Meaning and definition of capital budgeting
Capital budgeting refers to a process that involves a business to determine whether the projects, like investing in a long-term venture or building a new plant, are worth following. Many times, an eventual project’s lifetime cash inflows and outflows are evaluated so as to determine whether the generated returns congregate to a satisfactory target benchmark. Capital budgeting is also referred as “investment appraisal”.
As explained by Investopedia, ideally, business companies should carry out all projects and opportunities which enhance shareholder value. However, due to limited amount of capital available at a given time for a new project, management is required to implement capital budgeting techniques to determine which projects will generate the maximum return over a specific period of time.
The most popular methods for capital budgeting include net present value (NPV), nternal rate of return (IRR), discounted cash flow (DCF) and payback period.
Nature of capital budgeting
The nature of capital budgeting can be summarized in the following points:
- Capital expenditure plans rivet a huge investment in fixed assets.
- Capital expenditure once approved signifies long-term investment which cannot be withdrawn or reserved without sustaining a loss.
- Preparation of capital budget plans includes forecasting profits of many years in advance so as to judge the profitability of projects.
Capital budgeting procedure
The preparation of capital budgeting can be done in the following procedure:
- Organization of Investment Proposal
The primary step in capital budgeting is conception of a profit making idea.
- Screening the Proposals
In big organizations, a capital expenditure planning committee is instituted for the purpose of screening the various proposals received.
- Evaluation of projects
The next step involves evaluating the various proposals in terms of cost of capital, expected returns from alternative investment opportunities, and the assets’ life through different techniques.
- Establishing priorities
Unprofitable or uneconomic projects are dropped off after the screening of projects has been done.
- Final approval
The proposals which are finally recommended are passed on to the top management accompanied by the detailed report about the capital expenditure as well as the sources of funds to congregate them.
As a final step, an evaluation of the program, after being implemented completely, is carried out to assess the profitability.