MEANING AND NATURE OF CAPITAL BUDGETING-ALL YOU NEED TO KNOW
Capital budgeting is the process of making investment decisions in capital expenditures. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred of one point of time whereas benefits of the expenditure are realised at different points of time in future. In simple language we may say that a capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. The following are some of the examples of capital expenditure:
(2) Cost of addition, expansion, improvement or alteration in the fixed assets.
(3) Cost of replacement of permanent assets.
(4) Research and development project cost, etc.
Capital expenditure involves non-flexible long-term commitment of funds. Thus, capital expenditure decisions are also called as long term investment decisions. Capital budgeting involves the planning and control of capital expenditure. It is the process of deciding whether or not to commit resources to a particular long term project whose benefits are to be realised over a period of time, longer than one year. Capital budgeting is also known as Investment Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure and Analysis of Capital Expenditure.
From the above description, it may be concluded that the important features which distinguish capital budgeting decision from the ordinary day to day business decisions are:
(1) capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future;
(2) the future benefits are expected to be realised over a series of years;
(3) the funds are invested in non-flexible and long term activities;
(4) they have a long term and significant effect on the profitability of the concern;
(5) they involve, generally, huge funds;
(6) they are irreversible decisions.
Nature of Capital Budgeting:
Capital budgeting is the process of making investment decisions in capital expenditures. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year.
The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. In simple language we may say that a capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future.
NEED AND IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting means planning for capital assets. Capital budgeting decisions are vital to any
organisation as they include the decisions as to :
(a) Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.
(b) Analyse the proposal for expansion or creating additional capacities.
(c) To decide the replacement of permanent assets such as building and equipments.
(d) To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.
The importance of capital budgeting can be well understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern. The need, significance or importance of capital budgeting arises mainly due to the following:
(1) Large Investments. Capital budgeting decisions, generally, involve large investment of funds. But the funds available with the firm are always limited and the demand for funds far exceeds the resources. Hence, it is very important for a firm to plan and control its capital expenditure.
(2) Long-term Commitment of Funds. Capital expenditure involves not only large amount of funds but also funds for long-term or more or less on permanent basis. The long-term commitment of funds increases the financial risk involved in the investment decision. Grater the risk involved, greater is the need for careful planning of capital expenditure, i.e. Capital budgeting.
(3) Irreversible Nature. The capital expenditure decisions are of irreversible nature. Once the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.
(4) Long-term Effect on Profitability. Capital budgeting decisions have a long-term and significant effect on the profitability of a concern. Not only the present earnings of the firm are affected by the investments in capital assets but also the future growth and profitability of the firm depends upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost importance to avoid over investment or under investment in fixed assets.
(5) Difficulties of Investment Decisions. The long term investment decisions are difficult to be taken because
(i) decision extends to a series of years beyond the current accounting period,
(ii) uncertainties of future and
(iii) higher degree of risk.
(6) National Importance. Investment decision though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.
Thus, we may say that without using capital budgeting techniques a firm may involve itself in a losing project. Proper timing of purchase, replacement, expansion and alternation of assets is essential.
