Capital budgeting is a process that helps organizations plan and allocates funds for critical business investments. It involves estimating the cost of projects, figuring out how much money will be needed to finance them, and then allocating that money accordingly. Capital budgeting is essential for ensuring that businesses make the most appropriate investments, and it can help prevent costly mistakes.
The success and survival of any business depend on long-term investment decisions. At various times in running the business, the entrepreneur buys fixed assets such as land, buildings, furniture, machinery, etc., replaces these fixed assets, modernizes production methods, and markets new products without such many long-term investment decisions to be made.
How profitable these investment decisions will be for the company or whether they will be profitable or not, some methods or policies are needed for the proper evaluation of these investment decisions. In this article, we will learn about the methods or principles of financing that can help in making these long-term investment decisions.
What is The Capital Budgeting
Three friends Rahim, Karim, and Shankar run separate businesses. For some days Rahim has been thinking about buying a fridge for his grocery store. Karim started his tailoring business with a sewing machine six months ago.
Considering the additional demand, he now decided to buy another sewing machine. On the other hand, Shankar is thinking of buying the necessary furniture (wheelchair) and hair cutting machine to start a modern salon business.
Here, the decision to buy refrigerators for grocery stores, sewing machines for tailors, and wheelchairs and cutting machines for salons are all long-term investment decisions.
Finance requires an evaluation process to determine how profitable or even profitable these long-term investment decisions will be for the organization. Capital budgeting is an evaluation process.
In this case, every investment decision or project needs to be estimated. After the income-expenditure estimation, the net cash flow or net profit of these decisions or projects is determined. Here income means money earned from sales and expenses means raw material cost, selling cost, and other expenses including depreciation.
Subtracting expenses from revenue gives gross profit and deducting taxes from gross profit gives net profit. Again adding depreciation to net profit gives the cash inflow. If the inflows are greater than the outflows compared to the initial investment or cash outflows, then the investment appears profitable and is considered acceptable. This process is called the capital budgeting process.
Therefore it can be said that capital budgeting is a process involved in the long-term investment decision of the organization.
In this process, starting from the purchase of fixed assets of the organization such as: land, buildings, machinery, furniture, etc., to the replacement of these assets, business expansion such as: installation of new machines, modernization of production methods, and other long-term investment decisions by estimating the income and expenses, analyzing the potential profitability and making decisions accordingly. is accepted.
Importance of Capital Budgeting
Capital budgeting is the key to financing success. Business directly benefits if capital budgeting is realistic and accurate. When capital budgeting fails, the business usually fails. The finance manager has to take responsibility for the failure. Some of the reasons why capital budgeting is so important are mentioned below:
The main objective of an organization is to earn profit. Capital budgeting plays an important role in achieving profitability. The Company generally invests in its long-term investable funds-generating assets in the hope of generating cash flows. As a result, the profitability of the organization depends heavily on capital budgeting decisions.
Purchase of grocer’s refrigerators will naturally increase sales of cold drinks and ice cream. As a result, the profit of the business will increase. But if the people around the shop are not used to cold drinks and ice cream, the decision to buy a refrigerator will not bring any benefit to the organization.
Thus, good investment decisions can ensure sufficient income for the business, while bad investment decisions can cause the business to face losses. Hence, capital budgeting decisions are of particular importance in the subsequent prosperity of a business.
2. Size of investment:
Capital budgeting decisions such as purchase, addition, modernization, and replacement of fixed assets usually require large sums of funds. As a result, if the decision is wrong for any reason, there is usually no chance to correct it and even if there is a chance to correct it, a large fee has to be paid.
For example, a company decides to set up its factory at a place outside Dhaka thinking that it will get a timely supply of electricity and gas there. But after setting up the factory, it was found that the government has decided to stop new electricity and gas connections. In this case the business cannot start factory production. But the business may have to take a large loan from the bank, for this reason, the interest of which has to be paid to the bank regularly.
As a result, such a wrong decision can cause the business to fail. If it is a matter of a small amount, maybe, money could be raised from somewhere else but there is no chance of a big investment. Now if it is decided to sell the project and repay the bank loan, there will not be a suitable price. Because the project has already appeared unprofitable. So the business has to pay a huge fee.
3. Based on risk:
Most of the assumptions in capital budgeting depend on the future. The decision whether to invest in a fixed asset such as a machine depends on how much the product produced by the machine will make in the future and how much it will sell, how much the product will cost to produce, etc.
These forward-looking statements are based on assumptions, which may not be realistic. Thus, capital budgeting is always a risky decision. Eg: An umbrella manufacturer, anticipating excess rainfall during monsoons, expands its business and buys new machines to increase production capacity to produce more umbrellas.
According to the manufacturer’s estimate, the sales of umbrellas will not be as expected if there is no rain during the monsoon season. As a result, the business will face losses. For this reason, long-term investment requires risk assessment and risk acceptance. Capital budgeting plays an important role in this.
Application of capital budgeting
Capital budgeting is applied to all long-term investments. Capital budgeting has applications in all types of investments from the purchase of fixed assets, business expansion, business modernization, replacement of fixed assets, and new product launches. Now we will discuss some popular areas of application of capital budgeting.
Purchase of fixed assets:
Any company to start a new business needs to purchase fixed assets such as: land, building, machinery, furniture, etc. For example, a grocer has to decide to purchase a fridge, pillow, or weighing scale while starting his business. A restaurant owner has to decide on the purchase of chairs, tables, pots and pans, and other cooking equipment while starting his business.
Similarly, for large business establishments, land, buildings, factory construction costs, purchase of machineries, etc. have to be decided. Capital budgeting is applied in making these asset purchase decisions of any business organization. These fixed assets may become useless or damaged at various times during the course of business. In such cases, these fixed assets need to be replaced. In this case, also the company takes decisions by applying capital budgeting.
Expansion of business to increase production capacity:
An ongoing enterprise may need to increase its production capacity after starting its business. In order to increase the production capacity, the company needs to purchase new machines.
For example, a tailor shopkeeper may consider purchasing a new sewing machine considering the Eid demand of consumers, despite having 1 sewing machine in his current business. A grocer may decide to buy another refrigerator despite having one in his store.
Therefore, the shopkeeper has to make a decision by applying capital budgeting by estimating how much it will cost to buy a new machine, and how much the business income will increase due to it.
A company may need to launch new products in addition to existing products to expand its business. For example, a company may consider launching orange juice or apple juice alongside mango juice to diversify its product offering. New product launch decisions have to be made by estimating the life of the new product, cost of manufacturing the product, market demand, operating costs, and potential revenue. In this case, the application of capital budgeting can be observed.
Replacement and Modernization:
Business needs require replacing and modernizing production methods. For example, a tailor may decide to purchase an electric sewing machine instead of a foot-operated sewing machine. On the other hand, a hair cutting salon owner may decide to change the interior decoration of his shop and make it an AC salon.
The main objective, in this case, is to reduce the cost of production and thereby increase the profit of the business. In this case, it is necessary to compare the company’s old production method with the new method.
In both methods, the company has to calculate the income, operating expenses, life expectancy, etc. to determine the net cash flow and take the decision.
Therefore, the application of capital budgeting can be seen in the replacement and modernization of production methods.
Process of capital budgeting
The steps involved in applying the capital budgeting process to long-term investment decisions are as follows:
a) Cash flow forecasting
b) Determination of rate of return
c) Selection and application of capital budgeting methods.
Cash flow estimation:
Any long-term investment decision such as: the purchase of fixed assets, expansion of business, mechanization of the production process, and other decisions involve cash flow.
The first step in applying the capital budgeting process is to estimate cash inflows and outflows. To calculate the company’s cash flow, the company needs to forecast sales, forecast running costs, capital expenditures, and other expenses. A firm’s cash inflows from sales and cash outflows from operating expenses, capital expenditures, and other expenditure projections. Here the sales forecast, running costs, and fixed costs have to be determined very carefully.
As mentioned earlier, to estimate the total sales of an organization, the future sales price of each product and how many products will be sold each year have to predict. These are the total revenue earned from the sales every year after forecasting. Cash inflows are available from these earned incomes.
Therefore, an accurate estimation of cash flow depends on the sales price of the product in the future years and how many products will be sold. Because of this, errors in future sales price estimates or product sales estimates affect cash flow.
Similarly, cash outflows occur through the total expenses of the organization. The total cost of an organization is the combination of current costs and fixed costs. Current cost means the purchase of raw materials, the salary of employees, and other operating costs and fixed cost means office rent, insurance cost, depreciation, and other costs.
Every current cost and fixed cost forecast like sales forecast needs to be very careful.
If these cost estimates are wrong for any reason, capital budgeting can lead to wrong decisions, which can damage the organization.
b) Batta rate:
After determining the cash flows, the discount rate is needed to convert them into cash value. In the chapter on the time value of money, you learned that the present value of cash flows in future years is not equal even if they are equal in amount.
According to the time value of money, the latter the cash flow is received, the lower its present value. Since cash flows from an investment opportunity or project are available over several years, capital budgeting requires the present value of future cash flows to determine the right investment opportunity.
The factoring process converts future cash flows into present value. This is why batta rates are required. Usually, the firm’s cost of capital is used as a discount rate in the capital budgeting process. It is very important to determine the interest rate before estimating the income and expenses.
c) Application of capital budgeting method:
The capital budgeting method is selected after cash flow estimation and discount rate determination. There are various methods of capital budgeting for evaluating investment opportunities or projects. Not all methods have received equal acceptance. Each method has some advantages and disadvantages. The right method has to be selected considering the type of investment opportunity or project, risks and other factors.
Methods of capital budgeting
There are various methods of capital budgeting to guide the investment decisions of the organization. The function of capital budgeting methods is to select investments or projects that are consistent with the organization’s goals and are profitable overall.
Example: The capital budgeting method can give proper guidance on whether the decision to buy sewing machines for a tailor shop, refrigerators for a grocer, and machines for a hair cutting salon will be profitable for the business. The methods of capital budgeting are as follows:
1) Average profit rate method
2) Payback period method
3) Net present value method
4) Internal rate of return method
1. Average profit rate method
A simple method of capital budgeting is the average rate of profit method. Information obtained from the financial statements of the organization is used to determine the average rate of profit. In this method expected net profit is considered instead of expected cash flow. You know that all expenses including tax from sales exclusions yield net profit. The average rate of return is obtained by dividing the expected annual average net profit by the average investment. That is,
Average profit rate = (Average net profit / average investment ) X 100
In this method, dividing the expected total profit per year by the total number of years gives the average profit, and dividing the investment by 2 gives the average investment.
• The higher the average profit rate the better. If the project is financed with a loan from the bank, then the bank has a demand. Loans are not available if the average rate of profit is less than the bank interest.
In this case, the average profit of the project is acceptable if it is higher. Some companies have a predetermined minimum rate of average profit. If the average rate of return determined for a particular investment or project is less than the minimum rate determined by the management of the company, the investment opportunity or project is canceled or rejected.
Conversely, if the average rate of profit is greater than the desired rate, the project is accepted.
• In the case of multiple projects, the acceptable investment opportunities or projects are ranked according to the principles described above and the required number of investment opportunities or projects are selected depending on the capital adequacy of the organization.
It is easy to understand as the formula for measuring the average profit rate is not complicated. Again, it is popular with many as the necessary information is available from the financial statements of the organization. However, the method has some disadvantages.
First, the average profit method uses net profit instead of cash flow. However, many do not consider the method reliable as there are certain limitations on net profit.
Second, the method does not consider the time value of money. The cash flow of any investment opportunity or project comes from future years. Since 1 rupee today is not equal to 1 rupee in the future, future cash flows are not equal in value. But the average profit method considers all cash flows to be of equal value, which is the biggest limitation of the method.
The payback period method indicates the number of days in which the money invested in the business or project will be returned. The payback time method is a simple and popular method of investment decision or project evaluation. If the inflows from the business investment or project are equal, the payback period can be determined by dividing the invested amount by the annual cash flow.
In the payback period method, the shorter the payback period of the project, the more acceptable the project. Similarly, the longer the project’s payback period, the more unacceptable the project is considered.
Again, if the organization has one or more investment opportunities or projects, then the investment opportunities or projects are arranged sequentially according to the payback period. Subsequently, the necessary investment opportunities or projects are taken up subject to the adequacy of the organization’s funds, and the rest
The payback period used as a benchmark is determined by the management of the organization. Company officials are responsible for various issues such as: type of investment (purchase of fixed assets, business expansion, replacement or modernization of production methods), investment or project risk, and others.
It is determined by thinking about the subject.
Limitations of Payback Method
The payback method is the simplest and most popular method of capital budgeting. The reasons for its popularity are first:
This method is straightforward and simple. But it also has some disadvantages. Here are some of the pitfalls.
1. Payback is essentially no profit rate. It is a period when the invested capital is expected to return. If the payback period is over, the company will not make any profit, the company will only survive the loss.
2. If there are two or more projects, whichever has a shorter payback period; It is accepted that if there is a project, it cannot be decided by this method whether it is acceptable or not.
3. Cash flows outside the payback period are not counted. Payback in project A above was 2 years. In this case, if the project gives a huge cash flow in the 3rd year, the payback period will still be 2 years.
4. Payback does not take into account the time value of money. In the chapter on the time value of money, we learned that 100 rupees next year is worth more than 100 rupees 5 years from now, but the payback does not consider the time value of money. Here 100 taka next year and 100 takas 5 years later are considered equally valuable. This is a problem.
We can summarize our findings with this one statement and that is, Capital Budgeting is one of the most important and crucial elements of an effective business planning process. It provides a realistic view of your short-term as well as long-term financial goals, which leads to more focused decision-making about how to best secure your company’s success in the future.
Nowadays there are lots of different approaches when it comes to capital budgeting. However, you can be sure that if you follow some basic principles and create a solid plan for where you want your business to go next, everything will fall into place. KEY TAKEAWAYS Creating a good capital budget requires clear thinking and proper analysis skills
Once all preparations are done, sit back and enjoy time management!