Financial decision-makers within a company or organization use capital budgeting to make well-informed decisions. It is used for evaluating potential expenditures or investments that are significant in amount. It involves the decision to invest the current funds for the addition, disposition, modification, or replacement of fixed assets.
Capital budgeting, also known as an investment appraisal, is a financial management tool you can ensure it is adding the expected value and continue to measure the progress of the project. It determines the number of years it takes for a project’s cash flow to pay back the initial cash investment, an assessment of risk, and various other factors
Capital budgeting is an important financial management tool because when you need to assess and rank the value of projects or investments that require a large capital investment to determine whether they are worth pursuing. For example, investors can use capital budgeting to analyze investment options and decide which ones are worth investing in.
What are the Features of Capital Budgeting?
The features of capital budgeting are briefly explained below:
- Huge Funds: Capital budgeting involves the investment of funds currently for getting benefits in the future.
- High Degree of Risk: To take decisions that involve a huge financial burden can be risky for the company.
- Affects Future Competitive Strengths: The future benefits are spread over several years. Sensible investing can improve its competitiveness, whereas a wrong investment may lead to business failure.
- Difficult Decision: When the future is dependant on capital budgeting decisions, it becomes difficult for the management to grab the most appropriate investment opportunity.
- Estimation of Large Profits: Each project involves a huge amount of funds with the perspective of earning desirable profits in the long term.
- Long Term Effect: The effect of the decisions taken, will be visible in the future or the long term.
- Affects Cost Structure: For instance, it may increase the fixed cost such as insurance charges, interest, depreciation, rent, etc.
- Irreversible Decision: Capital expenditure decisions are irreversible since it involves a high-value asset which may not be sold at the same price once purchased.
What are the Objectives of Capital Budgeting?
To know more about the necessity of capital budgeting for the companies, let us go through the following objectives:
- Control of Capital Expenditure: Estimating the cost of investment provides a base to the management for controlling and managing the required capital expenditure accordingly.
- Selection of Profitable Projects: The company has to select the most suitable project out of the multiple options available to it. For this, it has to keep in mind the various factors such as availability of funds, project’s profitability, the rate of return, etc.
- Identifying the Right Source of Funds: Locating and selecting the most appropriate source of funds required to make a long-term capital investment is the ultimate aim of capital budgeting. The management needs to consider and compare the cost of borrowing with the expected return on investment for this purpose.
Capital Budgeting Process:
- Project identification and generation:
The company has various options for capital employment on a long-term basis. In the initial stage, the management needs to analyze the strengths and weaknesses of every project for foreseeing the potential of each option.
- Evaluating and Assembling Investment Proposals:
In the next step, the management assembles and compiles all the investment proposals on the grounds of cost, risk involvement, future profits, return on investment, etc.
Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to be explored by the finance team. This is called preparing the capital budget. The average cost of funds has to be reduced. A detailed procedure for periodical reports and tracking the project for the lifetime needs to be streamlined in the initial phase itself. The final approvals are based on profitability, Economic constituents, viability, and market conditions.
After the apportioning of the long-term investment, the company comes into action for the execution of its decision. To avoid complications and excess time consumption, the management should lay out a detailed plan of the project in advance.
The final stage of capital budgeting involves the comparison of actual results with the standard ones. The management needs to measure and correlate the actual performance with that of the estimated one to figure out the deviation and take corrective actions for the same.
Capital budgeting is a predominant function of management. Right decisions taken can lead the business to great heights. However, a single wrong decision can inch the business closer to shut down due to the number of funds involved and the tenure of these projects.