need and Importance of Capital Budgeting
Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of the firm. The need and importance of capital budgeting has been explained as follows:
Capital expenditure decision affects the company’s future cost structure over a long time span. The investment in fixed assets increases the fixed cost of the firm which must be recovered from the benefit of the same project. If the investment turns out to be unsuccessful in future or give less profit than expected, the company will have to bear the extra burden of fixed cost. Such risk can be minimized through the systematic analysis of projects which is the integral part of investment decision.
Capital investment decision are not easily reversible without much financial loss to the firm because there may be no market for second-hand plant and equipment and their conversion to other uses may not be financially viable. Hence, capital investment decisions are to be carried out and performed carefully and effectively in order to save the company from such financial loss. The investment decision which is undertaken carefully and effectively can save the firm from huge financial loss aroused due to the selection of unfavorable projects.
Long-term Commitments of Funds
Capital budgeting decision involves the funds for the long-term. So, it is long-term investment decision. The long-term commitment of funds leads to the financial risk. Hence, careful and effective planning is must to reduce the financial risk as much as possible.
Capital Budgeting Processes
The extent to which the capital budgeting process needs to be formalized and systematic procedures established depends on the size of the organization, number of projects to be considered, direct financial benefit of each project considered by itself, the composition of the firm’s existing assets and management’s desire to change that composition, timing of expenditures associated with the that are finally accepted.
The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm’s fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase.
This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple pay back method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances.
Considering the returns and risk associated with the individual project as well as the cost of capital to the organization, the organization will choose among projects so as to maximize shareholders wealth.
When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.
The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.
When a project terminates, or even before, the organization should review the entire project to explain its success or failure. This phase may have implication for forms planning and evaluation procedures. Further, the review may produce ideas for new proposal to be undertaken in the future.
Capital budgeting processes include:
- Estimation of initial investment
- Estimation of cash inflows
- Evaluation of projects
- Selection of projects