Oct 17,2020 | 3 min read

Capital Budgeting By Lawyered.in

Introduction

We all in our daily lives get acquainted with the concept of Capital Budgeting. Let’s say when our laptops don’t work properly or gets damaged then we think of either repairing it or buying a new one. The cost of both options is somewhat similar. Repairing it may give the laptop some life but no guarantee that it would run smoothly as it did before. Buying a new one will add extra features and long life. So, going with the option of buying a new laptop that fits the budget and adds extra or the same features are what in the management world called Capital Budgeting.

Meaning

Capital Budgeting is made of two words Capital and Budgeting. It is a process where long term investment and the cost incurred is analyzed to get higher returns on investments. The management has to take various decisions as to investment in which project will yield higher rates of return than the cost.

It includes investment in fixed assets. The future of a company depends upon such investments. It also boosts the shareholder's value. 

Objectives: 

Capital Budgeting serves the following objectives:

  1. Indulging in Profitable Projects: 

There is always a restriction on the capital of the organization. So a company needs to indulge in those projects which would give it higher profits.

  1. Controls Capital Expenditure:

Capital budgeting helps in controlling capital expenditure by forecasting the capital expenditure, budgeting it, and assuring that no future investment opportunities are missed.

  1. Funds allocation in the right way:

Capital Budgeting requires the funding of an investment proposal. It makes it easy to allocate the fund in the right direction which would bring higher returns to the organization in the future.

How Capital Budgeting is done?

The Capital Budgeting is done through the following process:

  1. Identifying Investment Opportunities: 

An organization has to identify various investment opportunities around it. So it needs to scan the environment regularly to identify the opportunity. 

  1. Evaluating Investment Proposals:

Once the opportunity is being identified the next step is to evaluate those opportunities. Like if the organization wants to expand itself, it has to evaluate the steps for the expansion. Like for expanding its product line, the organization has the following options:

  • In-house manufacturing 

  • Outsource Manufacturing

  • Purchasing from market

  1. Selecting a profitable investment:

After evaluating the options the company needs to finally select the one with high investment and less cost. The company may use various techniques like capital rationing to select the best one.

  1. Capital Budgeting and Apportionment:

After evaluating what is to do now the organization has to allocate funds to the project. For this, the source of funds is identified first and then the fund is allocated accordingly.

  1. Performance Review: 

In this step, the organization compares the actual performance with the expected return. This will help the organization to know the drawbacks and the actual return it is getting from capital budgeting.

Techniques of Capital Budgeting:

Capital Budgeting is a very important process in any organization as it decides the future of the organization. So for Capital Budgeting, the organization resorts to various techniques to ascertain the best investment for it. Some of the techniques are:

  • Payback period method: This technique involves the calculation of the time needed to earn the initial investment and the investment with a shorter period is chosen.

  • Net Present Value: 

Here the difference between the present value of cash inflow and cash outflow are taken over a period of time. The net present value in positive is being chosen. 

  • Accounting Rate of Return:

It involves the total net income of investment to be divided by the initial investment. It gives the most profitable investment.

  • Internal Rate of Return:

The investment with a higher IRR is bring chosen here.

  • Profitability Index:

It is the ratio of the present value of future cash flows to the initial investment of the project.

  • Traditional Method: 

It involves a preferable investment project with the term and return of the project in the mind. It does not take into account the time value of money.

Conclusion

Every organization needs to do capital budgeting to earn higher profits. There are many advantages of Capital Budgeting to businesses. It does not only help them grow from a different perspective but also adds value to its shareholders. It also helps an organization to survive in the market. 

Whole performing Capital Budget process organization needs to be very clear about the investment with higher returns and they should choose the proposals accordingly. Even a single mistake can incur a huge loss to the organization. A right decision can open up many opportunities or paths but only one wrong decision can make the whole organization collapse rendering huge losses. So it is advisable to choose the investment projects wisely. 

Webliography:

  1. Capital Budgeting, Retrieved from https://cleartax.in/s/capital-budgeting

  2. An Introduction to Capital Budgeting, Retrieved from https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp

  3. Capital Budgeting: Meaning, Process, and Techniques Retrieved from https://quickbooks.intuit.com/in/resources/budget/capital-budgeting/


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