Importance and Methods Of Capital Budgeting
In an ideal world, companies would explore all projects and opportunities that increase shareholder value and profit. Because the quantity of capital or money available for new projects in every firm is limited, management employs capital budgeting strategies to assess which initiatives will provide the best return over a given period.
What is a Capital Budgeting?
Capital budgeting is a method of evaluating assets and expenses in order to maximize return on investment. It entails deciding whether to invest current funds in fixed asset additions, dispositions, customizations, or replacements.
The purchase of fixed assets such as land, buildings, and repairing or replacing existing equipment are examples of substantial expenditures. Capital Expenditures is the term given to big investments like this.
An approach for increasing a company’s future earnings is capital budgeting. It often entails calculating each project’s future accounting profit by period, cash flow by period, and the present value of cash flow by taking the time value of money into the account.
Features of Capital Budgeting
Capital budgeting involves
- Large profit estimated
- Long time period between the initial investment and estimated returns.
Capital Budgeting Methods
1. Net Present Value Analysis
Calculate the net change in cash flows connected with the purchase of a fixed asset and discount them to present value. Then, until funds run out, compare all proposed projects with positive net present values and accept the ones with the highest net present values.
The future cash flows connected with a project are unknown and subject to manipulation, which is a risk with employing net present value analysis. As a result, forecasted cash flows can be altered in order to ensure that a project is approved.
This supposedly quantitative analysis method is actually subject to qualitative alterations that can significantly impact the decision outcome.
2. Constraint Analysis
In a manufacturing context, identify the bottleneck machine or work center and invest in fixed assets that maximize the utilization of the bottleneck activity. Because they are confined by the bottleneck operation, businesses are less likely to invest in areas downstream from the bottleneck and more likely to invest upstream from the bottleneck (since additional capacity there makes it easier to keep the bottleneck fully supplied with inventory).
This is likely the most effective capital budgeting analysis technique, as it constantly leads to capital investments that boost earnings.
3. Avoidance Analysis
Determine whether additional maintenance, rather than investing in new assets, can be used to extend the life of current assets. This study can significantly reduce a company’s overall fixed asset investment.
This is a particularly helpful alternative when the incremental maintenance cost is low, such as when a major equipment overhaul is not required.
However, upgrading to new technology may make more sense when the skills required to maintain present equipment are so difficult to come by that the company would be in danger if its maintenance people left.
4. Discounted Cash Flow Analysis
Discounted cash flow (DFC) analysis looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs
5. Payback Analysis
Payback analysis is the simplest form of capital budgeting analysis, but it’s also the least accurate. It’s still widely used because it’s quick and can give managers a “back of the envelope” understanding of the real value of a proposed project.
Payback analysis determines how long it will take to return an investment’s costs. The payback period is calculated by dividing the project’s original investment by the project’s expected average annual cash inflow. For example, if the original cash outlay is $400,000 and the project earns $100,000 in revenue each year, it will take four years to return the investment.
Importance of Capital Budgeting
The amount of money invested in a fixed asset investment could be so huge that if the venture fails, the company could go bankrupt. As a result, capital budgeting is a requirement for major fixed asset proposals.
Smaller investments are less of an issue; in these cases, it is better to streamline the capital budgeting process significantly, so that the focus is more on getting the investments made as quickly as possible; by doing so, profit centers’ operations are not hampered by the analysis of their fixed asset proposals.
Capital budgeting decisions are critical for any organization since they determine the following :
(a) Whether or not funds should be invested in long-term projects such as the setting up an industry, purchase of plant and machinery, etc.
(b) Analyze the proposal for expansion or creating additional capacities.
(c) To decide the replacement of permanent assets such as building and equipments.
(d) To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.
The Importance of Capital Budgeting May arise due to the following
The following are some of the reasons why the need for capital budgeting may become essential.
(1) Large Investments:
Large sums of money are typically invested in capital budgeting decisions. However, the firm’s funds are always limited, and the demand for capital considerably outnumbers the resources. As a result, it is critical for a company to plan and manage its capital spending.
(2) Long-term Commitment of Funds:
Capital expenditures include not just substantial sums of money, but also monies that will be used in the long run or on a more or less permanent basis. The financial risk associated with an investment decision is increased by a long-term commitment of funds. The bigger the risk, the more rigorous capital spending planning, i.e. capital budgeting, is required.
(3) Irreversible Nature:
Capital spending choices are final and cannot be reversed. Once you’ve made the decision to buy a long-term asset, it’s quite tough to get rid of it without losing a lot of money.
(4) Long-Term Effect on Profitability:
Capital budgeting decisions have a long-term, considerable impact on a company’s profitability. The firm’s current earnings are influenced by capital asset investments, but the firm’s future growth and profitability are also influenced by today’s investment decision. An ill-advised decision could be calamitous and lead to the company’s demise. To avoid overinvesting or underinvesting in fixed assets, capital budgeting is critical.
Limitations of Capital Budgeting
- All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances.
- The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obliviously the results based upon wrong data may not be good.
- There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.
- Urgency is another limitation in the evaluation of capital investment decisions.
- Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.