Capital Budgeting Practices

CAPITAL BUDGETING PRACTICES OF CORPORATE SECTOR :

Introduction.

"Capital budgeting is concerned with the allocation of the firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project, with the immediate and subsequent expenditures for it."

An analysis of the above definition shows that capital budgeting correlates the planning of available financial resources and their long term investment with a view to maximize the profitability of the firm. The financial manager has to focus on maximizing the wealth of shareholders through investment decisions. Investment decisions are long-term strategic decisions. Thus, he should be in apposition to evaluate whether a particular investment will facilitate achievement of this goal or not. It is also known as investment decision, capital expenditure, capital expenditure planning, project planning etc. It is a process of making decision regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture. Capital budgeting is the planning of the expenditure for a future return. It returns stretch themselves beyond a one-year time interval. Capital expenditure planning and control is a process of facilitating decisions covering expenditures on long-term assets. Since a company survival and profitability hinges on capital expenditure, specially the major ones, the importance of the capital budgeting process cannot be over emphasized.

Capital budgeting/investment decision or capital expenditure decision is nothing but an efficient allocation of capital, which is one of the important finance functions of the management, which influences the growth, profitability, and risk. A capital expenditure decision or capital budgeting decision is a firm's decision to invest its current funds most efficiently in some long term asset or source of income in expectation of a continuous flow of benefits (income) over a serious of years (period). Ofcourse firm's decisions include expansion, acquisition, modernization and replacement of the long term assets.

Capital budgeting decisions are crucial to a firm's success for several reasons. First, capital expenditures typically require large outlays of funds. Second, firms must ascertain the best way to raise and repay these funds. Third, most capital budgeting decisions require a long-term commitment. Finally, the timing of capital budgeting decisions is important. When large amounts of funds are raised, firms must pay close attention to the financial markets because the cost of capital is directly related to the current interest rate.

The need for relevant information and analysis of capital budgeting alternatives has inspired the evolution of a series of models to assist firms in making the "best" allocation of resources. Among the earliest methods available were the payback model, which simply determines the length of time required for the firm to recover its cash outlay, and the return on investment model, which evaluates the project based on standard historical cost accounting estimates. The next group of models employs the concept of the time value of money to obtain a superior measure of the cost/benefit trade-off of potential projects. More current models attempt to include in the analysis non-quantifiable factors that may be highly significant in the project decision but could not be captured in the earlier models.

This project explains budgeting models currently being used by large companies, the division responsible for evaluating capital budgeting projects, the most important and most difficult stages in the capital budgeting process, the cost of capital, cutoff rate, and the methods used to adjust for risk. A possible rationale is provided for the choices