capital budgeting


Contents -

1. Concept and Definition of Capital Budgeting.
2. Features of Capital Budgeting.
3. Types and Process of Capital Budgeting.
4. Factors Influencing Capital Budgeting.
5. Importance/Need of Capital Budgeting.
6. Difficulties in Capital Budgeting.
7. Types of Capital Expenditure Decision/Control.

Concept of Capital Budgeting / Capital budgeting meaning in simple words -

Capital budgeting or capital expenditure budget is a process of making decision regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture.
Capital budgeting correlates the planning of available financial resources and their long-term investment with a view to maximize the profitability of the firm.
Capital budgeting is also known as investment decisions. The word investment refers to the expenditure which is required to be made in connection with the acquisition and the development by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm.

When a business makes a capital investment, it incurs a cash outlay in the expectation of future benefits. The expected benefits generally extend beyond one year in the future. Out of different investment proposals available to a business, it has to choose a proposal that provides the best return and the return equals to, or greater than that required by the investors. The whole process is known as capital budgeting / expenditure.

Investment decision related to long-term asset are called capital budgeting. It involves the planning and control of capital expenditure. The term capital expenditure means the expenditure which is intended to benefit future period, i.e. in more than one year as opposed to revenue expenditure, the benefit of which is supposed to be exhausted within the year concerned.

Investment decision pertaining to long-term assets for the purpose of generating revenue for the business entity (and not for sales such as land, building, machinery, furniture, etc.) is term as 'Capital Budgeting'. It involves long-term planning and monitoring of capital expenditure, beside examining each proposal in a very logical and scientific manner so as to finalize the best proposal. Capital expenditure differs from the revenue expenditure in the sense that the benefits from such expenditure are necessary generated after a long gestation period which is generally beyond one year. In the case of revenue expenditure, on the other hand, the benefit are generated and exhausted within the year. Some of the authors have defined 'Capital Budgeting' as under :

Definitions of Capital Budgeting :

According to Charles T. Horngren :
"Capital budgeting is long-term planning for making and financing proposed capital outlays".

According to Robert N. Anthony :
"The capital budget is essentially a list of what management believes to be worthwhile projects for the acquisition of new capital assets together with the estimated cost of each product".

According to Milton H. Spencer :
"Capital budgeting involves the planning of expenditures for assets, the returns from which will be realized in future time period".

Features of Capital Budgeting -

The Capital Budgeting Features includes:

  • 1. Investment proposal for which the Capital Budgeting technique is to be applied should be of a long-term nature.
  • 2. Proposed investment is to be made during the current period, but return from the investment will be obtained over a number of years in the future period.
  • 3. Expenditure for the proposed investment and return from such investment should be measured in terms of cash flow that is cash outflow and cash inflow respectively.
  • 4. Investment decision may be taken for a single project proposal, or for two or more mutually exclusive project proposals.
  • 5. Acceptance or rejection of an investment proposal should be based on the maximization of value of the firm.
  • 6. Only the long term investment proposal are subject to capital budgeting technique.
  • 7. Proposed investments are made in the present, but the return of such investments accrued over a number of years in future.
  • 8. While undertaking the exercise of 'capital budgeting' in respect of an investment proposal, expenditure and projector return are measured in the term of cash flow, i.e. cash outflow and cash inflow respectively.
  • 9. The business may take investment decision on single project proposal or for two or more project proposal which are manually exclusive simultaneously.
  • 10. Maximization of value of the business organization should be the sole criteria for selecting or dropping of an investment proposals.

Types of Capital Budgeting -

The Capital Budgeting Types is as follows :

1) Expansion and Diversification -
A company may add capacity to its existing product lines to expand existing operations. For example, the Gujarat State Fertilizer Company (GSFC) may increase its plant capacity to manufacture more urea. It is an example of related diversification. A firm may expand its activities, in a new business, Expansion of a new business requires investment in new products and a new kind of production activity within the firm. 
If a packaging manufacturing company invest in a new plant and machinery to produce ball beings, which the firm has not manufactured before, this represent expansion of new business or unrelated diversification. Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional revenue. Investments in existing or new products may also be called as revenue-expansion investments.

2) Replacement and Modernization -
The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firms revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets that operate more economically. 
Capital budgeting techniques with examples, a cement company changing from semi-automatic drying equipment to fully automatic drying equipment. Replacement decisions help to introduce more efficient and economical assets and therefore, are also called cost-reduction investments. However, replacement decisions that involve substantial modernization an technological improvements expand revenues as well as reduce costs.

3) Mutually Exclusive Investments -
They serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company may, e.g. either use a more labour intensive, semi automatic machine, or employ a more capital-intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of the highly automatic machine.

4) Independent Investments -
They serve different purposes and do not compete with each other. For example, a heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a new product light commercial vehicles. Depending on their profitability and availability of funds, the company can undertake both investments.

5) Contingent investments -
Contingent investments are dependent projects, the choice of one investment necessitates undertaking one or more other investments. For example, if a company decide to build a factory in a remote, backward area, it may have to invest in houses, roads, hospitals, schools etc. for employees to attract the workforce. Thus, building of factory also requires investment in facilities for employees. The total expenditure will be treated as one single investment.

6) Research and Development Projects -
Traditionally, R&D projects absorbed a very small proportion of capital budget in most Indian companies. Things, however, are changing-Companies are now allocating more funds to R&D projects, more so in knowledge-intensive industries. R&D projects are characterized by numerous uncertainties and typically involve sequential decision making. Hence the standard DCF analysis is not applicable to them. Such projects are decided on the basis of managerial judgement. Firms which rely more on quantitative methods use decision tree analysis and option analysis to evaluate R&D projects.

7) Miscellaneous Projects -
This is a catch-all category that includes items like, interior decoration, recreational facilities, executive air crafts, landscaped gardens and so on. There is no standard approach for evaluating these projects and decisions regarding them are based on personal preferences of top management.

Process of Capital Budgeting -

Capital budgeting process steps there are 5 stages in the investment decision / capital budgeting process :

1. Investment Screening and Selection -
Projects consistent with the corporate strategy are identified by production, marketing and Research and Development management of the firm. Once identified project are evaluated and screen by estimating how they affect the future cash flows of the firm and hence the value of the firm

2. Capital Budget Proposal -
A capital budget is proposed for the projects surviving the screening and selection process. The budget lists the recommended project and the dollar amount of investment needed for each.
This proposal may start as an estimate of expected revenue and cost but as the project analysis is refined data from marketing, purchasing, engineering, accounting and finance functions are put together .

3. Budgeting Approval and Authorization -Projects included in the capital budget are authorized, allowing further fact gathering and analysis, and approved, allowing expenditures for the projects. In some firms, the projects are authorized and approved at the same time. In others, a project must first be authorized, requiring more research before it can be formally approved. Formal authorization and approval procedures are typically used on larger expenditures, smaller expenditures are at the discretion of management.

4. Project Tracking -
Alter a project is approved, work on it begins. The manager reports periodically on its expenditures, as well as on any revenues associated with it. This is referred to as project tracking, the communication link between the decision-makers and the operating management of the firm. For example, tracking can identify cost over-runs and uncover the need for more marketing research.

5. Post-Completion Audit -
Following a period time, perhaps two or three years after approval, projects are reviewed to see whether they should be continued. This re-evaluation is referred to as a post-completion audit. Through post completion audits are typically performed on selected projects, usually the largest projects in a given year's budget for the firm or for each division. Post-completion audits show the firm's management how well the cash flows realized correspond with the cash flows forecasted several years earlier.

Factors Influencing Capital Budgeting -

The following factors (both financial and non-financial) influence the capital expenditure :

1. Availability of Funds -
Availability of funds is the basic and most important determinant impacting the capital expenditure decisions. There are cases of abandoning of projects by companies due to scarcity of fund.
This is the crucial factor affecting the capital expenditure decision. Many project are dropped due to financial constraints.

2. Future Earnings -
Every project has to produce cash inflows in future. It is varied of each project and anticipated  revenues. This is the most significant factor, which affects the choice of a project.
While selecting a project the purpose of any project is to generate additional revenue for the business. The level of cash inflow varies for each project, but still every project is expected to result in cash inflows in the future.

3. Degree of uncertainty or Risk -
The level of risk involved in a project is not predictable one. In almost all the project, some elements of risk is involved, extent of which is difficult to assess at the beginning.

4. Legal compulsion -
When the statutory compulsion arises cost and benefit consideration have to be ignored the industry should provide. The safety measures according to the Factories Act, automobile industries need to follow euro emission norms.

5. Urgency -
Projects, which are to be immediately taken up for a firm's survival, have to be treated differently from optional projects.
All the project cannot and need not to be treated equally. Some projects may be of urgent nature and are required to be taken up on priority basis to survive in the business. Others may not be so urgent and hence can wait. Therefore, projects may be prioritized and the policy of 'one size fits all' needs to be abandoned. 

6. Research and Development Projects -
Technology based industry need R&D investments for obtaining competitive edge in the industry. Investment in research and development is an integral part of modern industry, especially Technology based industry. research and development enables an industry to maintain competitiveness in the market.

7. Obsolescence -
If absolute machine and plant exist in a firm then their replacement becomes a compulsion. Investment in the project involving replacement of obsolete plant and machinery of a manufacturing unit is of an urgent nature. Such investment decisions should preferably be taken even before the plant and machinery become actually obsolete. 

8. Integral Factors -
Firm's prestige, workers satisfy social welfare etc. influence the capital expenditure of a firm which may be deemed as emotional factors. Capital expenditure of a business organisation has influence of what may be considered as 'emotional factors', like social welfare schemes for its employees, safety measure prevailing for its workers, its reputation in the market etc.

9. Competitor's Activities -
When competitors perform certain activities, they may compel the company to undertake similar activities for its survival in the field. The activities undertaken by the river companies have an impact on a company, as it may be driven to undertake similar activities with a view to remain in the race with other firms in the market.

10. Compliance with Statutory Provision -
To comply with the statutory provisions is another factor, which simply cannot be sidelined. A project with the potential of generating a higher level of cash flow in future, if not is incompliance with even one of the legal requirements (e.g. provisions relating to the environment, Public Health etc.) cannot be implemented. Remedial measures need to be taken before going ahead with such projects.

Need/Importance of Capital Budgeting -

Importance of capital budgeting for taking an investment decision is the most effective and powerful tool. The importance of capital budgeting may be gauged from the following points :

1. Corporate Image -
The profits are vitally affected by capital budgeting decisions. These influence the market value of the shares. All projects which are accepted should yield profits leading to maximization of shareholders' wealth. The shareholders and other investors should be convinced about the success and future prospects of the project. If they don't invest, the objectives of the business would fail. The image of the company will also fall down. The capital budgeting decisions should improve the image of the company.
Capital budgeting decisions have the capability to impact the profitability of a company. Such impact may be either way, i.e. profit can increase or decrease (depending upon the quality of capital budgeting exercise). Market value of the company's share also get impacted accordingly. Share holders of a company are interested in dividends and appreciation in the value of the shares held by them. Both are dependent on the profit of the company. Successful projects result in increased profit of the company, which in turn leads to better dividend's and appreciation in the value of shares. There would be an increase in the demand of the company's shares and Goodwill in the market would improve.

2. Long-Term Effects -
Decisions taken through capital budgeting are generally Irreversible, they can be reserved, if at all possible, with a lot of difficulties. The outcome of a wrong decision may be heavy losses to the business enterprise. For example, if a company decides to set up a factory in a backward rural area with a provision of housing facilities for its employees. Construction of the factory and houses for the future employees stars. However, before the completion of the construction, the company comes to know that there was a fault on its part regarding clearance from environment ministry and the factory cannot be set up in that area. The company will have bear heavy losses in terms of money and time under the above circumstances.
Capital budgeting decisions cannot be changed so easily. Wrong decision, once taken will lead to heavy losses to the firm. To take a simple example, suppose construction of a premise has been started and the management has gone half the way. Now, the construction can't be left hanging in between since the amount spent cannot be recovered.

3. Risk and Uncertainty -
A great deal of uncertainty surrounds a capital budgeting decision. Investment is present and return is future. The future is uncertain and full of risk. Longer the period of the project, greater is the risk and uncertainty. The estimates about costs, revenues and profits may not come true.
Capital Budgeting decisions are based on two important components, viz., investment and return. While the former is certain and takes place in the present, the latter is totally uncertain, take place in future and only projections there of may be made. A lot of risk is associated with the future. Uncertainty and risks are directly proportional to the period of project. A long-term project has a higher degree of risk and uncertainty. Estimates and projections are based on certain assumptions, which may prove to be wrong in future.

4. Large Funds -
Large amount of funds are needed by any business organisation for taking up any capital investment. The exercise of capital budgeting gains a lot of importance due to the fact that huge amount of funds are at Stake and any error may lead to a disastrous situation and heavy monetary loss of to the company.
Any capital expenditure will naturally involve huge amount. The fixed commitment as regards large sums of money makes capital budgeting is an important exercise.

Difficulties in Capital Budgeting -

The difficulties and problems in capital budgeting decisions are as follows:

1. Future Uncertainty -
All capital budgeting decisions involve long-term which is uncertain. Even if every care is taken and the project is evaluated to every minute detail, still 100% correct and certain forecast is not possible. The finance manager dealing with the capital budgeting decisions, therefore, should try to be as analytical as possible. The uncertainty of the capital budgeting decisions may be with reference to cost of the project, future expected returns from the project, etc. Capital budgeting decision mostly relate to the projects which are spread over a long term horizon. Despite a very careful evaluation of a project by examining each aspects in detail and arriving at a projected cash inflow in future, it is possible that something may go wrong and the final result may be against the estimation. The uncertainty of a capital budgeting decision may relate to either cost of project (cash outflow) or expected return (cash inflow). The personnel involved in the capital budgeting need to be very analytical and scientific ( technical ) in their approach.

2. Time Element -
The implications of a capital budgeting decision are scattered over a long period. The cost and benefit of a decision may occur at different point of time. As a result, the cost and benefits of a capital budgeting decision are generally not comparable unless adjusted for time value of money. The cost of a project is incurred immediately, however, it is recovered in number of years. Moreover, the longer the time period involved, the greater would be the uncertainty. The implementation of project approved through a capital budgeting decision is spread over a prolonged duration of time. 
The cost involved in a project (cash outflow) is certain and is incurred in the beginning of the implementation. However, the benefit of revenue generation (Cash inflow) is uncertain and takes a place at the different point of time during the lifetime of a project. Therefore, cost and benefit analysis of a project is possible only after adjustment of the time of value of money. Uncertainty of benefit is directly proportional to the length of the time period. Longer the time period involved, more than uncertainty and risk. 

3. Measurement Problem -
A finance manager may also face difficulties in measuring the cost and benefits of a project in quantitative terms. For example, the new product proposed to be launched by a firm may result in increase or decrease in sales of other products already being sold by the same firm but by how much, this is very difficult to ascertain because the sales of other products may increase or decrease due to other factors also. Measurement of cost and benefit of a project in quantitative terms may at times pose difficulties because of some other factors involved.
For example, implementation of the project launch a new product by a company may result in increase or decrease of the sales of the company other product (which are already in the market). However, the quantum of such increase / decrease (due to the new product launching) is not easy to determine because phenomenon of such increase / decrease may not be necessarily due to the launching of the new product, it may also be the result of some other issues.

Types of Capital Expenditure Decisions / Control :

What is capital budgeting decision ? Following are the types of capital expenditure decisions :

1. Pre-sanction Control -
The board approval of a capital expenditure request or revenue expenditure request enables the project to be stared. Of course, even the directors, if making a decision on a major project, would not make it unless all board member were present or, if not present, then consulted for their opinion so as to enable a decision to be made with unanimous support if the decision could not be delayed. This unilateral support for a project is essential, as all directors are equally liable for the results of their joint decisions.
The procedure for approving the capital expenditure request and revenue expenditure request will be made by the board and recorded in the minutes by the company secretary. The signing of the capital expenditure sanction or revenue expenditure sanction would be by board authority, even if it is not physically done during the meeting.

The board may delegate the approval of capital expenditure requests or revenue expenditure requests for the purchase of replacement assets, motor vehicles or new assets below a specified value - say, $ 1,00,000 to the CEO. This would allow the CEO to make the final decision on the exact start date, but it would be unusual for this to be done without consultation with either the chairman or another director. Allowing the CEO this level of authority would be necessary if the board did not meet regularly or the board had a high degree of confidence in the CE0's judgment.

Levels of Authorities
The levels of authorities that are the delegated operating limits from the directors for the levels of management do not apply for capital and project expenditures. Most managers only have authority for their area of responsibility, which does not include any planning responsibility. They would certainly participate in the annual budgeting activity's and reviews of operating forecasts. Purchasing authority for asset expenditure would be denied them.

The three reports referred to earlier the capital expenditure status and the capital and revenue projects budgets reports provide the board with the information needed to be able to approve the capital expenditure requests and revenue expenditure requests. These reports also provide the necessary controls to ensure that approvals are not given to items that are not legitimate. There is a probability that if capital expenditure as reported on the capital expenditure status is to be reconciled with ledger accounts, then capital expenditure on projects approved the year before will need to be identified as a separate entry on the report.

2. Operational Control -
The decision making process for long term planning of a business's activities is mainly the domain of the directors and the highest levels of management. Internal controls at the high levels of management are not as formalized as those for lower levels of management. At the higher levels of the internal control system there is more policy direction than practical procedures. However, there are internal controls and they need to be observed. 
The top managers in a firm are usually in regular contact with the directors and are 'supervised' by them directly.
The operating controls for this sub-system are the continuing reviews of the business's operations to ensure that projects can be paid back by savings or other efficiencies and that financing costs and repayment of loans can be covered from expected profits. This sub-system is not an activity that is a part of the accounting system. The accounting section will be responsible for the recording and reporting aspects, but the planning, consideration of alternatives and long-term financing decisions will involve other sections and not the accounting function.

Long-Term Planning
Long-term planning would be carried out by an operations research or planning section from policy direction issued by the directors and studies of economic trends and forecasts. This would be an ongoing activity, being reviewed and modified probably every quarter. These long-term views of the company's operations would be provided to the directors to enable them to carry out a continuing review of capital expenditures and financing
alternatives. For major projects, detailed feasibility studies on cost and revenue projections would be compiled to justify the project's inclusion or modification so as to be able to meet the required rates of return.

Short-Term Planning
This involves the budget for the current year and forecasts for each quarter. The forecasts for each quarter are the final control on whether the planned capital commitments included in the current-year budget can go ahead. The basic point is that no matter how much research goes into preparing a forecast or budget, unexpected changes can occur. A firm that is able to cut back at the first warning sign will probably be saved from having to implement drastic measures later.

3. Post-sanction Control -
A reporting system which enable the board to was the Trends and behavior of the organisation or bank loan portfolio is a basis ingredient of board supervision. While large lines of credit should be approved by the board itself (or by the Executive Committee, if necessary) and the board should consider carefully all the relevant data and policy issues before according its approval, a monthly statement of all loans sanctioned in the course of each month by the Managing Director and other Bank officials in their respective discretionary powers should be submitted to the Board giving important particulars of each loan including past behavior in case of its extension, renewal or increase of an earlier facility. If the number of loans being sanctioned is very large, the Board may like to exempt small loans from detailed reporting requirement and may allow these loans to be reported only on consolidated basis. Another statement with the board should obtain on regular basis is that of over due advances. All such accounts should be reported periodically giving in each case along with other particulars the period for which the loan is overdue the action taken to get the outstanding adjusted and the position of the security. All delinquent advances, defaults of longer duration, say of more than 6 months or 1 year should be under constant scrutiny of the Board, should be discussed by it case by case so that it satisfied itself that the management is taking all possible action for recovery.
Minutes of the board meeting in which such advances are discussed should record these discussions in detail. Review and examination of defaults and delinquencies in the loan portfolio should also provide the Board with an opportunity to consider whether there is any thing wrong with the Bank's loaning policy, whether due care is not being taken in sanctioning loans, whether post-sanction control and supervision of credit lines is lacking, and to take in the  light of these considerations suitable remedial action.
In the case of bad and doubtful debts the Board would be well advised to follow a very cautious and conservative policy, waiting oft promptly advances that are irrecoverable and making adequate provision for advances the recovery of which is improbable and which the risk of ultimate loss is high. The power to write off or make provision for any loan should be vasted exclusively in the board. The Managing Directors or the General managers recommendation has of course to be taken into consideration but it is only for the Board to decide.
The Auditors' observations have to be given due weight but the Board would do well not to wait for its Auditors to ask for write off or provision. It is of course to be remembered that for every loss that accrues or is likely to accrue to the Bank, the management is ansrable to the Board and the Board is answerable to the shareholders. If the losses are large and have any bearing on the solvency of the bank, the accountability to the wider body of depositors and creditors cannot be escaped.