Capital expenditure budget or Capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sales such as land, building, machinery or furniture. Meaning of Capital Budgeting: Capital Budgeting is the process of making the investment decision in fixed assets or capital expenditure. Capital Budgeting also knows as an investment, decision making, planning of capital acquisition, planning and analysis of capital expenditure, etc. Also, learn about EVA and MVA.
Learn, Explain Capital Budgeting and its Meaning, Definition, Concept, Nature, and Procedure.
The word investment refers to the expenditure which requires making in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to the process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of the overall objectives of the firm.
What is a capital expenditure? It is a very difficult question to answer. The terms capital expenditure associate with accounting. Normally capital expenditure is one which intends to benefit future period i.e., in more than one year as opposed to revenue expenditure, the benefit of which suppose to exhaust within the year concern.
Definition of Capital Budgeting:
Capital budgeting is the process by which a company determines whether projects (such as investing in R&D, opening a new branch, replacing a machine) are worth pursuing. A project is worth pursuing if it increases the value of the company.
A project typically adds value to the company if it earns a rate of return that exceeds the cost of capital. The opportunity cost of capital expects to return that is foregone by investing in the project rather than in comparable financial securities, such as shares, with the same risk as to the project under consideration.
While capital budgeting is a fairly straightforward process from a conceptual viewpoint, it can be very challenging in practice. Not only is it difficult to determine the group’s appropriate cost of capital, but it is also often even trickier to accurately forecast the incremental cash flows that result from taking on the project.
Concept of Capital Budgeting:
Capital budgeting may define as the decision-making process by which, firms evaluate the purchase of major fixed assets, including buildings, machinery, and equipment; It also covers decisions to acquire other firms, either through the purchase of their common stock; or, groups of assets that can use to conduct ongoing business.
Capital budgeting scribes the firm’s formal planning process for the acquisition and investment of capital; and, results in a capital budget that is the firm’s formal plan for the expenditure of money to purchased assets. A capital-budgeting decision is a two-sided process. First, the analyst must evaluate a proposed project to calculate the likely or expected return from the project.
This calculation generally begins with the expenditure of the project’s service life; and, a stream of cash flowing into the firm over the life of the project. The calculation of expected, the turn may be done by two methods: 1) internal rate of return or 2) net present value, These two methods discuss later in this.
The second side of a capital-budgeting decision is to determine the required return from a project. We may calculate the likely return to being 12 percent but the question is whether this is good enough for the proposal to accept. To determine whether the return is adequate, the analysts must evaluate the degree of risk in the project and then must calculate the, required return for the given risk level. Two techniques may use to perform this analysis.
The weighted-average cost of capital uses when the new proposal assumes to have the same degree of risk as to the firm’s existing activities. The capital asset pricing model uses if the risk in the project views as different from the firm’s current risk level. Capital budgeting is important for the future well-being of the firm; it is also a complex, conceptually difficult topic.
A, we shall see later in this article, the optimum capital budget-the the level of investment that maximizes the present value of the firm simultaneously determined by the interaction of supply and demand forces under conditions of uncertainty. Supply forces refer to the supply of capital, the firm or its cost of capital schedule.
Demand forces relate to the investment opportunities open to the firm; as measured by the stream of revenues that will result from an investment decision Uncertainty enters the decision; because, it is impossible to know exactly either the cost of capital; or, the stream of revenues that will derive from a project.
Nature of Capital Budgeting:
Nature of capital budgeting can explain in brief as under:
- Capital expenditure plans involve a huge investment in fixed assets.
- Capital expenditure once approved represents the long-term investment that cannot reserve or withdrawn without sustaining a loss.
- Preparation of coital budget plans involves forecasting of several years profits in advance to judge the profitability of projects.
It may assert here that the decision regarding capital investment should take very carefully so that the plans of the company do not affect adversely.
The procedure of Capital Budgeting:
Capital investment decisions of the firm have a pervasive influence on the entire spectrum of entrepreneurial activities so careful consideration should regard in all aspects of financial management.
In the capital budgeting process, main points to be borne in mind how much money will need of implementing immediate plans, how much money is available for its completion and how are the available funds going to assign tote various capital projects under consideration. The financial policy and risk policy of the management should be clear in mind before proceeding to the capital budgeting process.
The following procedure may adopt in preparing capital budgeting:
1] The organization of Investment Proposal.
The first step in the capital budgeting process is the conception of a profit-making idea. The proposals may come from rank and file worker of any department or any line officer. The department head collects all the investment proposals and reviews them in light of the financial; and, risk policies of the organization to send them to the capital expenditure planning committee for consideration.
2] Screening the Proposals.
In large organizations, a capital expenditure planning committee establishes for the screening of various proposals received by it from the heads of various departments and the line officers of the company. The committee screens the various proposals within the long-range policy-framework of the organization. It is to ascertain by the committee whether the proposals are within the selection criterion of the firm; or, they do no lead to department imbalances or they are profitable.
3] Evaluation of Projects.
The next step in the capital budgeting process is to evaluate the different proposals in term of the cost of capital; the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation techniques;
- The degree of Urgency Method (Accounting Rate of return Method)
- Pay-back Method
- Return on Investment Method
- Discounted Cash Flow Method.
4] Establishing Priorities.
After the proper screening of the proposals, uneconomic or unprofitable proposals drop. The profitable projects or in other words accepted projects than put in priority. It facilitates their acquisition or construction according to the sources available and avoids unnecessary and costly delays and serious cot-overruns. Generally, priority fixed in the following order.
- Current and incomplete projects give priority.
- Projects for maintaining the present efficiency of the firm.
- Projects for supplementing income.
- Safety projects and projects are necessary to carry on the legislative requirements.
- Projects for the expansion of a new product.
5] Final Approval.
Proposals finally recommended by the committee are sent to the top management along with the detailed report; both of the capital expenditures and sources of funds to meet them. The management affirms its final seal to proposals taking in view the urgency, profitability of the projects and the available financial resources. Projects are then sent to the budget committee for incorporating them into the capital budget.
Last but not the least important step in the capital budgeting process is an evaluation of the program after it has been fully implemented. Budget proposals and the net investment in the projects compare periodically and based on such evaluation; the budget figures may review and present more realistically.