The plans of a business to modernize or apply long-term investments will influence the cash budget in the current year.
For this reason, capital expenditure decisions must be anticipated in advance and integrated into the master budget.
Capital budgeting is the planning of expenditure whose return will mature after a year or so. Thus, it is a process of deciding whether or not to commit resources to a project whose benefit would be spread over the years.
The objective of capital budgeting is to rank the various investment opportunities according to the expected earnings they will yield. The total capital (long/short term) of a company is used in fixed assets and current assets of the firm.
In the case of fixed assets, these refer to assets that are not intended for resale. Examples include land and buildings, plant and machinery, and furniture.
It is a challenging task for management to make a judicious decision regarding capital expenditure (i.e., investment in fixed assets).
In particular, the amount invested in fixed assets should ideally not be locked up in capital goods, which may have a far-reaching effect on the success or failure of an enterprise.
A capital asset, once acquired, cannot be disposed of without substantial loss. If these are acquired on a credit basis, a continuous liability is incurred over a long period of time.
It is, therefore, required to exercise long-range planning when making decisions about investments in capital expenditure. This is known as capital budgeting.
Definitions of Capital Budgeting
Several important definitions of capital budgeting are given below:
1. Charles T. Harngreen: “Capital budgeting is long term planning for making and financing proposed capital outlay.”
2. Richards and Green Law: “Capital budgeting generally refers to acquiring inputs with long-run returns.”
3. G.C. Philiphatos: “Capital budgeting is concerned with the allocation of a firm’s scarce financial resources amongst available market opportunities. The consideration of the expected future streams of earnings from a project, with the immediate and subsequent streams of expenditure for it.”
It is worth highlighting that the capital budget is prepared separately from the operating budget. It lists projects for the acquisition of new assets. Furthermore, each proposal needs justification.
A lump sum is often included in the capital budget for projects that are not large enough to warrant individual consideration.
Capital Budget Projects
Capital budgeting represents the plans for appropriations of expenditure for fixed assets during the budget period. Capital budget projects are generally classified under the following headings:
- New asset acquisition
- Cost reduction and replacement
- Expansion of existing product lines
- New products
- Health and safety
- Legal requirements
Approval of capital projects in principle does not provide authority to proceed. Some worthwhile projects may not be approved because funds are not available.
Follow-ups on capital expenditures include checks on the spending itself and the comparison of how close the estimates of cost and returns were to the actual values.
If there are wide variances, then a revised capital budget may be necessary to provide additional resource appropriation.
Nature of Capital Budgeting
There are several essential aspects in the nature of capital budgeting. These are:
1. Huge Investment: Capital expenditure is a huge investment plan for acquiring or expanding fixed assets.
2. Long-term Investment: Capital expenditure is not only a huge investment plan but also a long-term investment whose return will be available after a considerable period of time.
3. Futuristic Investment: Capital budgeting is a futuristic investment. It is a forecasting of several years profitability of several years.
4. Effect of Wrong Selection: Any error in the evaluation of a proposal may lead to serious consequences.
5. Permanent Commitment of Funds: The funds involved in capital expenditure are not only huge but also long-term decisions. The longer the time, the longer the period for which risks are involved.
6. Investment Decision: Long-term capital expenditure decisions are always complex. This is because long-term decisions are always associated with risk and uncertainty. For this reason, management should strive to make judicious decisions.
7. Wealth Maximization: Capital expenditure directly influences a firm’s financial health, and the aim should be to avoid over-investment and under-investment in fixed assets.
Further to the last point, careful management must select those proposals with greater profitability. This enables them to maximize shareholder wealth, which is the basic objective of each company.
Need and Importance of Capital Budgeting
Choosing the most profitable capital expenditure proposal is a key function of a company’s financial manager. As mentioned earlier, these are long-term and substantial capital investments, which are made with the intention of increasing profits in the coming years.
The need for capital budgeting can be highlighted as follows:
1. Heavy Investment: All capital expenditures are long-term investments and also involve huge sums that are collected from various external and internal sources. Thus, these funds pose a serious problem for capital investment planning.
2. Permanent Commitment of Funds: Capital budgeting is a long-term decision that has far-reaching effects. A poor capital expenditure decision may lead to unnecessarily heavy operating costs.
3. Guard Against Risk and Uncertainty: Capital expenditure decisions are more sophisticated and carry more risk and uncertainty compared to acquiring capital assets, which is a continuous process. Therefore, management must always be judicious.
4. Irreversible Decisions: Capital expenditure not only involves heavy investment but also irreversible decisions. In particular, the amount invested cannot be taken back without heavy financial losses.
5. Ranking of Investment Programs: Capital expenditure requires substantial investment, which is not easy to procure. Careful cash forecasts are needed to ensure that financial requirements are met at the right time.
6. Wealth Maximization: Capital expenditure is a long-term financial planning activity that benefits the interest of shareholders. It guards against over- and under-investment in fixed assets.
In this context, the most profitable projects are selected. There is every possibility that shareholders will derive the maximum benefit, which in turn results in wealth maximization.
7. Useful for Sound Depreciation Policy: Capital expenditure planning is a useful technique in depreciation policy and the replacement of fixed assets.
8. Cost Reduction: Capital budgeting is useful for cost reduction. The most modern machine is purchased whose capacity is greater than the old one, which means that the per-unit cost of output falls.
9. Replacement of Men by Machines: In the modern setup, all forms of government are assigning more importance to the labor force, and due to changing economic conditions, it is useful to replace manual work with machines.
Capital Budgeting Procedure
The steps involved in capital budgeting are the following:
1. Selection of Profitable Proposals: The starting point in capital expenditure planning is the conception of a profit-making idea. Such a proposal may come from the low level or from a high level.
All proposals are studied with seriousness in terms of investment and risk. These proposals, along with ranks, are sent to the Capital Expenditure Planning Committee (CEPC) for consideration.
2. Screening Proposals: In all large organizations, the CEPC is formed in order to screen the proposals received from various heads of departments or top executives.
The CEPC studies these proposals with long-range and sends them to the board of directors for final approval.
3. Evaluating Proposals: The next important point in capital budgeting is to evaluate different proposals in reference to investment, period of return, life of the proposal’s assets, and other factors. Various techniques are used to evaluate capital budgeting proposals:
- Degree of urgency method
- Payback period method
- Return on investment method
- Discount cash flow method
4. Ranking/Priority: Once the screening process is over, the uneconomical or non-profitable proposals are dropped. Profitable projects are selected and ranked. The best criteria of priority are:
- Current and incompleted projects are given top priority
- Projects of safety, as prescribed by state laws, are given priority
- Projects for maintaining the present efficiency of the firm are prioritized
- Projects leading to additions in income are given priority
- Projects for expansion of new product are prioritized
5. Final Approval: The proposals that are finally recommended by the CEPC are sent to the top management, along with detailed reports on the capital investment required and financing strategies.
These are subsequently sent to the budget committee to incorporate them into the capital budgeting.