Beginners’ Guide to Capital Budgeting | Managerial Economics

The below mentioned article provides a beginners’ guide to capital budgeting which will help you to understand:-

1. Definition of Capital Budgeting 2. Need of Capital Budgeting 3. Significance 4. Importance 5. Nature of Problems 6. Steps Involved.

Definition of Capital Budgeting:

While defining the word Capital Budgeting:

1. Milton H. Spencer has said that—”Capital Budgeting involves the planning of expenditure for assets, the returns from which will be realised in future time periods.”

2. According to Charles T. Homgreen/Harengren—”Capital Budgeting is long-term planning for making and financing proposed capital outlays.”

3. According to E. E. Nemeses—”Capital Budgeting or Capital Management may be defined as the process of determining which investment of allocations of long-terms funds are to be made by an enterprise.”

4. Joel Dean in his book has written—”Capital Budgeting is a kind of thinking that is necessary to design and carry through the systematic programmes for investing stockholders money.”

5. According to G. C. Philippates—”Capital Budgeting is concerned the allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project, with the immediate and subsequent stream of expenditures for it.”

6. On Capital Budgeting Sri R. N. Anthony has expressed his views which are as such—”Capital Budgeting as essentially a list of what management believes to be worth-while projects for the acquisition of new capital assets together with the estimated cost of each project.”

On the basis of analytical study of above definitions, it can be concluded that capital budgeting is the planning of long-term regular return on these investments.

Need of Capital Budgeting:

The Capital Budgeting is essential and its need has been considered because in its absence the firm may face heavy losses. If the rate of return is not considered and long-term investments are undertaken, this may result in losing projects or low return projects at the cost of most profitable projects.

Further, the Capital Budgeting is necessary, so that the proposal is examined in its all aspects. The area of Capital Budgeting is therefore a most important function of the managerial decision-making.

To elaborate the need of Capital Budgeting has been considered essential due to the following reasons:

1. Here large sums of money are involved and to make proper agreements, to cope with financial commitments well in time.

2. Long run nature of fund commitments:

Funds once invested cannot be taken back easily without making substantial loss.

3. The investment decisions broadens the base on which profit is earned and calculated:

This can be earned mostly through return on capital employed, so that the overall average return is in no way adversely affected.

4. To study implications of long-term investment:

Long-term investment decisions are more extensive mainly for two reasons:

(a) The effect of the decisions extend beyond the accounting period, therefore its correctness or otherwise cannot be known readily, and

(b) These decisions are subject to higher degree of risks and uncertainty due to time factor involved.

Therefore, the Capital Budgeting is necessary, so that the proposed is examined in its all aspects. The area of Capital Budgeting is most important function of the managerial decision-making.

Significance of Capital Budgeting:

Following are the important significance of Capital Budgeting:

1. It has Long-Term Effects and Implications:

Capital Budgeting decisions have long-term implications for the firm as they affect the future profitability of the firm and the cost structure. It influences the rate and direction of firm’s growth. A wrong decision may lead the firm to a disastrous future.

2. It involves the firm’s risk element:

Long-term commitment of funds may change the firm’s risk elements. If adoption of an investment proposal increases its average earnings, this fluctuations may be a risky affairs for the firm.

3. The Capital Budgeting decisions are irreversible:

It should be remembered that the heavy amount invested cannot be taken back without causing a substantial loss, because it is very difficult to find a market for the second-hand capital goods.

4. Impact on company’s future cost-structure:

In this a firm commits itself to a sizeable amount of fixed costs in terms of labour, supervisor’s salary, insurance, rent of the building and so on. If the investment turns out to be unsuccessful in future or yield less than anticipated profits, the firm will have to bear the burden of fixed cost unless the asset is completely written off.

5. It also determines the cost structure of the company’s product:

Capital investment decisions determine the future profits and cost for the firm which ultimately affects the competitive position of the firm.

6. It facilitates cash forecast:

It facilitates cash forecasts to plan the investment programmes carefully, so that the firm can meet its long-term obligations without any difficulty.

7. It protects the interest of the shareholders and of the enterprise:

It avoids over-investment and under-investment in fixed assets. The management facilitates the wealth maximisation of equity shareholders.

8. It assists in maintaining depreciation:

Budget assists in formulating a sound depreciation and assets replacement policy.

9. It is useful in cost reduction system:

Budget may be useful in considering methods of cost reduction required in the consideration of purchasing most up-to-date and modern equipment.

10. Helpful in the preparation of long-term plans:

Budget facilitates the manage­ment in making of the long-terms plans and assists in the formulation of General Policy.

11. It studies the impact of capital investment on the revenue expenditure of the firm:

This study is mostly applicable in depreciation insurance and other fixed assets.

Importance of Capital Budgeting:

In the modern complicated business world, importance of Capital Budgeting has been considered as very great and beneficial.

Proper and intelligent Capital Budgeting can help the management or the enterprise in the following ways:

1. Helpful in the replacement of current equipment:

It can help in better way the replacement of current obsolete equipment with more efficient and up-to-date equipment.

2. Helpful in the preparation of capital requirements of the firm:

It is of great help in estimating the capital requirements of the firm by selecting the best proposal for the capital investment.

3. Helpful in meeting financial commitments:

It helps to make proper arrange­ments to cope with financial commitments well in time.

4. Helpful in taking long-term investment decisions:

Capital Budgeting is of great help in taking long-term investment decisions.

5. Helpful in avoiding losses:

Capital Budgeting is necessary to avoid losses. It helps in taking a correct and proper decisions by evaluating various proposals of capital investment on the basis of their profitability and otherwise.

6. It helps in the calculation of money requirements in future, so that the firm may make necessary requirements of the capital.

7. It helps in knowing the profits of the concern:

It helps is knowing the effect of depreciation, insurance etc., on the profits of the concern.

8. It helps in reducing and avoiding unnecessary expenses:

Reduction in expenses will lead to increase in the profit that will help in timely payment of salary interest and bonus. This will increase reputation and goodwill of the firm.

Nature of Capital Budgeting Problems:

Every budgeting decision essentially involves four elements:

(i) A clear idea of what the problem is?

(ii) A good set of alternatives from amount which one can take make a choice,

(iii) An accurate set of estimates of the likely outcomes of the alternatives, and

(iv) The evaluation and comparison of the alternatives in the light of their cash inflows and outflows.

Thus, discussing the nature of capital budgeting problem Prof. R. M. Lynor has said, Capital Budgeting consists in planning the development of available capital for the purpose of maximising long-term profitability (return on investment) of the firm.

Capital Budgeting involves mainly three problems:

(1) Demand for Capital – i.e., how much money will be needed for expenditure in the coming period?

(2) Supply of Capital – i.e., how much money will be available and of what cost?

(3) Rationing of Capital – i.e., how should the available money be distributed amongst the various projects?

(1) Demand for Capital:

To study budgeting problem:

First:

The firm must make a survey of its capital needs.

Second:

This constitutes the demand for capital which is estimated by adding the requirements specified by the smallest operating units of the organisation.

Third:

This demand for capital is derived from the process of project generation.

Fourth:

It should be remembered that the demand schedules for capital can be prepared/constructed for one or two years but not for longer or distant future; because in the long run technical changes may take place which may change the demand for capital.

Fifth:

The demand may also change due to market developments and changes in the relative prices.

(2) Supply of Capital:

This is a problem to find out from where the money will come?

Here, the distinction between internal and external resources of funds must be made:

(a) The chief internal resources are—(i) Depreciation charges, and (ii) Retained earnings.

(b) The external sources are mainly the issue of shares and debentures to the public.

It is very important to forecast correctly as to:

(i) How much cash to be paid out of dividend, and

(ii) Also to decide how much of the remainder may be tied up in long-term projects?

The capital expenditure in some firms is confined completely to the amount available internally.

The amount that can be expected from accumulated:

(a) Depreciation, and

(b) Retained earnings are the most important part of capital expenditure budgeting.

Generally these estimates are confined to one year or two years. Such projections are not matter of forecasting the level of prices and costs; they also involve management decision on the adequacy of depreciation charges the level of dividend and the necessary degree of liquidity. Thus, it can be said that as a source of capital funds plough back policy forms an integral part of Capital Budgeting.

The problem of how much to plough back can be guided by a number of principles. Regarding the External Sources which depends upon the state of capital market and sound financial position and goodwill of the company.

(3) Rationing of Capital:

Capital is a scarce source, therefore it has got cost. The return on investment must be more than the cost of capital. Only that investment should be taken into consideration which yields a better rate of return i.e., in excess of cost of capital. The cost of capital sets the minimum rate that the investment must give as return. This is infect a deciding factor in Capital Budgeting to determine the actual investment in any place.

The basic aim of capital is to maximise the firms long-run profit potentials. We cannot take into consideration all profitable investment because the firm has limited supply of capital. In such a situation, we have to choose out the project which is most profitable.

Therefore, we can say that Capital Budgeting consists of:

(a) Determining the cost of capital,

(b) Determining the rate of return on different investment proposals under considera­tion and

(c) Deciding the proposals on the basis of their profitability and importance

Steps Involved in Capital Budgeting:

The Steps Involved in Capital Budgeting are as Follows:

1. The Concept of a Profit Making Idea:

The first step in the capital expenditure programme should be the creative search for profitable opportunities. This is also called the organisation of investment proposals. The proposal may come from the side of worker of any department or from any line executive. To facilitate the organisation of such ideas a periodic review and comparison of earning costs, procedures and product line should be made by the management.

2. Long Range Capital Plans:

If there is any long range capital plans, it must be verified by the management. It requires the determination of over-all capital budgeting policies based upon the projections of short and long-run developments.

3. Capital Budget of Short Range:

Once the timeliness and priority of a proposal have been established, it should be listed on the one year capital budget as an indicator of its approval.

4. Proper Measurement of Project Expenditure:

Small project expenditure is less and the amount could be approved by the departmental head. Larger projects be ranked according to their rate of return. Any one or more tests of profitability may be used for it.

5. Screening and Selection of the Firm:

Such criteria encompass the supply and cost of capital and the expected returns from the alternative investment opportunities. Once the proposal passes this stage it is authorised for outlays.

6. Establishing the Priorities:

Once the accepted projects are put in priority, it facilitates their acquisition or construction, avoids costly delays and serious cost over-runs.

7. Final Approval:

After the financial manager has reviewed the projects he will recommend a detailed programme both of capital expenditures and of sources of capital to meet them, to the top management. Next, he may present several alternatives. Capital expenditure budgets to the top management which will finally approve the capital budget for the firm.

8. Forms and Procedures:

This is a continuous phase that involves the preparation of reports for every other phase of capital expenditure programme of the company.

9. Completion and Disposal:

This step marks the end of the cycle in the life of a project. It involves more than the recovery of the original cost plus any adjustment for replacement programmes.

10. Evaluation of the Programme After it has been fully implemented:

While doing evaluation we must study-was the net investment greater than anticipated? Were the expected net cash benefits actually realised? Management can improve its Capital Budgeting techniques for the future by an evaluation of past performance. Such an evolution also has the advantage of forcing departmental heads to be more realistic and careful.