What is capital budgeting? Capital budgeting is an estimation of capital expenditure that covers several years. It is a six-stage process that covers the whole process of capital expenditure starting from the availability of capital investment to the evaluation of capital expenditure.
(If you are not clear about the definition of capital expenditure, and its differences with revenue expenditure, you can go through the table containing comparison between capital expenditure and revenue expenditure.)
Let’s get back to our topic of capital budgeting.
For instance, a company wants to expand its product range. Management needs to estimate the capital investment available to fund this expansion in the future. Then management identifies suitable projects. These projects may differ in terms of cost, product specifications, profitability, period, etc. These projects are then appraised, and the best alternative is chosen. Management authorizes the capital expenditure, and a project is approved. Lastly, the actual spending on the project is compared with the budget, and deviations are investigated. Project benefits are monitored over time.
This was a very basic example but it gives you an idea of how capital budgeting is carried out. In reality, projects are appraised using multiple methods of appraisal like:
- Net Present Value Method (NPV)
- Internal Rate of Return (IRR)
- Payback Method
- Discounted Payback Method etc.
We have explained these investment appraisal methods in separate articles.
Importance of capital budgeting
Capital budgeting is a critical area for a business because it involves heavy spending of cash for actions that are likely to be irreversible. For e.g., you import a specialized plant or machinery without properly analyzing the project and its utility in your geographical location. The products made by this plant may be too expensive for the market in which you are operating, and now that plant is useless for your business. You can dispose off that plant and recover some of the investment, but you would still suffer a significant loss, all because of lack of appropriate capital budgeting and investment appraisal. Sometimes, investment in capital assets is so extensive that a business cannot afford the failure of such project. It can lead to bankruptcy and liquidation of the business. Therefore, proper capital budgeting is extremely important for all business.
Capital Budgeting – The Six Stages
One of the stages is the appraisal of projects or simply investment appraisal. In this stage:
- Future costs and benefits over the life of the project are estimated
- Net expected return by a project is then assessed
Factors to consider in investment appraisal
The main factors, around which investment appraisal revolves, are:
- Cashflows instead of profits
- Concept of relevance
- Time value of money