Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure.
Capital expenditure budget or capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture.
- Capital expenditure plans involve a huge investment in fixed assets.
- Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss.
- Preparation of coital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects.
- Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future.
- The future benefits are expected to be realized over a series of years.
- The funds are invested in non-flexible and long term activities;
- They have a long term and significant effect on the profitability of the concern;
- They involve, generally, huge funds;
- They are irreversible decisions.
- They are ‘strategic’ investment decisions, involving large sums of money, major departure from the past practices of the firm, significant change of the firm’s expected earnings associated with high degree of risk, as compared to ‘tactical’ investment decisions which involve a relatively small amount of funds that do not result in a major departure from the past practices of the firm.
Need & purpose:
- Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.
- Analyze the proposal for expansion or creating additional capacities.
- To decide the replacement of permanent assets such as building and equipment’s.
- To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.
- Large investment .
- Long term commitment of funds.
- Long term effect on profitability .
- Help in increase a growth of business.
- Avoid a risk in business.
5 Tools & Techniques:
i.Payback period: The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow.
ii.Accounting Rate of Return method: The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.
iii.Net present value method: The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.
iv.Internal Rate of Return Method: The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows of an investment. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.
v.Profitability index: It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one.
We have discussed a meaning ,need, purpose and various techniques of capital budgeting . in consultaxx we provide a proper guideline for capital budgeting to take a correct decisions for the growth and become a success in business. We also provide a guideline to take a suitable decision to overcome a risk.