Nature of Capital Budgeting
Capital budgeting involves a current investment in which the benefits are expected to be received beyond one year in the future (Van-Hornc). Capital budgeting may, therefore defined as the planning of expenditure whose returns stretch themselves beyond one-year time interval. It is the process of deciding whether or not to commit resources to a project whose benefits would be spread over several time periods. According to Charles T. Horngren, capital budgeting is the making of long-term planning decisions for investment (Capital outlays) and their financing. Most expenditures for plant, equipment and other long lived assets affect operations over a series of years. They are large, permanent commitments that influence long-run flexibility and earning power. Decisions in this area are among the most difficult, primarily because the future to be foreseen is distant and hard to perceive. Since the unknown factors be collected and properly measured before a decision is reached. Hence, the capital budgeting decisions are now generally based on the proper evaluation and analysis of all the available projects and the facts relating thereto. As they involve more extended estimation and prediction of the things to come in the future. It requires a high order of intellectual ability for their economic analysis.
The main exercise involved in capital budgeting is to relate the benefits to costs in some reasonable manner would be consistent with the wealth maximization objective of the business. The profitability of business decision depends on two vital factors : (a) future net increase in cash inflows or net savings in cash outflows, and (b) required investment (capital outlay) Evaluating. The quantitative approach to the selection of projects generally compares predicated cash flows to the required investments (Horngren). Thus, all projects whose rate of return exceeds the minimum rate of return would be desirable, vice-versa. A project that is expected to return 20 percent would ordinarily be more desirable than one with a return of 15 percent However before a final choice is made, it must be ensured that all the available alternatives have been taken into consideration. The process of capital budgeting therefore, involves, three things; Developing, Evaluating and Choosing. It thus becomes an exercise in determining an optimum quantity quality mix (of the capital project) for achieving objectives of the firm both in the short and the long run. It is one of the most developed areas in management since World War II where a lot of mathematical analysis has been possible. It is however, to be noted that capital budgeting is and should be noted that capital budgeting is and should be a continuous process due to the dynamic environment and increasing complexities of the problem.
As regards the nature of capital investment decisions, the capital budgeting techniques are applicable in a number of situations. These may be enumerated as follow :
(i) Creation of new facilities.
(ii) Expansion of existing facilities.
a) for the same products;
b) for the diversified products.
(iii) Replacement decisions where the existing old machinery/equipment/building can be replaced with one or more units of new equipment; or hiring equipment/instruments.
(iv) Modernization-for taking advantage of modern and changing technology.
(v) Acquisition of existing business.
(vi) Make or buy decisions (for capital equipment)
(vii) Research and Development.