Capital Budgeting: Introduction and Process
What is Capital Budgeting?
Capital Budgeting refers to the company’s formal process that is used for assessing potential expenditures or investments that are substantial in amount. This process includes a decision that invests the current funds for addition, disposition, modification or replacement of fixed assets. The huge expenditures include the purchases of fixed assets; land and building, new equipment, research, and development etc. The large amounts used in these types of projects are known as Capital Expenditure. Capital Budgeting is a tool that is used to maximize the future profits of the company.
Capital Budgeting mainly involves the calculation of every project’s future profit by period, the flow of cash by period, the current value of cash flows, an assessment of risk and various other factors.
Capital is the total investment of the company and budgeting is the right art of creating budgets.
Features of Capital Budgeting
- It includes higher risks
- Huge profits are projected
- Long time period between the initial investments and the approximated returns
Capital Budgeting Process
- Project Identification and Generation
The initial step towards capital budgeting is to produce a proposal for the funds. There could be various reasons to take up investments in the business. It may be the addition of a new product line or expanding the current one. The proposal may either be to increase the production or reduce the costs of results.
- Project Screening and Evaluation
This step mainly involves the selection of the correct criteria to judge the capability of the proposal. This has to match up with the organizational objectives with the motive of expanding the market value. The tool of the time, value of money comes handy in this step. Also, the assessment of benefits and costs needs to be done rightly. The total inflow and outflow of the cash need to be analyzed and suitable provisioning needs to be done for the same.
- Project Selection
There is no such specific method that can be used to select a proposal for the investments. This is because different businesses have different business needs. This is the reason why the consent of investment is done on the basis of the selecting criteria and the screening process. Every business has its own defined process according to the investment objectives. Once a proposal has been finalized, the finance team needs to explore the different alternatives in order to acquire funds. The final approvals are based on productivity, feasibility and market conditions.
Money is consumed and thus the proposal is applied. Implementing the proposals, project completion within a time period, reduction of cost etc. are some of the various responsibilities. The organization then takes up the task of monitoring and containing the execution of the proposals.
- Performance Review
The last and final stage of capital budgeting includes the comparison of the actual results with the standard ones. The unwanted and unfavorable results are recognized and various difficulties of the projects are removed.
- Capital Budgeting Decisions
The core of capital budgeting is profit maximization. There are two ways to do the same; either increase the number of revenues or reduce the costs. The rise in the revenues can be achieved by the expansion of the operations by adding a new line of product. Reduction of costs means demonstrating obsolete return on the assets.
- Accept/ Reject Decision: If the proposal is accepted, the firm capitalizes in it and if it is rejected the firm doesn’t participate. Usually, the proposals that yield a higher rate of return than a certain required return rate or cost of capital are accepted and others are rejected. All the autonomous projects are accepted. The projects that don’t compete with other projects and give unbiased acceptance of another.
- Mutually Exclusive Project Decision: Mutually exclusive projects compete with the other projects in such a way that the acceptance of one will exclude the acceptance of the other ones. Mutually exclusive investment decisions gain importance when more than one proposal is acceptable under the accept and reject decision. The acceptance of the best alternative eradicated the other alternatives.
- Capital Rationing Decision: In a situation where the organization has unlimited funds, the process of capital budgeting becomes very simple. In this, the independent investment proposals that yield a higher return than the predetermined levels are accepted.