Capital Budgeting
What is Capital Budgeting?
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment. An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments. Capital budgeting as a concept affects our daily lives.
Let’s look at an example-
Your mobile phone has stopped working! Now, you have two choices: Either buy a new one or get the same mobile repaired. Here, you may conclude that the costs of repairing the mobile increases the life of the phone. However, there could be a possibility that the cost to buy a new cell phone would be lesser than its repair costs. So, you decide to replace your cell phone and you proceed to look at different phones that fit your budget!
What are the objectives of Capital budgeting?
Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.
The following are some other 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.
Principles of Capital Budgeting
Capital budgeting has five principles that play a crucial role in the allocation of money and the process of capital budgeting. The five principles are;
(1) decisions are based on cash flows, not accounting income,
Relevant cash flows are based on incremental cash flows. This represents the changes in cash flow if the project is undertaken. Aspects of cash flow that affect capital budgeting are sunk costs and externalities. These are both costs that cannot be avoided. Sunk costs are costs that are unavoidable, even if the project is undertaken. Externalities are side effects of a project that affect other firm cash flows.
(2) cash flows are based on opportunity cost,
Cash flows are based on opportunity cost. In other words, it is the cash flow that will be lost due to the financing of a project. These are cash flows that are accumulated by assets the firm already owns and would be sunk if the project under consideration is undertaken.
(3) The timing of cash flows are important,
The timing of cash flow is crucial because it is dependent on the time value of money. Cash flow that is received now will be worth more in the future if it were to be received later.
(4) cash flows are analyzed on an after tax basis,
Cash flows are measured on an after tax basis. It is useless to measure cash flow before taxes because it is not its present value. Firm’s value is based on cash flow that a firm gets to keep, not the money that is sent to the government.
(5) financing costs are reflected on project’s required rate of return.
Financing costs are reflected on project’s required rate of return. Rate of return is an aspect of financing that has potential risks. Project’s that are expected to have a higher rate of return than their cost of capital will increase the value of the firm.
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