Capital Budgeting: Importance, Types and Planning Period

After reading this article you will learn about Capital Budgeting:- 1. Importance of Capital Budgeting 2. Types of Capital Budgeting 3. Planning Period.

Importance of Capital Budgeting:

Capital budgeting decisions have given the primary importance in financial de­cision-making since they are the most crucial and critical business decisions and they have significant impact on the profitability aspect of the firm.

As the capital bud­geting/expenditure decision affects the fixed asset only which are the sources of earning revenue, i.e. in other words, the profitability of the firm, special attention must be given in their treatment.

Capital budgeting decisions have placed greater emphasis due to the following:

(a) Capital budgeting has long-term implications:

The most significant reason for which the capital budgeting decisions is taken is that it has long-term implications, i.e. its effects will extend into the future, and will have to be endured for a longer period than the consequences of current operating expenditure. Because, an opportune investment decision can yield spectacular returns whereas a wrong investment decision can endanger the very survival of the firm.

That is why, it may be stated that the capital budgeting decisions determine the future destiny of the firm. Moreover, it also changes the risk complexion of the enterprise. When the average benefits of the firm increases as a result of an investment proposal which may cause frequent fluctuations in its earnings that will become a more risky situation.

(b) They require large amounts of funds:

Capital investment decisions require large amounts of funds which the majority of the firms cannot provide since they have scarce capital resources. As a result, the investment decisions must be thoughtful, wise and correct. Because, a wrong/incorrect decision would result in losses and the same prevents the firm from earning profits from other investments as well due to scarcity of resources.

(c) They are not reversible:

Once the capital budgeting decisions are taken, they are not easily reversible. The reason is that there may neither be any market for such second hand capital goods nor there is any possibility of conversion of such capital assets into other usable assets, i.e., the only remedy is to dispose of the same sustaining a heavy loss to the firm.

(d) They are actually the most difficult decisions:

Capital investment decisions are, no doubt, the most significant since they are very difficult to make. It is because of the fact that their assessment depends on the future uncertain events and activities of the firm. Similarly, it is practically a difficult task to estimate the accurate future benefits and costs in terms of money as there are economical, political and technological forces which affect the said benefits and costs.

Types of Capital Budgeting Decisions:

Since capital budgeting includes the process of generating, evaluating, selecting and following up on capital expenditure alternatives, allocation of financial resources should be made by the firm to its new investment projects in the most efficient manner.

A firm may adopt the following three types of capital budgeting decisions:

(i) Mutually exclusive projects:

It means if a firm accepts one project, it may rule out the necessity for other, i.e. the alternatives are mutually exclusive and only one is to be chosen.

For example, if there is a need to transport supplies from a loading dock to the warehouse, the firm may adopt two proposals, viz.,

(a) Fork lifts to pick up the goods and move them, or,

(b) A conveyer belt may be connected between the dock and the warehouse.

If one proposal is accepted it will eliminate the other

(ii) Accept—reject decisions or acceptance rule:

The proposals which yield a higher rate of return in comparison with a certain rate of return or cost of capital are accepted and naturally, the others are rejected. For example, if the minimum acceptable return from a project is say 10%, after tax and an invest­ment proposal which shows a return of 12%, may be accepted and another project which gives a return of 8% only may be rejected.

In other words, using Net Present Value Method Criterion an invest­ment opportunity will be accepted if NPV>0, or, the same will be rejected if NPV< 0. That is, all independent projects are accepted under this criterion.

It is to be noted that independent projects are those which do not compete with one another, i.e. the acceptance of one precludes the acceptance of other. At the same time, those projects which will satisfy the minimum investment criterion should be taken into consideration.

(iii) Capital rationing decision:

Capital rationing is normally applied to situations where the supply of funds to the firm is limited in some way. As such, the term encompasses many different situations ranging from that where the borrowings and lending rates faced by the firm differ to that where the funds available for investments are strictly limited In other words, it occurs when a firm has more acceptable proposals than it can finance.

At this point, the firm ranks the projects from highest to lowest priority and as such, a cut-off point is considered. Naturally, those proposals which are above the cut-off point will be accepted and those which are below the cut-off point are rejected, i.e. ranking is necessary to choose the best alternatives.

Illustration:

Minimum acceptable rate of return (after-tax) is 10%.

Investments to be made Rs. 12,00,000.

Four alternative investment opportunities, are there viz. A, B, C and-D.

Expected returns from the above alternatives are:

A — 8%,

B — 11%,

C — 13% and

D — 12%.

Solution:

Since alternative a shows a return which is less than the standard return laid down by the firm, it should be totally rejected Among the remaining three, ranking is done on the basis of profitability which is shown as under:

Proposals C is the most profitable project and hence, it may be accepted.

Planning Period for the decisions of Capital Budgeting:

The future time period for which the capital expenditure budget is prepared, is determined in the decision programme.

The time period should be determined in the context of the following major consideration which are:

(a) The type of industry:

For example, a pharmaceutical firm is to make plans for a shorter period since its equipment’s are short­-lived whereas a mining firm has to make a plan for a longer period.

(b) The general economic conditions:

At the time of prosperity, the planning time gets longer whereas at the time of crisis the same is shorter.

(c) The degree of faith the executives have in long-range planning:

If they believe in it, there will be longer time period and in the opposite case, it will be reversed.

However, there are some authors who prefer to classify the time horizon in investment decisions into two following groups:

(i) Long period:

Which may include a period from 5 to 20 years.

(ii) Short period:

Which is considered for inclusion in the next annual budget period.

Generally, investments in long-term assets require a plan for several years ahead for a number of reasons, which are noted below:

(a) Long-term investment expresses a framework for the future development of the firm which must be visualised in advance;

(b) A long gestation period lies between the time of planning the project and the actual operation of the plant;

(c) Arrangement must be made for required fund from different sources in advance which needs careful planning.

Short-term budgets, on the other hand, may be influenced by the financial resourc­es. Of course, in case of an emergency need, the funds are to be procured / arranged from different source so that the project may be taken up.

Kinds of Investment:

Generally, two types of investments are made, viz.:

(i) The replacement of existing assets; and

(ii) The purchase of completely new assets for expansion.

It may also be mentioned that there may be other types of investment as well which are considered as a matter of policy.

They are:

(a) Welfare projects:

Investment is made in order to promote the morale of the employees and/or staffs.

(b) Educational and training projects:

Investment is also to be made for educational and training projects for improving the efficiency of the employees although it is very difficult to evaluate the result from it.

(c) Research and development projects:

The research projects may be successful but it is very difficult to measure the benefits which are derived in future.

(d) Projects to be complied with statutory requirements:

According to the Factories Act, 1948, every employee should make proper provisions for accidents, fire-fighting devices, rest room etc., which is obligatory on the part of the employer.

(e) Prestige-valve projects:

In order to create a favourable image among the public, this type of investment is to be made, e.g. to construct a guest house.

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