WHAT IS CAPITAL BUDGETING?
Capital budgeting is
a company’s formal process used for evaluating potential expenditures or
investments that are significant in amount. It involves the decision to invest
the current funds for addition, disposition, modification or replacement of
fixed assets. The large expenditures include the purchase of fixed assets like
land and building, new equipments, rebuilding or replacing existing equipments,
research and development, etc. The large amounts spent for these types of
projects are known as capital expenditures. Capital Budgeting is a tool
for maximizing a company’s future profits since most companies are able to
manage only a limited number of large projects at any one time.
Capital budgeting
usually involves calculation of each project’s future accounting profit by
period, the cash flow by period, the present value of cash flows after
considering time value of money, 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
is the total investment of the company and budgeting is the art of building
budgets.
FEATURES OF CAPITAL BUDGETING
1) It involves high
risk
2) Large profits are
estimated
3) Long time period
between the initial investments and estimated returns
CAPITAL BUDGETING PROCESS:
A) Project identification and generation:
The first step
towards capital budgeting is to generate a proposal for investments. There
could be various reasons for taking up investments in a business. It could be
addition of a new product line or expanding the existing one. It could be a
proposal to either increase the production or reduce the costs of outputs.
B) Project Screening and Evaluation:
This step mainly
involves selecting all correct criteria’s to judge the desirability of a
proposal. This has to match the objective of the firm to maximize its market
value. The tool of time value of money comes handy in this step.
Also the estimation
of the benefits and the costs needs to be done. The total cash inflow and
outflow along with the uncertainties and risks associated with the proposal has
to be analyzed thoroughly and appropriate provisioning has to be done for the
same.
C) Project Selection:
There is no such
defined method for the selection of a proposal for investments as different
businesses have different requirements. That is why, the approval of an
investment proposal is done based on the selection criteria and screening
process which is defined for every firm keeping in mind the objectives of the
investment being undertaken.
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.
D) Implementation:
Money is spent and
thus proposal is implemented. The different responsibilities like implementing
the proposals, completion of the project within the requisite time period and
reduction of cost are allotted. The management then takes up the task of
monitoring and containing the implementation of the proposals.
E) Performance review:
The final stage of
capital budgeting involves comparison of actual results with the standard ones.
The unfavorable results are identified and removing the various difficulties of
the projects helps for future selection and execution of the proposals.
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