Capital Budgeting

Capital Budgeting

It is the process of making investment decision in capital expenditures. Capital expenditure defined as an expenditure the benefits of which are expected to be received more than one year. It is incurred in one point of time and the benefits are received in different point of time in future.

^Ø    Cost of acquisition of permanent asset as land and building, plant and machinery, goodwill

^Ø    Cost of addition, expansion and improvement or alteration in fixed assets

^Ø    Cost of replacement of permanent assets

^Ø    Research and development project cost etc.

Why the capital budgeting is considered as most important decision over the others?

^Ø    The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets.

^Ø    The capital budgeting decision is a decision of capital expenditure or long term investment or long term commitment of funds on the fixed assets.

Principles

^v   Decisions are based on cash flow not accounting income

^v   The capital budgeting decisions are based on the cash flow forecasts instead of relying on the accounting income.these are the incremental cash flows that is additional cash flows that will occur if the project undertaken compare to if the project is not undertaken

^v   Timing of cash flows

^v   To estimate the timing of cash flows as accurately as possible.it is used the concept of time value of money,the time at which the cash flows occur significantly impacts at the present value of the project.

^v   Financing cost should be ignored

^v   Cash flow should be considered

^v   Opportunity cost are also considered

Need and importance/Nature

(1)  Large investment

-          Involve large investment of funds

-          Fund available is limited and the demand for funds exceeds the existing resources

-          Important for firm to plan and control capital expenditure

(2) Long term commitment of funds

-          Involves not only large amount of fund but also long term on permanent basis.

-          It increases financial risk involved in investment decision.

-          Greater the risk greater the need for planning capital expenditure.

(3)Irreversible Nature

-          Capital expenditure decision are irreversible

-          Once decision for acquiring permanent asset is taken, it become very difficult to dispose of these assets without heavy losses.

(4)Long-term effect on profitability

-          Capital expenditure decision are long-term and have effect on profitability of a concern

-          Not only present earning but also the future growth and profitability of the firm depends on investment decision taken today

-          Capital budgeting is needed to avoid over investment or under investment in fixed assets.

(5)Difficulties of investment decision

-          Long term investment decision are difficult to take because (i) decision extends to a series of year beyond the current accounting period

-          (ii) uncertainties of future

-          (iii) higher degree of risk

(6)National importance

-          Investment decision taken by individual concern is of national importance because it determines employment, economic activities and economic growth.