Capital Budgeting

Capital Budgeting is a first step of an investment decision. Every new business required proper plan to execute. Capital Budgeting gives a proper estimation of fund, which is required to start or run a business. Capital means the fund or resource available for investing. Budgeting is the numerical aspect of planning. Decision or decision-making is the process of deciding whether alternative action is to be undertaken or not. In this way, capital budgeting decision is the process under which different investment alternatives are evaluated and the best alternative is selected. In other words, Capital Budgeting decision is concerned with the long-term investment decision i.e. making capital expenditure. Capital budgeting is a decision process, which include investment, evaluation, planning and financing major projects of an organisation. It is a part of long term planning and selection of best investment alternative. This process is called “Capital Budgeting Decision”.

Objectives of Capital Budgeting

To find out Capital Expenditure.
To find out Profitability in a business.
To find out the best alternative options for the Project.
To access the various sources of finance for capital expenditure.
To evaluate the merits of each proposals to decide which project is best.

Importance of Capital Budgeting

Long Term Goal

Capital Budgeting helps companies to predict long-term goals and make decisions according to it. For the growth & prosperity of the business, long-term goals are very important for any organization. A wrong decision can be disastrous for the long-term survival of the firm. Capital budgeting has its effect in a long time span. It also affects companies future cost & growth.

Need of Large Funds

Capital Budgeting is important in choosing the best alternative option for capital investment. Capital Investment requires a large number of funds. As the companies have limited resources, the company has to make a wise & correct investment decision. The wrong decision would harm the sustainability of the business. The large investment includes the purchase of an asset, rebuilding or replacing existing equipment.

Irreversible Decisions

The capital Investment decisions are generally irreversible, as it requires large amounts of funds. It is difficult to find the market for that asset. The only way remains with the company is to scrap the asset & incur heavy losses.

Transform of information

Capital Budgeting is an information, which is helpful for the decision makers within an Organisation. The time that project starts off as an idea, it is accepted or rejected; numerous decisions have to be made at a various level of authority. The capital budgeting process facilitates the transfer of information to appropriate decision makers within a company.

Maximization of Wealth

Capital Budgeting is been made with an interest of making profit in the given respect of time. Long-term investment decision of the organization helps in safeguarding the interest of the shareholder in the organization. If the organization has invested in a planned manner, the shareholder would also be keen to invest in that organization. This helps in the maximization of wealth of the organization. Any expansion is fundamentally related to further sales and future profitability of the firm and assets acquisition decisions are based on capital budgeting.

Types of Capital Budgeting Decisions:

Accept – Reject Decisions or Acceptance Rule

Acceptance Rule state that those proposal, which yield a high rate of return in comparison with a return of the second proposal then we should accepts the highest one. Capital Budgeting always make a sense of choosing best alternative with benefits. For example, If a Project 1 yield a return of 10% after tax deduction and Project 2 yield a return of 8% after tax deduction then we can say that Project 1 shows a best alternative and should be accepted.

Mutually exclusive Project

If we have two options for accomplishing a project, then we choose the best alternative and second one is automatically excluded from the decision process. For Example, if there is a need to transport supplies from a loading dock to the warehouse, the firm may adopt two proposals, viz., (a) fork lifts to pick up the goods and move them, or, (b) a conveyor belt may be connected between the dock and the warehouse. If one proposal is accepted, it will eliminate the other.

Capital Rationing Decisions

Rationing is a process of restriction on the non-priority acceptable proposals. Capital rationing is normally applied to situations where the supply of funds to the firm is limited in some way. In other words, it occurs when a firm has more acceptable proposals than it can finance. At this point, the firm ranks the projects from highest to lowest priority and, as such, a cut-off point is considered. Naturally, those proposals which are above the cut-off point will be accepted and those which are below the cut-off point are rejected, i.e., ranking is necessary to choose the best alternatives.