Capital Budgeting Process
Capital Budgeting Process
* Dr. P.Shanmukha Rao ** Dr.N.V.S.Suryanarayana
Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefit to the achievement in future and future is always uncertain. However, the following procedure may be adopted in the process of capital budgeting.
1. Identification of Investment Proposals
The capital budgeting process begins with the identification of investment proposals. The proposal or the idea about potential investment opportunities may ordinate from the top management or may come from the rank and file worker of any department of from any officer of the organization. The department heads analysis the various proposals in the light of the corporate strategies and submits the suitable proposals to the capital expenditure.
Screening the proposals:
The expenditure planning committee screens the various proposals received from different departments. The committee views these proposals from various angles to ensure that these are in accordance with the corporate strategies or selection criterion of firm and also do not lead to department imbalances.
Evaluation of Various Proposals
The next step in the capital budgeting process is to evaluate the profitability of various proposals. There are many methods which may be used for this purpose as pay back period method, rate of return method, net present value, value method, internal rate of return etc.,
Fixing Priorities
After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. But it may not possible for the invest immediately in all the acceptable proposals due to limitation of funds.
Final approval and preparation of capital expenditure budget:
Proposals meeting the valuation and other criteria are finally approved to be included in the capital expenditure budget. However, proposals involving smaller investment may be decided at lower levels for expeditious action. The capital expenditure budget placed on amount of estimated expenditure to be incurred on fixed assets during the budget period.
Implementing proposals:
A request for authority to spend the amount should further be made to capital expenditure committee, which may like to review the profitability of the project in the changed circumstances.
Performance review:
The last stage in the process of capital budgeting is the evaluation of the performance of the project. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one, and also comparing the actual return from the investment with the anticipated return.
Limitation of capital budgeting:
Capital budgeting techniques suffers from the following limitations.
All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances.
The techniques of capital budgeting require an estimation of future cash in flows and outflows. The future is always uncertain and the data collected for future may not be exact. Obviously the results based upon wrong data may not be good.
There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified, which otherwise substantially influence the capital decision.
Urgency is another limitation in the evaluation of capital investment decision.
Uncertainty and risk pose the biggest limitation to the technique of capital budgeting.
Three steps are involved in the evaluation of an investment:
Estimation of Cash Flows.
Estimation of the required rate of return.
Application of a decision rule for making the choice.
The investment decision rules may be referred to as capital budgeting techniques or investment criteria. A sound appraisal technique should be used to measure the economic worth of the investment project. The essential property of a sound technique is that it should maximize the shareholder's wealth. Many firms use the payback period as an accept for reject criterion as well as a method of ranking projects. If the payback period calculated for a project is less than the maximum or standard pay back period set by management, it would be accepted, if not, it would be rejected. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project, which has highest payback period.
The project should be accepted if NPV is positive it should be clear that the acceptance rule using NPV method is to accept the investment project if its net present value is negative (NPV CASH OUTFLOW). The positive net present value will result only if the project generates cash inflows at rate higher than the opportunity cost of capital.
Capital Budgeting Process
By: S.R.PADALA & NVS SURYANARAYANA
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