VUAC Finance

A firm may be interested to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. This decision by the management is called as “Capital Budgeting”

The long term assets are those which affect the firm’s operations beyond one year period. The firm’s investment decision would generally include expansion, acquisition, modernization and replacement of long term assets.

Capital budgeting also refers to investment or capital expenditure decisions.

Capital budgeting or capital expenditure includes all those expenditure which are expected to produce various benefits to the firm over one year period and it encompasses both tangible and intangible assets.

A large number of companies are covering only expenditure on tangible fixed assets

Most companies follow the accounting convention to prepare asset-wise classification of capital expenditure, which is hardly of much use in the decision making exercises.

Some companies classify capital expenditure in a manner, which could provide useful information for decision making. The usual classifications are as follows:
Replacement
Modernization
Expansion
New project
Research and development
Diversification
Cost reduction

Capital budgeting involves a current outlay of funds in the expectation of deriving a stream of benefits extending over a period of time. Capital budgeting or capital expenditure represents the growing edge of a business.

Capital budgeting is considered to be very important for the under mentioned reasons:
They have consequences extending to a longer period
Capital expenditure decisions have considerable impact on what the firm can do in future
Capital expenditure decisions often involve substantial outlays
It may be difficult to reverse capital expenditure decisions because the markets for used capital equipment is often imperfect

Capital budgeting is a complex process, which may be divided into the following phases:

Identification of potential investment opportunities
Assembling of proposed investments
Decision making
Preparation of capital budget and appropriations
Implementation
Performance review

Identification of potential investment opportunities:

Capital budgeting involves identification of investment ideas which help in:

Monitoring the external environment regularly to scout investment opportunities
Formulating a well defined corporate strategy based on a thorough analysis of strengths, weaknesses, opportunities and threats
Sharing corporate strategy and perspectives with the persons who are involved in the process of capital budgeting
Motivating the employees to come out with various suggestions

Assembling of investment proposals:

Prospective investment proposals identified by the unit are assembled and  routed through different departments in order to have a different perspective about the investment opportunities available, thus helping in creation of a climate for bringing about coordination of interrelated activities/departments.

Decision making:

The decision making authority ensures the genuineness of the investment proposals before taking any decisions and the capital budgeting exercise ensures that the investments are made judiciously over a period of time

The decision making process consists of three levels:

Operating capital budgeting
Strategic capital budgeting
Administrative capital budgeting

Implementation:

Implementation  of the capital budgeting or investment decisions are done as per the following:

Adequate formulation of projects
Use of the principle of responsibility accounting
Use of network techniques
Evaluation

Performance review:

The post completion audit called as “performance review” is a feedback device and  is useful as follows:

It throws light on how realistic are the assumptions underlying the project and capital budgeting
It provides a documented log of experience that is highly valuable for decision making
It helps in uncovering judgmental biases
It induces a desired caution among the project sponsors