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Capital Budgeting

Byadmin

Sep 17, 2022 ,
  • Preface
  • Meaning and Definition of Capital Budgeting
  • Objective of Capital Budgeting
  • Main Characteristics of Capital Budgeting
  • Types of Capital Expenditure or Capital Projects
  • Technique of Capital Budgeting
  • Important Factors of Capital Budgeting
  • Importance of Capital Budgeting
  • Limitation of Capital Budgeting

Successful operation of business requires financial resources which are obtained by way of share capital, loan capital or credit. These are invested in current and fixed assets. Investment in current assets is that expenditure, the benefit of which is received by the organization in a maximum period of one year, hence they are also called revenue expenditure. These revenue expenditures are planned and controlled by making various functional budgets. Investment in fixed assets is an expenditure.

The benefits of which accrue to the organization in more than one year. Most of the long-term capital of any business is invested in these assets. Expenditure on fixed assets is called capital expenditure. Under this expenditure, expenditure is included on the purchase, renovation, modernization, replacement of fixed assets, development of new technology, discovery and research, etc. These assets provide the basis of the business, hence they are called structural or basic assets.

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Since most of the capital is invested in fixed assets, it is necessary that such expenditure should be done very carefully. Any kind of wrong decision affects the future earnings, production capacity, production type, profit volume and employment potential etc. in the long run. In this situation, it becomes the responsibility of the managers to take decisions regarding them before making capital expenditure in such a way that the future risks are minimum and the expectation of earnings is maximum. By using capital budgeting technique, managers can discharge this responsibility well. Capital budgeting is that technique of management, under which the best option or opportunity is selected after analyzing all the opportunities and options for capital investment. Capital budgeting techniques are known by different names. In this technique, decisions related to capital expenditure are made, so it is called ‘Capital Expenditure Decision, planning of fixed assets is done on the basis of this technique, hence Management of Fixed Assets, Long Term Capital Expenditure is managed through it, hence Capital Expenditure Management or ‘Long Term Investment Decision, due to its use in the decision of a specific project, it is also known by the names of Project Budgeting Method etc.

Capital budgeting is a management technique that is used to consider the proposed capital expenditures and their economic management, plan and implement the best investment from the available resources. Some of its major definitions are as follows:

According to Prof. R. N. Anthony, there is a list of new capital assets sought for projects in which the project approval cost is also given.

In the words of Charles T. Horngren, capital budgeting is the long-term planning of knowing and managing proposed capital expenditures.

“According to Lawrence Gitman, capital budgeting refers to the whole process of evaluation, selection and follow-up in capital expenditure options;

According to Keller and Ferreira, capital budgeting represents the plans made for the investment and expenditure in fixed assets during a budget period.

In the words of Milton H. Spencer, capital budgeting is the planning of expenditure for assets that will yield returns in future periods.

According to RM Lynch, capital expenditure budgeting is concerned with planning for the development of available capital,

whose firm Capital budgeting in simple words refers to the process of deciding whether or not to invest money in projects whose costs and benefits are long term.

Thus, it is clear from the above definitions that capital budgeting is such a managerial technique by which various investment proposals are generated, appraised, decided, The conversion processes are completed.

Capital budgeting in business organizations is done for the following purposes:-

  1. Financing of Capital Expenditures : With capital budgeting, the management gets to know in advance about how much amount of capital. will have to be appropriated. So that the management of the organization can also make proper arrangements for that amount from time to time. Doing so has a relatively low cost.
  2. Determine of Priority: By adopting capital budgeting technique, various projects can be arranged in the correct order according to their profitability. With this, the management gets detailed information about the projects as well as the order of their utility and profitability in the organization.
  3. Evaluation of Capital Expenditure Projects: The main objective of capital budgeting is to evaluate the various proposed capital expenditure projects available before the institute so that the task of selecting profitable projects can be simplified.
  4. Analysis of Past Decisions: This can be ascertained by analyzing the decisions taken in the past period under capital budgeting. To what extent those decisions were appropriate and keeping this in mind the decision
  5. Safety from future losses : Only information becomes available. As a result, these future losses are avoided by taking protective measures.
  6. Valuation of Fixed Assets: By using this technique, the valuation of fixed assets is done from time to time, so that it is convenient to tell them in the company’s balance sheet. And the information about the present value of the business is also kept by the managers.
  7. Coordination: The tasks are decentralized under a large organization, but for effective control, it is very important to maintain coordination between them. Through capital budgeting, a balance can be established in the capital expenditure of different departments.
  8. Effective Control on Capital Expenditure: In capital budgeting, the budget is prepared for the expenditure to be done on the project in the same way as other budgets, by comparing the actual expenditure with the predetermined expenditure. Effective control can be kept on the capital expenditure made by the departments.

Capital budgeting decisions are different from normal business decisions and these decisions affect the future of the business as well as the investors as they involve long term investment. The main features of capital budgeting are as follows:-

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  1. Long Term Effect : Capital projects affect the earnings of the next several years of the business. For example, replacement of machinery in place of labor increases the fixed costs of the business. Capital investment directly affects the profitability and financial position of the organization. Along with this, the management becomes dependent on future events for the financial elasticity of its organization. Therefore, these investments need to be done with great care.
  2. Investment of Large Funds : Through this technique, decisions are made about big projects that they have to be implemented. Or not . Large funds are invested in these projects of the institutions, so efficient budgeting of funds is essential.
  3. Comparative Analysis : Under the capital budgeting technique, a comparative analysis of the costs and potential benefits of different plans of future investment is done. Under this, information is also obtained about how much time it will take to implement various projects.
  4. Study of Future Capital Investment Plans : Under the capital budgeting process, a detailed and in-depth study of various future investment plans of the organization is done so that it can be decided which project is profitable.
  5. Decision Marking : After doing a comparative study of all the projects, it is decided that which project is to be deployed. Since this decision has long term implications, the decision should be taken after considering the cost of the project and the benefits to be realized, the amount of resources available, the potential for future benefits, the need for future investments, etc.
  6. Unchangeable Decisions : Capital budgeting decisions in a business organization are often irreversible. Once the capital appropriation plan is implemented, it is not possible to change it. Therefore, it is very important to take a prudent decision regarding capital investment.
  7. Most Difficult Decision : These decisions are taken in future but future events and actions are uncertain and future depends on many factors like economic, political, technical factors, which are very important to evaluate with complete accuracy. A difficult decision is made.
  8. Capital Structure Planning : For capital budgeting, information about surplus earned by the organization is required which is known on the basis of cost of capital and structure of capital, hence capital structure planning is done automatically.
  9. Permanent Investment : Money invested in capital projects is a permanent investment. Once such an appropriation is made, money cannot be immediately withdrawn from them without significant loss. As a result of these decisions, money has to be invested in fixed expenses like insurance, building rent, interest etc. If the project does not produce the desired results or fails, the burden of these fixed expenses will also affect the profitability of the organization, so efficient appropriation i.e. capital budgeting is essential.
  10. Uncertainty and Risk : The intricacies of long-term investment decisions are more elaborate than short-term decisions because on the one hand, the effect of these decisions lasts beyond the current year and their accuracy is immediately accurate. Cannot be guessed. Secondly, due to the impact of these projects for many years to come, they are also high in uncertainty and risk.

Capital expenditure refers to all such expenses incurred in the business which are done for achieving the long-term specific objective of the business. The projects started with these expenses are income generating (Revenue Generating) i.e. those investments which increase the current income or cost reducing i.e. reducing the current cost which indirectly increase the profit. Yes, it can be of any type. These projects can be as follows:-

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  1. New Projects – Capital expenditure has to be incurred on land, building, plant, machinery, installation work etc. in the newly established firm. Since these new firms are employed for the first time, the decision of the suitability of these projects is often based on inevitability.
  2. Replacement and Modernization Projects – Due to continuous use of machines, they get destroyed or reach a dilapidated state. Some machines are not destroyed but become obsolete due to the advent of new types of machines. In both cases, it is necessary to reinstall the machines. Restoration decisions should be made keeping in view the savings in operating expenses due to the installation of machines and additional benefits due to higher production, hence these are called cost reducing decisions.
  3. Expansion Projects – The projects undertaken to expand the ongoing business are called expansion projects. This expansion can be related to the expansion of existing capacity, to increase the market share of the firm or to create new products, new markets, additions, hence they are called revenue generating projects. The suitability of these is decided on the basis of the cost of investment and the expected profit to be generated from it.
  4. Research and Development Projects – Continuous research and development for new designs, shapes, models etc. to improve, change, change in demand, sales promotion, to stay in competition, in the variety of goods produced by the institutions. The work is done. The projects which are made for this are called research and development projects.
  5. Product of Process Improvement Projects – Such projects are started with the aim of reducing cost or increasing profit by developing new products or improving the manufacturing process of old products. These projects also include projects to replace human labor with machines. Their suitability is also decided on the basis of cost benefit statement.
  6. Other projects – Such projects which are not directly related to the original purpose of the organization (maximum profit), but are implemented under compulsion or to fulfill social or legal obligations. Such projects have a favorable indirect effect on production and profitability.

This includes the following projects:-

  • Prestige Projects – External pretense is also necessary for the reputation of the organization in public or in the eyes of customers. Attractive and beautiful administrative buildings, guest houses or construction of convenient sales departments etc. are such works which increase the prestige of the organization.
  • Education and Training Projects – Educational and training programs are run to improve the efficiency of employees, information about production techniques, working techniques, sales promotion etc.
  • Employee Welfare Projects – Projects established to motivate and satisfy workers are called employee welfare projects, such as construction of workers’ housing buildings, canteens, entertainment centers, hospitals, educational institutions etc.

There is no universally accepted method of budgeting capital expenditure in commercial institutions, as there is variation in the nature of production institutions and their projects, amount of investment desired, priority etc. Generally in a large firm the following process of capital budgeting is followed:-

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1. Origin of Investment Proposals – The first step in the process of capital budgeting begins with the emergence of investment proposals. Investment proposals in a business organization can be originated or considered at any level of management or from outside the organization. The higher management of the institution can bring this idea or any party working in the institution like factory manager, foreman labor, etc. can put such idea before the higher management, which is further considered. Information about different types of projects is also received from fairs, meetings and seminars, sales campaigns, research and development organizations.

2. Presentation of Projects – The above proposals are prepared by the departmental managers in proper format, after which they are presented before the budget or planning committee, in which the following information is usually given:

Name of the department

Date and proposal number of the proposal

Objective and details of the proposed project

Expected benefits or income from the project

Details of the risks involved in the project

Estimated cost of the project i.e. desired appropriation

Time taken in the project

Life span of the project

Net Savings and rate of return,

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3. Screening the Proposals – Appropriation proposals sent by various departments are scrutinized by the budget committee in depth. This check is done according to the parameters established by the top management and budget committee. The budget committee sees whether the proposal is in accordance with the long term development programs of the institution. These proposals will not create imbalance in other departments. Whether the organization will be able to finance them or not. After considering all these things, the proposals which are found to be suitable are further economic analysis done.

4. Project Evaluation – After examining the proposals by the budget committee, the next step in the capital budgeting process is to evaluate the profitability of various projects. This requires-

  • Estimating the benefits and costs in cash flows and
  • Determining the time taken for the project and
  • Selecting an appropriate criterion for assessing the suitability of the projects.

Valuation of cash flows depends on future uncertainties. Therefore, the risk involved should be carefully analyzed and adequate planning should be done for the different types of risks. If necessary, expert opinion should also be taken in this regard. Several methods are used for project appraisal, which are discussed in detail in the next chapter. Whichever method is used, the decision must serve the purpose of maximizing the market value of the institution.

5. Project Selection – When the profitability evaluation of various projects is done, those projects are left out of them which are uneconomic or unprofitable. Out of the profitable projects that are left, considering the funds available with the organization, various projects are selected according to the pre-determined priorities of the firm. The priorities of the firm are different at different times. These preferences may be in relation to early completion of ongoing or incomplete projects, to accept replacement projects, to accept cost-cutting projects or to meet statutory requirements. The decisions taken for these projects are divided into three parts:

  • Accept Reject Decision – Those projects which are not competitive with each other, that is, the acceptance of one does not prevent the acceptance of the other, are called independent projects. Approved or rejected decisions are taken in relation to these projects. After analyzing the various projects, the projects which meet the prescribed criteria are accepted and the remaining projects are rejected. Generally those projects are accepted whose rate of return is higher than the cost of capital.
  • Mutually Exclusive Decision – Mutually Exclusive Decision refers to the decision in which if one offer is accepted, all other proposals are rejected, that is, acceptance of a proposal is done by sacrificing other alternative proposals. These decisions become important when more than one proposal is acceptable under the accepted rejected decision. In such a situation the best among them is selected. Acceptance of this best option automatically eliminates other alternatives.
  • Capital Rating Decisions – It is not possible to select all profitable projects due to the limited capital resources. In such a situation, the cut-off point is determined with reference to the cost of capital of the project, after which the proposals are ranked on the basis of profitability. The proposals which fall within the prescribed cut off point are accepted, the rest are rejected.

6. Final Approval and Preparation of Capital Budget – After the selection and prioritization of suitable and feasible projects, the project proposals are presented to the Board of Directors for final approval. After thorough examination by the Board of Directors, the eligible proposals are approved. After the approval of the Board of Directors, the project is included in the annual capital budget. The budget allocation for the project by the finance department, period wise determination of estimated expenditure and capital expenditure budget is prepared keeping in mind the sources of capital.

7. Sanction of Expenditure and Execution of Project – After the preparation of capital expenditure budget by the finance department, various heads of departments are authorized to do so on the specific plan approved for their department. A fixed amount can be spent in this year. After that the head of the department starts the process of implementation of the project. For this the project is divided into different phases. What to do first is determined. Accordingly, the actual expenditure is done by starting the work.

8. Performance Review and Follow-up – Finally, the performance of the project is reviewed by comparing the actual performance with the budget estimates during its lifetime and after completion. By getting information about the variance, their reasons are ascertained. When required, the standards are revised or effective steps are taken for cost control. To do this, a systematic process should be developed which will help in improving the forecasting techniques along with accurate predictions.

Capital investment decisions depend on the information about the cost and the resulting future revenues. Evaluating various capital expenditure proposals and selecting the best option, the following information is required before using any technique of capital budgeting:-

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1. Net investment or cash outflows – this is the amount that is spent on a project. Hence, it can be called the cost of the project. It is calculated in the following way

a. New Project: In the case of a new project, the cost of the property is included in the cost of the property, other expenses, opportunity cost and additional necessary working capital, i.e., the cash of the new property. The outflow is calculated as follows:

Computation of Initial Investment or Net Cash Outflows (New Project)

Purchases price of New Machine / Project ………………..

(Including Duties and Taxes)

Add – (i) Installation cost ………………..

b. Insurance & Fright ………………..

c. Net Opportunity Cost ………………..

d. Additional Working Capital Required ………………..

Less – (i) Investment Allowance ………………..

(ii) Saving in Working Capital ………………..

Net Cash Outflows ………………..

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b. Replacement Project – When old asset is replaced by new asset, it is called replacement project. The cash outflow of these projects is calculated as follows:

Computation of Net Cash Outflows (Replacement Project)

Purchases Price of the Assets (including taxes and duties) ………………..

Add – (i) Insurance, Freight ………………..

(ii) Installation Cost ………………..

(iii) Net Opportunity Cost (if any) ………………..

(iv) Increase in Working Capital ………………..

(v) Increase in Tax Liabilities ………………..

Less – (i) Scrap or Salvage value of old machine ………………..

(ii) Investment Allowance ………………..

(iii) Decrease in Working Capital ………………..

(iv) Decrease in tax liabilities ………………..

Net Cash Outflows or Initial Investment ………………..

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(2) Net Cash Inflows – Net cash inflow is the net increase in cash due to the project, we can also call it net cash profit. But this is not an accounting profit, because accounting profit is calculated taking into account depreciation, accrual. Whereas cash inflow means cash income before depreciation but after tax. If non-cash expenses such as write-off of goodwill, construction of event, which have already been deducted for computing profit after tax, these should be added again. These cash inflows may be the same every year over the life of the project or may change from year to year. In short, the profitability statement can be prepared as follows to calculate the net amount received:-

(a) Profitability Statement (New Project In Revenue Increasing Decisions)

Annual Sales ………………..

Less- Operating Expenses including depreciation ………………..

Earning Before Tax (EBT) ………………..

Less- Income tax ………………..

Earning After Tax (EAT) ………………..

Add – Depreciation ………………..

Net Cash Inflows ………………..

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(b) Profitability Statement (Replacement Project or In Cost Redaction Decision)

Savings in Cost (Due to replacement) ………………..

Less – (i) Additional Depreciation ………………..

Any other additional cost ………………..

Net saving before tax ………………..

Less – Income Tax ………………..

Savings after tax ………………..

Add – Additional Depreciation ………………..

Net Additional Depreciation ………………..

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Note: – It is clear from the above tables that:

  • While computing the cash flow of the last year, the amount of working capital freed up will also be included as that which was invested in the initial funds at the time of net working capital appropriation, when the project
  • The cash residual or salvage value received from the sale of existing property shall be included in the cash inflow of the last year.
  • Costs which the entity cannot recover and which are unrelated to future decisions are called costs, hence these costs are not taken into account while computing cash inflows.

3. Cut-off rate or Required rate of return – The minimum rate of return is the rate, failing which the investment proposal is rejected. This rate is needed to calculate the present value of money and to find out the profitability of the proposals, hence it is also called ‘average cost of capital’ of the organization.

4. Project Life – Every project is expected to generate income for a specified period, which is called the economic life of the project. Lifespan is determined by taking into account the factors like nature of the project, asset use, possible technical changes, maintenance etc. It is the economic life of the project which can be less or more than the physical life.

5. Available Funds – Capital expenditure decisions are related to the allocation of more money over a long period of time. Therefore, the decision to accept the project should be made keeping in view the resources available with or to be available with the institute.

6. Opportunity Cost – Opportunity cost is the income that could have been received if the fund was invested elsewhere. Opportunity cost is important in capital expenditure decisions as it is needed while computing the desired minimum rate of return.

7. Risk of Obsolescence – Due to rapid technological changes or fashion, the existing production methods, machines, equipment become obsolete, and they are replaced by new methods, machines. Therefore, the management should carefully consider the risk of obsolescence before implementing the project. Such a project may be selected which has a short repayment period so that the cost can be recovered quickly.

8. Type of Management – Capital appropriation decisions depend on the thinking of the management. If the management is of modern and progressive ideology, then research and development projects will be encouraged in the institution. On the contrary, if there is a conservative ideology of management, traditional methods will be used. New investment and research will not be given much importance.

9. Competitors Strategy – The strategy of the competitor also plays an important role while taking capital investment decisions. If a new plant is set up by the competitor to increase the production or the quality of the product is improved through research and development, then the institution under consideration will also have to do the same for its survival.

10. Intangible Factors – Capital expenditure decisions are not made only on the basis of financial aspects, non-economic factors also have to be considered before taking the decision. What will be the impact of the chosen project on the morale of the employees working in the organization? How will this affect the reputation of the organization? Government policies are favorable or unfavorable for such a project? Will the trade union oppose it?, etc. It is also necessary to keep in mind the factors.

11. Market Situation – The demand for a product in the market also plays an important role in the long-term investment decisions. If the future forecast shows that there is a wide market for the product in the long run, then the decision of new capital investment must be taken.

12. Fiscal Policy – Tax policies of the government such as exemption on new investment, tax exemption on investment income, method of depreciation, tax rates etc. Appropriation decisions affect decisions.

Difference between capital budgeting and project planning: – Project refers to any investment opportunity made for profit and planning is the setting of goals and the preparation of programs to achieve them. Therefore, the process of deciding whether to accept or reject an investment opportunity by comparatively reviewing the expected cost and revenue is called project planning. Both capital budgeting and project planning are techniques of planning and decision making, but the main difference between these two are as follows:

  • Capital budgeting is the technique of planning capital expenditure whereas project planning is the technique of planning of investment opportunities.
  • Capital budgeting is usually done by an existing company, whereas project planning may be in relation to the establishment of a new company or for the development, expansion and reorganization of the business of an existing company.
  • For capital budgeting, a comprehensive evaluation of capital expenditure options is adopted, whereas in project planning a detailed outline of the desirability is given.
  • Reporting work is not important in capital budgeting whereas the design of project report is very important in project planning.

The importance of capital budgeting is not only because more money is invested in capital projects for the long term and these decisions have a profound effect on the future earnings of the business, but its importance is also due to the following reasons:-

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  1. From capital budgeting Proper arrangements can be made for the necessary finances for the purchase of capital assets, so that this work is not hampered due to financial difficulties in time.
  2. It helps in long term planning and policy. Proper capital budgeting gives information about the right time for purchase of assets and improvement of existing assets.
  3. Expansion of fixed assets is done keeping in view the future sales. Therefore, capital budgeting considers the possibilities of augmentation of production facilities to meet the additional sales amount shown in the sales budget.
  4. It shows the comparative position of various alternative assets available for replacement of destroyed or obsolete assets.
  5. It helps in formulating a sound policy of depreciation and restoration of assets.
  6. With capital budgeting, a firm can determine the appropriate time for the purchase of the required assets for itself, keeping in mind the demand and supply conditions of capital goods in the market.
  7. It may prove beneficial in considering ways to reduce costs. To reduce the cost, the purchase of latest machines is also considered.
  8. It presents an estimate of the capital cost of improving working conditions or safety facilities, as well as helps in the formulation of labor welfare schemes.
  9. Capital budgeting is helpful in examining the impact of capital cost on depreciation, insurance expenses and other fixed expenses.
  10. It highlights the desirability of using machines in place of human labour.
  11. It provides necessary information for meeting the cash budget.

In capital budgeting, there is a systematic analysis of alternative proposals by various methods of evaluation of investment proposals, so that there is a possibility of taking the right decisions by the management. But these methods cannot always be expected to select the best option if the data used for evaluation is inaccurate. Therefore, some difficulties come in front of the managers in the capital budgeting process, for which a suitable solution is necessary. These difficulties or limitations are as follows:-

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1. Difficult to estimate the cost of capital: Estimating the cost of capital is the first requirement for capital expenditure decision because the amount which has been received for investment will definitely incur some cost. But estimating this cost for a given period is often a difficult task. The cost of capital can be estimated on the basis of many assumptions only.

2. Difficult to estimate the rate of return: How much profit will be made in the future period from the capital employed? It is not easy to predict. Often the future remains uncertain and as mentioned earlier, today’s era is an age of uncertainties and risks. Therefore, in such a situation, forecasting the future is a complicated process,

3. It is difficult to estimate the duration: how much investment will have to be done every year and for how many years and for how many years the income will continue to be received, it is also necessary to know, then only which asset to be invested in? Appropriate decision can be taken in this regard. Generally determining these periods is also a difficult problem.

4. The outcome of the decision is uncertain: In the age of competition and development, it is very difficult to say that the basis on which the decision of capital expenditure has been taken will continue and the results will be obtained accordingly. To use the new plant, new technology has to be used and the workers are able to cooperate by understanding this new technology.

5. Impact of Non-Measurable Factors: While studying the project proposals, there are many factors related to the project which affect the investment decisions but whose quantitative measurement is not possible, such as the morale of the employees, the economic, social and political environment of the country etc. These factors also complicate capital investment decisions. As a result, the success of the decisions taken by the capital budgeting technique becomes doubtful.

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