Capital budgeting is a mixture of two words “capital” and “budgeting.” Capital expenditure here means spending the funds of a company for large expenditures such as purchasing fixed assets, repairs to assets, research and development, and expansion of business activities. Budgeting is a technique of setting targets and goals to ensure maximum profitability.
What is capital budgeting?
The process of evaluating investments and huge expenses to obtain the best possible return on investment is known as capital budgeting.
Every organization comes under a difficult situation where it has to face challenges to choose one between two investments, two projects, or buy vs. replace decision. Well, every business wants to invest in all the profitable projects but due to limitations in capital, a business has to choose one between different investments. Capital budgeting not only affects large organizations but it also affects daily lives of people.
Let’s have an example of Capital Budgeting-
You have a mobile phone that suddenly stopped working! Now you have two choices. Either you have to purchase the new mobile phone or get the same mobile phone repaired. You may conclude that the costs of repairing the mobile phone will increase the life of the phone. However, buying a new cell phone will cost lesser than its repair costs. So, you have to choose and pick one. Similarly, organizations need to choose one choice wisely and make a wise capital budgeting decision.
What are the objectives of capital budgeting?
Capital budgeting have a long-term impact on the organizations structure and thus while performing a capital budgeting analysis, companies need to keep the following objectives in mind:
- Select profitable projects: Organizations need to choose their projects and investments wisely. There are many options available to choose from variety of profitable projects but choosing the best out of all is crucial. Due to capital restrictions, one cannot choose every investment or projects and thus, an organization needs to select the right mix of projects that are profitable and increase shareholder’s wealth.
- Capital expenditure control: Selecting the best investment opportunity and the most profitable project is the crucial objective of capital budgeting. However, controlling the capital expenditure is also important. Estimating capital expenditure requirements and budgeting it in a proper way along with ensuring that no investment opportunities are lost is the crux of budgeting.
- Finding the right sources of Fund: The most important goal for capital budgeting is determining the correct sources and quantity of funds. There has to be a correct balance between the cost of borrowing and ROI as the important aspect of capital budgeting.
Capital budgeting process:
The capital budgeting process is as follows:
1. Identifying investment opportunities:
An organization has to be very cautious in identifying an investment opportunity. It can be anything from a new business line to expanding a product to purchasing a new asset. For example, if a company finds new products that suit their business, it can add those products to their product line.
2. Evaluating investment proposals:
After recognizing an investment opportunity, it needs to evaluate the options for investment. For instance, if a business has decided to add new product line in their business, the next step is to how to acquire those products. There might be multiple options. Some of them are:
- Manufacturing in-house
- Outsource manufacturing
- Purchase from the market.
3. Choosing a profitable investment:
Once identifying the investment opportunities and evaluating organizations needs one has to decide the most profitable investment and select it. While selecting the most profitable investment one has to use the technique called as capital rationing where projects are ranked as per returns and then a company has to choose the best option available. In our example, the company has to decide which option is more profitable for them, manufacturing or purchasing the products.
Capital budgeting and apportionment:
After selecting the best possible option, the company needs to fund that particular project. It needs to identify the sources of funds and allocate them in the best possible manner to fund the project and its needs. The sources of funds could be reserves, investments, and loans.
Performance review:
The last and final step of capital budgeting is to review the investment. Initially, the company has estimated a return on investment before choosing that investment. Now, it is the time to compare the actual performance with estimated performance.
How capital budgeting works:
One of the first tasks of an organization during capital budgeting decision is to determine whether the project would be profitable or not. The payback periods (PB), internal rate of return (IRR), and net present value (NPV) methods are the most common techniques for selecting the best project. Detail analysis on these topics will be covered in the next article.
An ideal capital budgeting solution will indicate the same decision. It largely depends upon the management’s preferences and selection criteria, which approach they are going to consider. However, there are many advantages and disadvantages associated with these valuation techniques.
Conclusion:
Capital budgeting is a very predominant method as the correct decision can make the business leading to achieve new heights whereas wrong decisions can break the business, leading to shutting down of the company due to number of funds involved.
In the next article, we will be learning about various capital budgeting methods in detail.
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