Capital Budgeting: Meaning, Need, Process and Classification | Firms | Economics

In this article we will discuss about:- 1. Meaning of Capital Budgeting 2. Need for Capital Budgeting 3. Process 4. Classification.

Meaning of Capital Budgeting:

Capital budgeting is the process of making investment decisions in capital expenditure. Capital expenditure is an expenditure, the benefits of which are expected to be received over a period of time exceeding one year.

Some of the examples of capital expenditure are listed below:

1. Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill, etc.

2. Cost of addition, expansion, improvement, or alteration in the fixed assets.

3. Cost of replacement of permanent assets.

4. Research and development project cost, etc.

Capital expenditure involves non-flexible long-term commitment of funds. Thus, capital expenditure decisions are also called long-term investment decisions, and capital budgeting involves the planning and control of capital expenditure.

Capital budgeting is the process of deciding whether to commit resources to a particular long-term project whose benefits are expected to be realized over a period of time, which is normally longer than one year.

It can be concluded that the important features of capital budgeting decisions are as follows:

1. They involve the exchange of current funds for the benefits to be achieved in future.

2. The future benefits are expected to be realized over a series of years.

3. The funds are invested in non-flexible and long-term activities.

4. They have a long-term and significant effect on the profitability of the concern.

5. They involve, generally, huge funds.

6. They are irreversible decisions.

7. They are strategic investment decisions, involving large sum of money.

Capital Expenditure Decisions:

Since capital expenditure generally involves large amounts, it is desirable that a proper decision is made in selecting a capital project from amongst a number of alternative proposals. The main factor to be considered at the time of making a choice for a suitable project is the rate of return expected from such a project.

Is this return equal to a suitable project? Is the rate of return expected from such a project? Is this return equal to or greater than that required by investors at the margin? If the answer is yes, capital expenditure may be incurred and if the answer is no, proposals of the expenditure should be dropped.

The various other factors, in addition to the rate of return, which are required to be considered before a final choice of the capital project is made are listed as follows:

1. The amount and timing of cash inflows and outflows – The shorter is the periods within which the cost of the project is recovered, the less risky is the project and the greater is its liquidity.

2. Cost of capital projects – The cost of acquiring the fixed assets, the cash position and the availability of cash either from within or by borrowing should be considered before making a choice of a suitable project. It is futile investing borrowed funds in a capital project if the rate of interest paid on such funds is more than the return expected from such a project. The working capital required when the project goes into operation should also be assessed.

3. Product demand – It should be seen whether there will be sufficient demand in future for the increased production because of additional fixed assets. It is not worthwhile to purchase a fixed asset having not sufficient demand for the increased production.

4. The relative importance of the profit – Sometimes, non-profit projects such as setting up of a hospital or canteen or acquisition of a pollution control device, though not yielding any return on the amount invested, may be given preference over profit earning projects on the grounds of their urgency and essentiality.

5. Opportunity cost – Opportunity or alternative cost should be considered while making a choice of capital expenditure. The return obtainable from the funds, if utilized somewhere else, should be compared with the return expected from the proposed project.

6. Cost of production – The ultimate aim of cost accounting is to reduce cost of production by eliminating all types of wastages. So, the effect of the alternative capital projects on reduction of future cost of production should be studied. The project which reduces cost of production should be favored. Cost reduction should not be at the cost of quality.

7. Other considerations – Besides cost consideration, there are other non-financial factors which influence the choice of a capital project. Sometimes, capital expenditure is incurred to create a favorable image in the minds of the public. For example, investment may be made in schools, colleges, hospitals, and guest houses.

Need for Capital Budgeting:

Capital budgeting means planning for capital assets.

They are vital decisions to any organization, which include the following:

(a) To decide if funds should be invested in long-term projects such as selling of a company, purchase of plant and machinery, etc.

(b) To analyze the proposal for expansion or for creation of additional capacities.

(c) To decide for replacements for permanent assets.

(d) To make financial analysis of various investment proposals and to choose the best out of many alternative proposals.

Process of Capital-Budgeting:

Capital-budgeting decisions involve the following:

(a) Evaluating different proposals on the basis of return expected by the investors of the firm and the return promised by the proposal, and

(b) Applying different techniques to select an alternative with the objective of maximization of value of the firm.

Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefits to be achieved in future; and the future is always uncertain.

Classification of Capital-Budgeting:

The ultimate objective of capital budgeting is to maximize the profitability of a firm or the return on investment. It can be achieved by either increasing the revenues or by reducing the costs.

The decisions in capital budgeting are broadly classified into two categories:

i. Those that increase revenues

ii. Those which reduce costs

The first category includes the decisions to be taken relating to expansion of the production capacity or size of operation by adding a new product line for increasing revenue.

The second category includes the decisions to be taken relating to replacement of obsolete, outmoded, or worn out assets to reduce costs.

Both the categories include the decisions regarding the investment in fixed assets, but the difference between these two is that increasing revenue investment decisions are subject to more uncertainty as compared to cost-reducing investment decision.

Capital-budgeting decisions may also be classified as:

1. Accept-reject decisions

2. Mutually exclusive project decisions

3. Capital-rationing decisions

1. Accept-Reject Decision:

When the investment projects do not compete with each other, accept-reject decisions are taken. Such decisions are compared with a minimum required rate of return or the cost of capital; the one with the highest rate of return is accepted and others are rejected. The firm invests only in the accepted proposal.

2. Mutually Exclusive Project Decisions:

When proposals compete with each other, one proposal is accepted at the cost of the other. For example, a firm intends to replace its machinery, it can either buy a new machine or buy a used machine or even hire an old machine. Thus, the firm by deciding on any one option renders other two options/proposals as rejected.

3. Capital-Rationing Decisions:

When the firm has several profitable investment proposals but due to limited funds, the firm has to ration them.

Rationing implies selection of combination of proposals that will yield the greatest profitability. The investment proposals are ranked in a descending order as per their profitability, and the limited funds are distributed so as to earn maximum returns.