In the industrial sector or corporate world, every business organizations need money to run their firm properly. No one actually retains thesurplus sum of money to meet their future requirements, but they have acertain amount of money for their day to day operations. This amount of money is known as Working Capital.
During the business operations, every organization requires either allocation of their finances or borrowing of certain amount of money. In this context, companies need sufficient capital outlay to meet the requirements out of their total investment for fixed projects.
Here, it comes the need for capital budgeting. It plays a significant role in managing the finance to maintain the capital outflow and inflow at a proper level.Thus, the requirement of capitals in addition to fixed assets to new development can be fulfilled without any delay.
Concept of Capital Expenditure:
Capital Expenditure is crucial to maintain the investment criteria either for fixed assets or new development projects. It is required especially for the future periods. This not only benefits the firm but the purpose of improving the rate of return is also checkedto a great extent.
What is Capital Budgeting?
Capital budgeting can be defined as the long-term planning to maintain the allocation of capital in different sectors of the organization. In other words, it can also be defined as the decision making for the investment of capitals in relation to the expenditures of the organization.
Capital budgeting is also known as capital expenditure decision, investment decision making, planning capital expenditure and much more in different organizations.
According to the Charles T Horngreen, “Capital Budgeting is considered as the long-term planning for making proper outlays of proposed financial capital.”
Lynch has defined capital budgeting as, “It is the planning for development of capital for maximizing the profitability of the firm without any negative impact on its present market stand.”
Need for Capital Budgeting:
- If any decision goes wrong and the firm has to makeup their losses, then capital budgeting plays an important role to save the organization from complete collapse. In this context, the available resources can be used to bring stability in the business.
- Some firms involve funds allocation at a huge amount. This makes a huge difference in their growth and development. Thus, with proper capital budgeting, any firm is able to take care of essential planning for the allocation of resources and assets.
- Apart from the original investment on the project, capital budgeting takes care of future requirements. In this context, the shorter pay back period is always recommended.
Calculation of pay back period:
- For even cash inflows:
Pay back period for even cash inflows can be formulated as,
Pay back period = Original Cost/ Annual Cash Inflow
Annual Cash Inflow = Net Savings or Net Profit + Depreciations
While solving the problems if cash inflow statistic is provided, you should use that value to solve the problem. In case, the cash inflow value is not available;then it is mandatory to find out its value.
- For uneven cash inflows::
When the cash inflows are ununiformed, the calculation will take a cumulative way. To determine the even cash inflow, one has to wait until the net cash inflow should become equal to the original cost of the project.
- Post Pay Back Profitability Method:
To calculate, the total cash inflow from the proposal will be
During its Economic Life xx
Less : Original Cost xx
Post Pay Back Profitability xx
- Accounting Rate Return Method:
It is termed as Accounting Method. This method is known as Accounting Rate of Return Method, Average Rate of Return Method or Return on Investment Method.
According to its formulae, it can be written as,
- Average Investment Method = Average Annual Profit/ Average Investment x 100
- Average Rate of Return = Average Annual Profit/ Original Investment
- Return per unit of
Investment Method = Total Profit/ Net Investment x 100
- Rate of Return on Average
Investment Method =Profit after Depreciation Tax/ Average Investment
(Average Investment = Original Investment/ 2)
- Rate of Return on Original
Investment Method = Profit/ Original Investment
- Time Adjustment Method:
- Net Present Value Method
It is also called as net gain method or excess present value method.
Sum of its discounted cash inflow xx
Less :Its Original Cost xx
Its Net Present Value xx
Suppose the present value of the cash inflows is greater than or equal to the present value of cash outflows. It is then considered that project is accepted. If anyhow, this value is less, then the project will not be accepted.
- Internal Rate of Return Method
According to theinternal rate of return method, it is the discount rate of return that is equal to the ratio of cash inflows to cash outflows. In other words, it can be defined as the rate of return which equates the cash inflows and cash outflows.
In general cases, the internal rate of return can be found by using hit and trial method. Mathematically, the internal rate of return can be formulated as,
Cash Inflows/ Cash Outflows = 1