Meaning of Capital Budgeting
Capital Budgeting is the process of making investment decision in fixed assets or capital expenditure. Capital Budgeting is also known as investment, decision making, planning of capital acquisition, planning and analysis of capital expenditure etc.
Objectives of Capital Budgeting
The following are the objectives of capital budgeting.
1. To find out the profitable capital expenditure.
2. To know whether the replacement of any existing fixed assets gives more return than earlier.
3. To decide whether a specified project is to be selected or not.
4. To find out the quantum of finance required for the capital expenditure.
5. To assess the various sources of finance for capital expenditure.
6. To evaluate the merits of each proposal to decide which project is best.
Features of Capital Budgeting
The features of capital budgeting are briefly explained below:
1. Capital budgeting involves the investment of funds currently for getting benefits in the future.
2. Generally, the future benefits are spread over several years.
3. The long term investment is fixed.
4. The investments made in the project is determining the financial condition of business organization in future.
5. Each project involves huge amount of funds.
6. Capital expenditure decisions are irreversible.
7. The profitability of the business concern is based on the quantum of investments made in the project.
Limitations of Capital Budgeting
The following are the limitations of capital budgeting.
1. The economic life of the project and annual cash inflows are only an estimation. The actual economic life of the project is either increased or decreased. Likewise, the actual annual cash inflows may be either more or less than the estimation. Hence, control over capital expenditure can not be exercised.
2. The application of capital budgeting technique is based on the presumed cash inflows and cash outflows. Since the future is uncertain, the presumed cash inflows and cash outflows may not be true. Therefore, the selection of profitable project may be wrong.
3. Capital budgeting process does not take into consideration of various non-financial aspects of the projects while they play an important role in successful and profitable implementation of them. Hence, true profitability of the project cannot be highlighted.
4. It is also not correct to assume that mathematically exact techniques always produce highly accurate results.
5. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not be practically true in some particular circumstances.
6. The morale of the employee, goodwill of the company etc. cannot be quantified accurately. Hence, these can substantially influence capital budgeting decision.
7. Risk of any project cannot be presumed accurately. The project risk is varying according to the changes made in the business world.
8. In case of urgency, the capital budgeting technique cannot be applied.
9. Only known factors are considered while applying capital budgeting decisions. There are so many unknown factors which are also affecting capital budgeting decisions. The unknown factors cannot be avoided or controlled.
Rationale of capital budgeting decisions
The rationale behind the capital budgeting decisions is efficiency. A firm has to continuously invest in new plant or machinery for expansion of its operations or replace worn out machinery for maintaining and improving efficiency. The main objective of the firm is to maximize profit either by way of increased revenue or by cost reduction. Broadly, there are two types of capital budgeting decisions which expand revenue or reduce cost.
1. Investment decisions affecting revenue
It includes all those investment decisions which are expected to bring additional revenue by raising the size of firm’s total revenue. It is possible either by expansion of present operations or the development of new product in line. In both the cases fixed assets are required.
2. Investment decisions reducing costs
It includes all those decisions of the firms which reduces the total cost and leads to increase in its total earnings i.e. when an asset is worn out or becomes outdated, the firm has to decide whether to continue with it or replace it by new machine. For this, the firm evaluates the benefit in the form of reduction in operating costs and outlays that would be needed to replace old machine by new one. A firm will replace an asset only when it finds it beneficial to do so. The above decision could be followed decisions following alternative courses: i.e., Tactical investment decisions to strategic investment decisions, as briefly defined below
Tactical investment decisions
It includes those investment decisions which generally involves a small amount of funds and does not constitute a major departure from what the firm has been doing in the past.
Strategic investment decisions
Such decisions involve large sum of money and envisage major departure from what the company has been doing in the past. Acceptance of strategic investment will involve significant change in the company’s expected profits and the risk to which these profits will be subject. These changes are likely to lead stock-holders and creditors to revise their evaluation of the company.