The term Capital Budgeting is defined as an investment appraisal technique. Very frequently, it is used to evaluate the pros and cons of a particular project of investment. It has a set of criteria associated with itself. Depending on the fulfillment of those criteria, a given investment project is said to be financially feasible or financially infeasible.
Importance of capital budgeting decisions
Capital budget comprise capital receipts and payments. Capital receipts include the loans that are raised by the government from the public. Capital payments include the expenses towards asset acquisition. These assets can be machinery, equipment, buildings or land.
Capital budgeting decisions are the decisions that are taken for allocation of a confined capital to different projects. These decisions are governed by expansion and acquisition of new assets. A businessâ€™s growth, profitability and risk is associated with capital budgeting decisions.
The following points list the importance of capital budgeting decisions.
- Long term effect
Investment in long term capital assets yield returns in future. Thus, they include the future prospects of a company.
- Excess of funds
Fixed capital investment demands excess of funds. This makes the capital budgeting decisions, even more crucial as large amounts of funds remain blocked for a very long time period.
- High risk involvement
When the monetary investment is higher, the risk factor is also higher. It is therefore, that these decisions are said to be risky and have a long term impact on the existence of the company.
- Irrevocable decisions
The capital budget decisions once made cannot be undone, because that will again involve a huge capital. The loss that is usually incurred in these processes is also very high.
Factors demanding long term capital investment:
- Expected rate of return
This indeed is the most crucial factor that affects decisions of investment in any project. Projects whose return rates are higher are preferred over those that offer a less rate of return.
- Criteria of investment
There are several criteria that determine the decision of investment in any project. These criteria may range from availability of raw materials, to access to technology. The pros and cons of investments and suggested alternatives are weighed properly on various grounds. On the basis of that the investment decisions are taken.
Some techniques involved in capital budgeting:
- Net present value (NPV)
The Capital Budgeting projects are either independent projects or mutually exclusive projects. A project is said to be independent, if acceptance or rejection of other projects does not make any change to it.
Mutually exclusive projects on the other hand, involve a big umbrella which shelters a set of projects. From that set, at max only one will be accepted. Only the net present value decision rule lead to the correct decision of choice in case of the mutually exclusive projects. The assumption that the net present value takes into consideration is that a projectâ€™s cash flow can be reinvested at the cost of capital of a firm.
- Internal rate of return (IRR)
It can be explained as the discount rate that gives a zero net present value. It is a often used as a common measure for investment efficiency. The result that IRR method provides is the same decision as that obtained by the NPV method in an environment having no constraint. Normally, a negative cash flow occurs at the start of the project. Cases where zero NPV discount rate exists have no unique IRR.
- Payback period
This is the time period that is required to recover the expended funds in an investment. In simple words, payback period measures the time that is required by someone to â€˜pay for himself or herselfâ€™. Shorter payback points are preferable over longer ones. Though there are certain limitations to it, yet its ease at usability makes it a choice.
- Profitability index
It is also known as profit investment ratio. It is the ratio of payoff to investment in a project. The quantification of values created per unit of investment makes this tool a very useful for ranking projects. A profitability index of 1 means breakeven. A value less than one signify that the present value of the project is less than the initial investment. As the value increases, the financial attractiveness of the project also increases.
Difference between capital budgeting decision, financing decision and revenue budget decisions
The financing decisions are the decisions that are related to identification of various sources of funds that involve debt and equity. These decisions are achieved by a fair amount of risk and profit consideration.
The revenue budget decision refers to a budget that depicts the revenue receipts and Government revenue expenditures. It is generally a short-term one
Capital budgeting on the other hand includes decisions that are around the allocation of fixed capital to different projects. It is a long term decision and in most of the cases cannot be altered.