Wednesday, June 1, 2011

CHARACTERISTICS OF CAPITAL BUDGETING

Question expected – Describe the characteristics of Capital Budgeting?


1)    Capital Expenditure for Long Period:

Capital budgeting entails heavy expenditure. In fact, this is very important characteristic which explains the importance of capital budgeting decisions to a firm. Capital is sunk for a long period. This long-term commitment adds considerably to the risk of capital budgeting decisions. Capital expenditure is the main link between the present and the future, for it is the principal means by which an industrial company tries to attain its long-term goals and objectives. Because of its relationship with long-term profit planning, its disproportionately heavy impact on short-term profits and its high volume capital expenditure should be planned and controlled. Decisions, which involve the authorisation of capital expenditure projects, are among the most important for the Board of Directors and their managerial advisers. Most capital expenditure schemes call for a permanent commitment of relatively large sums of money over a number of years.
  • Creative Search for Profitable Opportunities:
The concept of the profit – making idea must be embodied inthe capital facility. Profitable opportunities for the company’s invested capital must be turned up. A corporation’s future profitability and growth are linked to the soundness of its capital expenditure policy. This calls for the need for clearly identifying the steps of a capital expenditure management programme. These steps then requires to be integrated into a procedure to be used for the conduct of an organisations capital expenditure programme.
  • Long-Range Capital Planning
To provide consistent benchmarks for proposals originating in all parts of the organisation, it is necessary to have some kind of a plan sketched and for the future even though it is a tentative plan. In the words of Joel Dean: “Today’s capital expenditures make the bed that the company must lie in tomorrow. The capital expenditure budget embraces a company’s plans for replacing,improving and adding to its capital equipment”.
  • Short-Range Capital Planning:
The purpose of preparing a short-range capital budget is to force the operating management to submit the bulk of its capital proposals early enough to give the top management an indication of the company’s credit demands for funds.
  • Measurement of Project Worth:
In order to permit an objective of the projects, the productivity of the proposed outlay will have to be measured properly.
  • Screening and Selection:
A screening standard should be set in the light of the supply of cash available for capital expenditures, the cost of money to the company, and the attractiveness of alternative investment opportunities.
  • Control of authorised Outlays;
Control has to be exercised by the top management in order to ensure that the facility conforms to the specifications and that the outlay expenditure is incurred, it is most difficult to change the course of expenditure. As capital assets are usually of limited specific use, the future needs of such assets should be carefully assessed.
  • Post Mortem:
In order to preserve the integration for the estimates of projected earnings, a post completion audit of the company’s performance should be effected.
  • Retirement and Disposal:
A management’s responsibility for an investment approach ceases only when the facilities have been disposed of. The asset must be retained throughout its economic life until it virtually becomes worthless at the time of disposal.
  • Forms and Procedures:
An effective system of capital expenditure control should be implemented with the use of specialized forms, written procedures, etc – all tailored to the company’s needs.
  • Economics of Capital Budgeting:
good estimates of the rate of return on capital expenditure projects presuppose an understanding of the economic concepts that underlie sound investment decisions.
  • Increase the Breadth of Analysis Leading of Decision Making:
in evaluating capital expenditure decisions or a profit plan, it has been fairly common to consider only a few alternative strategies or economic assumptions before reaching a decision.
  • Tool for special Problems:
More and more attention is being devoted by management to temporary and special problem situations.
  • Understanding Inherent Logic of the Financial System:
As a by-product of financial modeling, some executives have found, that the act of defining the logic and interaction of the financial system in developing the model, is in itself, a very important and revealing activity.

2)    Forecasting:

As funds are committed over extended periods of time, there is a need for proper forecasting. a bird in hand is worth two in the bush. There is an element of uncertainty and risk which may lie in store for the future. All these factor have to be properly evaluated in the process of forecasting. A proper cost-benefit relationship should also be established.

3)    Planning Asset Capacities:

A firm has to assess the capacities of the assets properly before arriving at its long-term decisions. Both under capacities and over-capacities should be avoided. Moreover, the management should determine the timing and the quality of asset acquisitions. Asset capacities have to be related to market factors, which may change over a period of time because of various cyclical fluctuations. A firm should, therefore, plan and fix the capacities of its assets in which long-term investment is going to be sunk.

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