The capital budget is the planning process by which a company determines and evaluates possible expenses or investments which by their nature are large. These expenses and investments include projects such as building a new plant or investing in a long-term venture.
In this process, financial resources are assigned with the capitalization structure of the company (debt, capital or retained earnings) to large investments or expenses. One of the main objectives of investments in capital budgets is to increase the value of the company for shareholders.
Capital budgeting involves calculating the future profit of each project, the cash flow per period, the present value of the cash flows after considering the value of money over time, the number of years that the project cash flow you must pay the initial capital investment, assess risk and other factors.
Because the amount of capital available for new projects may be limited, management needs to use capital budgeting techniques to determine which projects will generate the highest returns over a period of time.
Techniques
Capital budgeting techniques include performance analysis, net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF), and payback.
Three techniques are the most popular for deciding which projects should receive investment funds when compared to other projects. These techniques are performance analysis, CDF analysis, and payback analysis.
Capital budgeting with performance analysis
Performance is measured as the amount of material that passes through a system. Performance analysis is the most complicated form of capital budget analysis, but it is also the most accurate in helping managers decide which projects to take on.
Under this technique, the entire company is viewed as a single, profit-making system.
The analysis assumes that almost all costs on the system are operating expenses. Similarly, a company needs to maximize the performance of the entire system to pay for expenses. Finally, that the way to maximize profits is to maximize the throughput that goes through a bottleneck operation.
A bottleneck is the resource in the system that requires the most time to operate. This means that managers should always take more account of capital budgeting projects that impact and increase performance that goes through the bottleneck.
Capital budgeting using DCF analysis
The DCF analysis is similar or equal to the NPV analysis in terms of the initial cash outflow required to finance a project, the combination of cash inflows in the form of income, and other future outflows in the form of maintenance and other costs.
These costs, except for the initial outflow, are discounted back to the present date. The number resulting from the DCF analysis is the NPV. Projects with higher NPVs should rank above the others, unless some are mutually exclusive.
Investment recovery analysis
It is the simplest form of capital budget analysis and is therefore the least accurate. However, this technique is still used because it is fast and can give managers an understanding of the effectiveness of a project or group of projects.
This analysis calculates how long it will take to pay back a project investment. The payback period for the investment is identified by dividing the initial investment by the average annual cash income.
Example
Small businesses should account for inflation when evaluating investment options through capital budgeting. When inflation increases, the value of money falls.
Projected returns are not worth as much as they seem if inflation is high, so seemingly profitable investments can only come to a standstill or perhaps lose money when inflation is accounted for.
Capital budgeting for a dairy farm expansion involves three steps: recording the cost of the investment, projecting the cash flows of the investment, and comparing the projected earnings with inflation rates and the time value of the investment.
For example, dairy equipment that costs $ 10,000 and generates an annual return of $ 4,000 seems to "pay off" the investment in 2.5 years.
However, if economists expect inflation to increase 30% annually, then the estimated return value at the end of the first year ($ 14,000) is actually worth $ 10,769 when inflation is accounted for ($ 14,000 divided by 1.3 equals $ 10,769). . The investment generates only $ 769 in real value after the first year.
Importance
The amount of money involved in a fixed asset investment can be so great that it could bankrupt a business if the investment were to fail.
Consequently, capital budgeting should be a mandatory activity for large fixed asset investment proposals.
Long-term investments involve risks
Equity investments are long-term investments that carry higher financial risks. That is why proper planning is needed through capital budgeting.
Large and irreversible investments
As investments are huge but funds are limited, proper planning through capital expenditures is a prerequisite.
Furthermore, capital investment decisions are irreversible in nature; that is, once a fixed asset is purchased, its elimination will bring losses.
Long term in business
The capital budget reduces costs and brings changes in the profitability of the company. Helps prevent investments from being excessive or insufficient. Proper planning and analysis of projects help in the long run.
Capital Budgeting Meaning
- Capital budgeting is an essential tool in financial management.
- Capital budgeting provides ample scope for financial managers to evaluate different projects in terms of their feasibility to invest in them.
- Helps to expose the risk and uncertainty of different projects.
- Management has effective control over capital spending on projects.
- Ultimately, the fate of a business is decided by the optimal way in which available resources are used.
