Capital Budgeting decision is considered most important and most critical decision for finance manager. It involves decisions related to long-term investments of capital nature. The returns from such investments are scattered over a number of years. Since it requires huge amount of funds, it is considered irreversible.
Some examples of capital budgeting decisions are Purchase of new plant and machinery, replacement of old plant and machinery, expansion and diversification decision, research and development projects etc.
Definition of Capital Budgeting
According to Charles T. Horngren:
“Capital Budgeting is long-term planning for making and financing proposed capital outlays.”
According to L.J. Gitman:
“Capital Budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.”
Nature of Capital Budgeting
- It is a long-term investment decision.
- It is irreversible in nature.
- It requires a large amount of funds.
- It is most critical and complicated decision for a finance manager.
- It involves an element of risk as the investment is to be recovered in future.
The process of Capital Budgeting
The process of capital budgeting involves following steps
- Project Generation: In the first step, projects for investments are identified. This projects may be undertaken to increase revenue or to reducing cost. for this, proposals for expanding production capacity, proposals for replacement of plant etc. could be undertaken.
- Project Evaluation: In this step, costs and benefits from such projects are evaluated. Projects are judged on the basis of profitability and returns it offers to the firm.
- Project Selection: The projects generated and evaluated are then screened at various levels of management. After screening, the top management may decide whether to select or reject the proposal.
- Project Execution: A project is executed after final selection is made by the management. Required funds are allocated to execute the project.
- Follow-up: Executed projects are then followed-up. Actual performance of the project is compared with the expected performance and deviations are found out. With the help of which future decisions are taken.