Definition and Meaning of Capital Budgeting: Economics is concerned with the allocation of scarce resources between alternative uses to obtain the best objectives. The Concept of Capital Budgeting: Nature of Capital Budgeting, Importance of Capital Budgeting, and Limitations of Capital Budgeting. Capital expenditure/budgeting, on the other hand, concentrates on these allocations over time; on decisions that involve current outlays in return for expectations of future benefits, i.e., a return for an anticipated flow of future benefits. Also learned, Capital Budgeting: Nature, Importance, and Limitations!
Learn, Explain Capital Budgeting and its Nature, Importance, and Limitations.
In other words, it is applied to evaluate expenditure decisions that involve current outlays but the benefits are likely to be produced in the future, i.e., over a longer period. The said benefits may be earned either in the form of the reduction in cost or the form of increased revenues. And that is why it includes addition, alteration, modification, disposition, and replacement of fixed assets.
Nature of Capital Budgeting:
Capital budgeting is the process of making investment decisions in capital expenditures. Capital Expenditure may define as an expenditure for the benefits of which are expected to be received over a period exceeding one year.
The main characteristic of capital expenditure is that the expenditure incurs at one point in time whereas the benefits of the expenditure are realized at different points in time in the future. In simple language, we may say that capital expenditure an expenditure incurs for acquiring or improving the fixed assets, the benefits of which expect to receive over several years in the future.
The following are some of the examples of capital expenditure:
- Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill, etc.
- Cost of addition, expansion, improvement or alteration in the fixed assets.
- Research and development project cost, etc.
- Cost of replacement of permanent assets.
Capital expenditure involves the non-flexible long-term commitment of funds. Thus, capital expenditure decisions are also called long-term investment decisions. Capital budgeting involves the planning and control of capital expenditure. It is the process of deciding whether or not to commit resources to a particular long-term project whose benefits are to realize over some time, longer than one year. Capital budgeting also knows as Investment Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure and Analysis of Capital Expenditure.
- Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long-term planning for making and financing proposed capital outlays.”
- According to G.C. Philippatos, “Capital budgeting is concerned with 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 streams of earning from a project, with the immediate and subsequent streams of expenditures for it”.
- Richard and Greenlaw have referred to capital budgeting as acquiring inputs with the long-run return.
- In the words of Lynch, “Capital budgeting consists of planning development of available capital to maximize the long-term profitability of the concern.”
Features of Capital Budgeting:
From the above description, it may conclude that the important features which distinguish capital budgeting decision from the ordinary day to day business decisions are:
- Capital budgeting decisions involve the exchange of current funds for the benefits to achieve in the future.
- The funds are invested in non-flexible and long-term activities.
- They have a long-term and significant effect on the profitability of the concern.
- They involve, generally, huge funds.
- The future benefits are expected to be realized over a series of years, and.
- They are irreversible decisions.
They are ‘strategic’ investment decisions, involving large sums of money, a major departure from the past practices of the firm, significant change of the firm’s expected earnings associated with a high degree of risk, as compared to ‘tactical’ investment decisions which involve a relatively small amount of funds that do not result in a major departure from the past practices of the firm.
Need and Importance of Capital Budgeting:
Capital budgeting means planning for capital assets.
Capital budgeting decisions are vital to any organization as they include the decisions as to:
- Whether or not funds should invest in long-term projects such as setting an industry, purchase of plant and machinery, etc.
- Analyze the proposal for expansion or creating additional capacities.
- To decide the replacement of permanent assets such as building and types of equipment.
- To make the financial analysis of various proposals regarding capital investments to choose the best out of many alternative proposals.
The importance of capital budgeting can well understand from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern.
The need, significance or importance of capital budgeting arises mainly due to the following:
1] Large Investments:
Capital budgeting decisions, generally, involve the large investment of funds. But the funds available with the firm always limit and the demand for funds far exceeds the resources. Hence, a firm needs to plan and control its capital expenditure.
2] Long-term Commitment of Funds:
Capital expenditure involves not only a large number of funds but also funds for long-term or more or less permanently. The long-term commitment of funds increases the financial risk involved in the investment decision. Greater the risk involved, greater is the need for careful planning of capital expenditure, i.e. Capital budgeting.
3] Irreversible Nature:
The capital expenditure decisions are irreversible. Once the decision for acquiring a permanent asset takes, it becomes very difficult to dispose of these assets without incurring heavy losses.
4] Long-Term Effect on Profitability:
Capital budgeting decisions have a long-term and significant effect on the profitability of a concern. Not only the present earnings of the firm affects by the investments in capital assets but also the future growth and profitability of the firm depend upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost importance to avoid over-investment or underinvestment in fixed assets.
Difficulties of Investment Decisions:
The long-term investment decisions are difficult to take because:
- The decision extends to a series of years beyond the current accounting period,
- Uncertainties of future and
- The higher the degree of risk.
1] National Importance:
Investment decision though taken by individual concern is of national importance because it determines employment, economic activities and economic growth. Thus, we may say that without using capital budgeting techniques a firm may involve itself in a losing project. Proper timing of purchase, replacement, expansion, and alternation of assets is essential.
2] Importance of Capital Budgeting:
Capital Budgeting decisions have given the primary importance to financial decision-making since they are the most crucial and critical business decisions as they have a significant impact on the profitability aspect of the firm. As the capital budgeting/expenditure decision affects the fixed assets only which are the sources of earning revenue, i.e., the profitability of the firm, special attention must give to their treatment.
Capital budgeting decisions have placed greater emphasis due to:
3] Capital budgeting has long-term implications:
The most significant reason for which capital budgeting decisions take is that it has long-term implications, i.e. its effects will extend into the future, and will have to be endured for a longer period than the consequences of current operating expenditure. Because, a proper investment decision can yield spectacular returns, whereas a wrong investment decision can endanger the very survival of the firm.
That is why it may state that the capital budgeting decisions determine the future destiny of the firm. Moreover, it also changes the risk complexion of the enterprise. When the average benefits of the firm increase as a result of an investment proposal which may cause frequent fluctuations in its earnings that will become a risky situation.
4] Capital budgeting requires a large number of funds:
Capital investment decisions require a large number of funds which the majority of the firms cannot provide since they have scarce capital resources. As a result, the investment decisions must be thoughtful, wise and correct. Because a wrong/incorrect decision would result in losses and the same prevents the firm from earning profits from other investments as well due to the scarcity of resources.
5] Capital budgeting is not reversible:
Once the capital budgeting decisions take, they are not easily reversible. The reason is that there may neither be any market for such second-hand capital goods nor there is any possibility of conversion of such capital assets into other usable assets, i.e., the only remedy is to dispose-off the same sustaining a heavy loss to the firm.
They are the most difficult decisions:
Capital investment decisions are, no doubt, the most significant since they are very difficult to make. It is because their assessment depends on the future uncertain events and activities of the firm. Similarly, it is practically a difficult task to estimate the accurate future benefits and costs in terms of money as there are economic, political and technological forces that affect the said benefits and costs.
Limitations of Capital Budgeting:
Capital budgeting techniques suffer from the following limitations:
- All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances.
- The techniques of capital budgeting require the estimation of future cash inflows and outflows. The future is always uncertain and the data collected for the future may not be exact. Obliviously the results based on wrong data may not be good.
- There are certain factors like the morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.
- Urgency is another limitation in the evaluation of capital investment decisions.
- Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.