SIGNIFICANCE AND PRICIPLES OF CAPITAL BUDGETING

Question expected as – What is the significance and principles of Capital Budgeting?

Capital Budgeting Significance

Capital budgeting is significant for the following reasons:
1)    The decision maker looses some of his flexibility, for the results continue over an extended period of time. He has to make a commitment for the future.
2)    Asset expansion is related to future sales.
3)    The availability of capital assets has to be phased properly.
4)    Asset expansion typically involves the allocation of substantial amounts of funds.
5)    Many firms fails, because they have too much or too little capital equipment.
6)    Decisions relating to capital investment are among the difficult and at the same time, the most critical a management has to make – critical, because the effects of such decision will have a far reaching influence on a firm’s profitability for many years to come.
7)    The most important reason for capital budgeting decisions is that they have long – term implications for firm. The effects of a capital budgeting decision extend into the future and have to be put up with for a longer period than the consequences of current operating expenditures.
8)    Capital Budgeting is a vital function of management for it is one of the critical determinants of the success or failure of a company. Ill advised or excessive capital spending may create excessive costs, limit the viability of company funds and reduce its profits.

Principles of Capital Budgeting

Capital expenditure decisions should be taken on the basis of the following factors:
1)    Creative Search for Profitable Opportunities:
The first stage is conception of the profit making idea. Profitable investment opportunities should be sought to supplement existing proposals.
2)   Long – Range Capital Planning:
A flexible programme of a company’s expected future development over a long period of time should be prepared.
3)    Short – Range Capital Planning:
This is for a short period. It indicates its sectoral demand for funds to stimulate alternative proposals before the aggregate demand for funds is finalised.
4)   Measurement of Project Works:
The economic worth of a project to a company is evaluated at this stage. The project is ranked with other projects.
5)    Screening and selection:
The project is examined on the basis of selection criteria, such as the supply and cost of capital, expected returns, alternative investment opportunities, etc.
6)    Control of Authorised Outlays:
Outlay should be controlled in order to avoid costly delays and cost over-runs.
7)   Post Mortem;
The ex-post routines of a completed investment project should be re-evaluated in order to verify that their exact conformity with exact projections.
8)    Retirement and disposal:
The expiry of the cycle in the life of a project is marked at this stage.
9)    Forms and Procedures:
These involve the preparation of reports necessary for any capital expenditure programme.
10)    Economics of Capital Budgeting
It includes estimating the rate of return on capital expenditures. A knowledge of economic theory underlying investment decisions is needed for this purpose. This broad field of decision – making for capital investment is one of the most difficult, one of the most recurrent and one of the most controversial of management areas; and it is also an area where there are tremendous opportunities for basic improvements in operations and policies. It may be emphasizes here that the use of a model or of any of the mathematical techniques of the operations researcher does not imply management by computers. The mathematical model itself is a tool of management rather than replacement for management.
11)    Authorisation:
Since capital expenditure budget does not contain detailed expenditure, it is essential that before any individual projects relating to capital items are started, the expenditure should be specially authorised.