Learn All About Capital Budgeting

Learn about capital budgeting, different capital budgeting techniques, characteristics, limitations, and much more.

The primary purpose of companies is to obtain greater profitability at the lowest cost and within the shortest time to recover investments quickly. Thus it is essential to carry out capital budgeting to maintain and survive the fluctuations that may lead to the failure of a project or a company’s operations. The cost of capital must offer a minimum return so that the investment can add value to the company. 

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The capital budget is used for planning expenses that correspond to the company’s assets, whose economic benefits are expected to be developed in terms greater than one fiscal year. Learn more about capital budgeting in this blog.

Content 

• What is Capital Budgeting?
• Why is Capital Budgeting Important?
• When Do We Need A Capital Budget?
• Process of Capital Budgeting
• Characteristics of Capital Budgeting
• Objectives of Capital Budgeting
• Capital Budgeting Methods
• Limitations Of Capital Budgeting

What is Capital Budgeting?

“Capital budgeting is the process of planning and managing the company’s long-term investments”. Gómez S. (2015)

This process enables the managers to identify, develop and evaluate investment opportunities that can be profitable for the company. This evaluation is made by checking whether the cash flows that the investment in an asset will generally exceed the flows required to carry out the said project”.

To carry out the evaluation, it is necessary to be clear about the concepts required to prepare the capital budget. In general, it is necessary to collect the primary data of the investment project, such as the initial investment cost, estimated income, variable costs, fixed costs, and financing data.

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Some examples of capital expenditure are – 

• Costs involved in acquiring permanent assets like real estate (building, land), plant and equipment, etc.
• The cost involved in the expansion and improvement of fixed assets.
• Cost of replacing permanent assets.
• Project research and development costs, etc.

Why is Capital Budgeting Important?

Capital budgeting is important because asset expansion usually involves huge expenses, and before a company can spend a large amount of money, it must have sufficient funds available. Therefore, a company contemplating a major capital expenditure program should set up its financing several years in advance so that the required funds are available.

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When Do We Need A Capital Budget?

Some scenarios in which a company needs a capital budget imperatively are as follows:

• Territorial expansion.
• Conversion of the business to franchise.
• Acquisition of companies from other countries as subsidiaries.
• Investment in human capital based on advanced training.
• Renewal of non-current assets, such as machinery or vehicle fleet.
• Business line expansion.

These are some of the cases in which the company may require significant investment and techniques and in which it must be carefully studied whether the investment will have an impact in the usual way.

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Process of Capital Budgeting

Following are the steps of the capital budgeting process:

Idea Generation

Generating good investment ideas is the first step to capital budgeting. These investment ideas can come from senior management, functional areas, employees, or sources outside the company.

Proposal Analysis

A manager gathers information to forecast each project’s cash flows and determine its expected profitability. The acceptance or rejection of the capital investment decision is based on the future expected cash flows of the investment.

Capital Budget Planning 

Businesses must prioritize profitable projects according to the project’s cash flows, available resources, and business strategies. Thus, prioritizing and scheduling projects is essential because of financial and other resource issues.

Monitoring and Conducting a Post Audit

A finance manager then tracks the capital budgeting decisions and compares actual with projected results. He must then explain why projections did not match actual performance. Therefore, a systematic post-audit is essential to find systematic errors in forecasting and improve company operations. 

Remember – 

• Analysis of the incremental cash flows is the net cash flows that the company will receive if it undertakes the new project from year 1 to year 5.
• The initial investment is the cash flow available for said investment.
• The project receives differential cash flows during its lifetime.
• Terminal cash flows are those shown at the end of the project.

Characteristics of Capital Budgeting

The following features characterize Capital Budgeting:

• The duration between the initial investments and the expected returns is long
• Organizations usually estimate immense profits
• The process implicates high risks
• It is a long-term and fixed investment
• All projects require significant amounts of funding
• The amount of investment made in the project determines a company’s profitability
• Offers the possibility of radically changing the financial policy of the company

Objectives of Capital Budgeting

Capital budgeting aims to –

• Balance the different financial sources, depending on the investments that the organization intends to make
• Determine the optimal financial structure, with an adequate proportion between own and external resources, trying to keep the cost of capital as low as possible
• Facilitate the preparation of forecast accounting statements and operating budgets

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Capital Budgeting Methods

Methods used to evaluate fixed assets under a formal capital budgeting system are as follows – 

Net Present Value (NPV) Analysis

NPV analysis method analyzes and determines the net change in cash flows associated with a fixed asset acquisition and discounts them to their current value. 

The proposed projects with positive net present values are compared, and the ones with the highest net present values are considered. 

NPV = (Present value of cash inflows – Initial investment)

Decision Criteria:

• If the NPV is greater than 0, the project is accepted
• If the NPV is less than 0, the project is rejected

If the NPV exceeds 0, the firm will earn a return greater than its cost of capital, increasing the company’s market value and, consequently, the owner’s wealth.

One issue with NPV analysis is that the future cash flows within a project are uncertain and subject to manipulation. This issue can only be discovered when you compare actual to projected cash flows.

In short, NPV analysis is subjected to qualitative alterations, which can significantly impact the decision outcome.

Constraint Analysis

The constraint analysis method allows you to examine the impact of a proposed project on the bottleneck operation of the business. You can then invest in fixed assets that maximize the utilization of the bottleneck operations. 

This approach enables businesses to invest upstream from the bottleneck. This is the best capital budgeting analysis tool since it consistently results in capital investments that enhance business profits.

Payback Period

The payback approach helps determine the time needed to generate sufficient cash flow from a project to pay for its initial investment. It is a risk measurement technique that focuses on the time the investment is at risk of not being repaid to the company. This method helps to supplement the preceding two analysis methods.

The challenge with this method is that it does not measure the goal of maximizing wealth because it is not based on discounting cash flows to determine whether they increase the company’s value. Another disadvantage of this method is that it needs to fully capture the time value of money. It needs to consider the cash flows that occur after recovery.

Avoidance Analysis

Avoidance analysis helps determine if the life of existing assets can be prolonged with increased maintenance without investing in replacement assets, particularly fixed ones. 

This method is helpful if the incremental maintenance expenses are low. For example, there is no need for a major equipment overhaul. 

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What Are The Limitations Of Capital Budgeting?

Capital budgeting limitations are as follows:-

• It has long-term implementations in business operations. Capital budgeting can’t be used for short terms. A wrong decision in the early stages of the project can affect the company’s long-term survival. 
• An inadequate investment makes it challenging for businesses to enhance their budget and capital.
• Capital budgeting involves huge funds, so the decision must be taken carefully.
• Decisions in capital budgeting could be more adaptable as locating the market for capital goods takes work.
• Capital budgeting decisions have a long-term and significant effect on the business’s profitability.
• Higher degrees of risks involved.

Key points

• Companies use the capital budget to evaluate large projects and investments, such as new plants or equipment.
• The process involves analyzing a project’s cash inflows and outflows to determine if the expected return meets a preset benchmark.
• The main capital budgeting methods include Net Present Value (NPV) Analysis, Constraint Analysis, Payback Period, and Avoidance Analysis.

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