Capital Budgeting

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Capital expenditures (also referred to as capital investments or capital projects) is very important for three inter-related reasons: They have long-term consequences. 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 market for used capital equipments is often imperfect. Given the crucial significance of capital expenditure decisions, it is not surprising that firms spend considerable time in planning these decisions and involve top executives from production, engineering, marketing, and so on, in evaluating capital expenditure proposals-these decisions are too important to be left to financial managers alone.

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 - The capital budgeting process begins with the identification of potential investment opportunities. Typically, the planning body (it may be an individual or a committee organised formally or informally) develops estimates of future sales which serves as the basis for setting production targets. This information, in turn, is helpful in identifying required investments in plant and equipment.For imaginative identification of investment ideas it is helpful to (i) monitor external environment regularly to scout investment opportunities, (ii) formulate a well defined corporate strategy based on a thorough analysis of strengths, weaknesses, opportunities, and threats, (iii) share corporate strategy and perspectives with persons who are involved in the process of capital budgeting, and (iv) motivate employees to make suggestions.

DBIT Pvt. circulation Notes by Prof.S.P.Sabnis

Assembling of investments proposals

Investment proposals identified by the production department and other departments are usually submitted in a standardised capital investment proposal form. Generally, most of the proposals, before they reach the capital budgeting committee or somebody which assembles them, are routed through several persons. The purpose of routing a proposal through several persons is primarily to ensure that the proposal is viewed from different angles. It also helps in creating a climate for bringing about coordination of interrelated activities. Investment proposals are usually classified into various categories for facilitating decision-making, budgeting, and control. An illustrative classification is given below. Replacement investments Expansion investments New product investments Obligatory and welfare investments
Decision making - A system of rupee gateways usually

characterises capital investment decision making. Under this system executives are vested with the power to okay investment proposals up to certain limits. For example, in one company the plant superintendent can okay investment outlays up to Rs 200,000, the works manager up to Rs 500,000, and the managing director up to Rs 2,000,000. Investments requiring higher outlays need the approval of the board of directors.

DBIT Pvt. circulation Notes by Prof.S.P.Sabnis

Preparation of capital budget and appropriations - Projects involving smaller outlays and which can be decided by executives at lower levels are often covered by a blanket appropriation for expeditious action. Projects involving larger outlays are included in the capital budget after necessary approvals. Before undertaking such projects an appropriation order is usually required. The purpose of this check is mainly to ensure that the funds position of the firm is satisfactory at the time of implementation. Further, it provides an opportunity to review the project at the time of implementation. Implementation Translating an investment proposal into a concrete project is a complex, time-consuming, and risk fraught task. Delays in implementation, which are common, can lead to substantial costoverruns. For expeditious implementation at a reasonable cost, the following are helpful. Adequate formulation of projects The major reason for delay is inadequate formulation of projects. Put differently, if necessary homework in terms of preliminary studies and comprehensive and detailed formulation of the project is not done, many surprises and shocks are likely to spring on the way. Hence, the need for adequate formulation of the project cannot be over-emphasised. Use of the principle of responsibility accounting Assigning specific responsibilities to project managers for completing the project within the defined time-frame and cost limits is helpful for expeditious execution and cost control. Use of network techniques For project planning and control several network techniques like PERT (Programme Evaluation Review Technique) and CPM (Critical Path Method) are available. With the help of these techniques monitoring becomes easier. Performance review Performance review, or post-completion audit, is a feedback device. It is a means for comparing actual performance with projected performance. It may be conducted, most appropriately, when the . rations of the project have stabilised. It is useful in several ways: (i) it throws light on how realistic were the assumptions underlying the project; (ii) it provides a documented log of experience that is highly valuable for decision-making; (iii) it helps in uncovering judgmental biases; and (iv) it induces desired caution among project sponsors.

DBIT Pvt. circulation Notes by Prof.S.P.Sabnis

Must Read !

Chap 3 The Time Value of Money Chap 6 Basics of Capital Budgeting Chap 9 Capital Budgeting Additional Techniques
(sec 9.1 Additional Investment Criteria)

From Book Fundamentals of Financial Management by Prasanna Chandra (Publisher- TMH)

DBIT Pvt. circulation Notes by Prof.S.P.Sabnis