MEANING OF CAPITAL BUDGETING
In modern times, the efficient allocation of capital resources is the most crucial function of financial management. This function involves the organization’s decision to invest its resources in long-term assets like land, building facilities, equipment, vehicles, etc. All these assets are extremely important to the firm because, in general, all the organizational profits are derived from the use of its capital in investment in assets which represent a very large commitment of financial resources, and these funds usually remain invested over a long period of time.
The future development of the firm hinges on the capital investment projects, the replacement of existing capital assets, and/or the decision to abandon previously accepted undertakings which turns out to be less attractive to the organization than was originally thought, and divesting the resources to the contemplation of new ideas and planning. For new projects such as investment decisions of a firm fall within the definition of capital budgeting or capital expenditure decisions.
Capital budgeting refers to long-term planning for proposed capital outlays and their financing. Thus, Capital Budgeting includes both raising of long-term funds as well as its utilization. It may, thus, be defined as the “firm’s formal process for acquisition and investment of capital.” To be more precise, capital budgeting decision may be defined as “the firms’ decision to invest its current fund more efficiently in long-term activities in anticipation of an expected flow of future benefit over a series of years.” The long-term activities are those activities that affect a firm’s operation beyond the one-year period. Capital budgeting is a many-sided activity. It contains searching for new and more profitable investment proposals, investigating, engineering, and marketing considerations to predict the consequences of accepting the investment, and making economic analysis to determine the profit potential of the investment proposal.
The basic feature of capital budgeting decisions are:
(1) current funds are exchanged for future benefits;
(2) there is an investment in long-term activities; and
(3) the future benefits will occur to the firm over a series of years.
NEED FOR CAPITAL BUDGETING
This is the logical question and the answer to that is rather easy. The following factors give rise to the need for capital budgeting:
(a) Wear and tear of old types of equipment.
(c) Variation in product demand necessitating a change in the volume of production.
(d) Product improvement requiring capital additions.
(e) Learning-curve effect.
(g) Change of plant site.
(i) Productivity improvement.