Reasons Capital Budgeting Is Important

Capital budgeting is a process that determines whether the company’s investments are worth the funds allocated. Capital refers to fixed assets such as buildings and machines. The Capital budgeting process involves assessing the costs and returns of capital investment in the business.

The process is mainly done before making significant capital investment decisions in the business. These decisions may involve improving fixed assets such as a warehouse or a machine and launching a new product. The primary purpose of capital budgeting is to ensure the business is more valuable to the shareholders.

How does capital budgeting effectively evaluate investments?

Capital budgeting effectively evaluates investments by analyzing investment returns and expenditure. The analysis determines whether the estimated cash inflow meets the actual investment returns. Capital budgeting enables the firm to choose the right investment projects. The following are reasons why capital budgeting is essential.

Long-run profitability.

For any business to prosper, a proper long term decision on the investments must be made. These investment decisions can impact the business either negatively or positively. Capital budgeting helps the business owner to make the right investment decisions. This process also ensures that there is a proper allocation of resources in the business. Proper distribution of resources can lead to long term profitability. A wrong allocation of resources can endanger the profitability of the firm. Capital budgeting decisions have long term impacts on the business.

Ensures proper investment decisions making.

A good investment is essential to the business. Making the correct investment decision can be challenging, especially when a business has limited resources. A wrong investment decision can lead to failure or even closure of the business. Capital budgeting enables the business owner to analyze the project’s costs and returns before making an investment decision. The process takes into consideration all the possible outcomes of an investment project, thus providing accountability.

Maximizes wealth.

A business that invests in long-term projects attracts new investors and shareholders. A capital budgeting process is a crucial tool for long term investment decisions. The process enables the firm to make planned decisions that lead to exponential growth. The growth leads to future profitability that motivates shareholders and attracts new investors.

Proper financial planning.

Specific investment projects require proper financial planning. Capital budgeting enables an organization to know how much money is needed for such investments. The process allows the firm to calculate the returns on investment. Capital budgeting also answers the question of how much expenditure a firm can spend. With this information, the firm is in a position to make proper decisions on how to fund the project.

Reduces risks.

Capital investment projects can be very risky at times. The business can run on either a loss or a profit. These outcomes depend on the investment projects the business undertakes. The capital budget gives you confidence and a clear picture of the projects to take. This knowledge lowers the number of risks encountered.

Improves the position of the company.

Capital budgeting involves making long term investments. The process enables the firm to make planned decisions that can increase future profits. Profits will allow the firm to grow, thus improving its position in the market.

Facilitates the monitoring and evaluation of expenditure.

Capital investments require large amounts of money. Unnecessary spending can be very disastrous to the company. Capital budgeting ensures that the firm makes the necessary expenditures. The process ensures profitability in the long-run.

Ensure the transfer of information.

Before a project is implemented, various decisions have to be made at different administrative levels. This process begins with drafting a proposal. The proposal is then submitted to managers for approval. The capital budgeting process ensures that the information is transferred to the decision-makers.

Five steps of the capital budgeting process

The investment proposal making phase: A proposal is a document that states why a particular project should be considered and the impact the project has on the business. Capital budgeting proposals should be made for consideration before financial decisions are made.

The study and analysis phase: Once the proposal is forwarded, it should be critically analyzed. The analysis is to ensure that the company’s interests are met in the project. The analysis is also done to ensure that the estimated costs and benefits are achieved. The risks are also evaluated at this stage The decision-making phase: At this stage, the firm considers the funds to be allocated. The firm should also discuss the impact of the project. In most companies, decisions are made by the board of directors.

The implementation phase: The implementation stage occurs once the proposal has been approved. The funds and resources required to start the project are provided during this phase. The follow-up phase: Once the project starts, a follow up is required to monitor the use of provided resources. The follow up ensures that the current expenditure does not exceed the estimated budget. The business expenditure should not exceed the estimated budget. Immediate action should be taken when expenditures exceed the budget.

Capital budgeting techniques

Payback period technique

This method is also known as the payout technique. The payback technique can be defined as the period required to recover the initial investment. Time is calculated in years. The time is computed by dividing the amount invested by the annual cash returns. A short payback period means that the project had a positive impact on the firm.

Accounting rate of return technique

The accounting rate of return technique determines the estimated profits from the proposal. The method uses the information given in the financial statements. The accounting rate of return is calculated by dividing the average income returns by the average invested amount. Businesses commonly use the technique because of its simplicity. The limitation of this method is that it does not consider the reinvestment of the returns.

Net present value technique

The net present value technique computes the current value of income returns of an investment. The technique uses a given discount rate. The net present value technique also calculates the net profit value. Net profit value is calculated by subtracting the cash outflows from income outflows. The advantage of this npv method is that it put into consideration the present value of money. One disadvantage of this method is that it may give inconclusive results if the projects have different investment amounts.

Internal rate of return technique

The internal rate of return technique identifies the present value of revenues with the present value of costs in an investment. Businesses prefer this method because it puts into consideration the time value of cash.

Profitability index technique

The profitability index is also known as benefit-cost. The technique is defined as the ratio of the present value of expected future returns to the current expenditure of the investment. Like the Net present value technique, the profitability index puts into consideration the time value of cash.

FAQ

How is capital budgeting used to make decisions?

The value of money over time plays an important role when it comes to making a capital budgeting decision, knowing how to choose the best alternative in terms of economically profitable projects and return on initial investment are inherent elements to grow the installed capacity of the industrial plant.

The elaboration of capital budgeting projects requires several interrelated ideas. Sometimes it is necessary to carry out an investment appraisal to incremental cash flow. For this, the financial manager demands a capital budgeting method to evaluate the capital project to determine if the project is profitable or not. That is if the cash flow shows sufficient profit with the objective that the project exceeds the costs and if it is sustainable in a time interval.

To sum up, capital budget analysis is vital since large corporations mainly analyze and make decisions to composing a capital investment proposal, and prioritize them depending on the net cash flow available and/or the value generated over time. Capital budgeting is the selection of alternatives, and their result can be a profit (good) or a loss (bad), that is why we associate the obtained results with good or bad decisions, but in reality, results are consequences of a “decision process” that the decision-maker and/or decision analyst prepared, and from the level of preparation and use of sophisticated tools to shape and evaluate the real situation of the current or future cash flow. Therefore, this tool is very useful to make decisions regarding an investment project.

What are the objectives of capital budgeting?

Capital budgets are the main control documents with respect to financial planning for long-term investments. It has many objectives but the main one is administrative control, where the scope of a product has to be determined, which allows the project planners to set a financial scope of a project. As the capital budget is established a long time before the project starts. Also within the objectives is determining the sources of funding which is responsible for identifying how much money will be needed from each source and the associated costs with the use of this method of funding. Another goal is to project cost control, as the project progresses, project managers observe weighted average cost and outlay, and further, try to make sure the project is on perfect budget. Lastly, other objectives are sounder cash business management, helping to avoid idleness of operational capacity, choosing the right time to choose the operating cash flow, and issuing shares and credits.

How do these characteristics influence the capital budgeting decisions?

The budgeting makes it possible to control the evolution of a company, contrasting what was foreseen with reality, to be able to analyze deviations. These characteristics do influence the capital decisions as budgets have the ability to predict future financial statements, based on estimations. Depending based on the information, the budget may affect a high grade of uncertainty. Also, the budget gives the probability of projecting the expenses that are expected to be incurred in a given time, as well as the income that will be generated during the scheme. Unquestionably, the budget is very essential as it represents the financial image of a project. Moreover, budget largely contributes to the understanding of the project by the investors and provides security.

How can you apply capital budgeting in your business?

All new ventures, expansion, conversion, and restructuring take up large sums of capital to finance them. Investments cannot be improvised. For their justification, evaluation, and regulation, the company uses planning tools such as feasibility studies, business plans, and capital budgets. To implement the capital budget in a business, it is necessary to measure progress, establish controls, and also improving measures. Among other steps, we can find:

  • Identify the capital needs for the next few years: differentiate between short and long term needs, and segregate the actions or needs that should be handled by the operating budget. The organization’s capital development goals are defined and include a period of 3 to 5 years.
  • Determine the total amount of investment: collect data to estimate the financing needed for capital expenditures. It considers the viability of any capital expenditures, such as new construction, restructuring, new locations, technology, or machinery.
  • Estimate the cash flows that will return the investment: cash flows are the net income adding the items that do not represent cash outflow such as depreciation expenses. The financial statements, income statement, balance sheet, and cash flow statement should be analyzed to get a better idea of financial health.
  • ¬†Evaluate the investment or possible alternatives: financing capital expenditures with loans means to pay more money in interest. It is not a wise decision for an organization to finance all investments with its own resources.

Why is it important for organizations to consider qualitative factors when making capital budgeting decisions?

The realization of capital budgets or investment projects is vital to be able to maintain and subsist to the fluctuations that have been presented worldwide. Therefore, an effective capital budget can develop both the timing of asset acquisitions and the quality of proven assets. A company that forecasts its capital asset needs in advance will have the opportunity cost to purchase and install those assets before they are demanded. On top of everything, capital budgeting practices are highly important for organizations since asset expansion usually involves very large expenses and before a company is able to capital spending a huge amount of money, it must have sufficient funds available. Therefore, a business contemplating a larger capital expenditure program should establish its financing several years in advance so that the required funds are available.

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