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Capital budgeting for financial management and its process
Financial management is of prime importance in virtually all organizations that are performing any types of activities. It helps to set rational goal of the firm and guides how financial decisions should be made to achieve the organizational or business goal. Financial management is also important to an individual equally. For sound financial management good financial decision making is very essential and for good financial decision making the concepts, techniques and theories of finance should be known.
Every businessman should have proper knowledge of financial management for effective and efficient management of finance. Among the various techniques one of the most important techniques is capital budgeting technique. Budgets are of two types they are capital budget and operational budget. Operational budget is the budget that is planned and prepared for short period. It is prepared maximum for a year and is simply the estimation and planning for the business operation within a year. Capital budget in other hand is the long –term budgeting which may be five years, ten years and even more than twenty years. Capital budgeting depends on the size and nature of assets and properties a company or business acquires in near future. Capital budgeting is necessary for a business entity to get or step forward in the business and make important and risky decisions like new projects, business extensions, new plant and machinery, research and development. In the context of capital budget is provision of resources for acquiring fixed assets. Capital budgeting is the way of acquiring the fixed assets or process of investment in capital projects. Capital budgeting is the step-by-step process which includes identification of investment opportunities, prediction of relevant cost and benefits of identified projects, confirmation and monitoring & controlling the projects. Capital budgeting if done properly than there is sure the project runs towards success.
Following process should be adopted for successful capital budgeting:
1. * Find out why to invest: There can be many and different reasons why to invest. Reason may be form any sources it can be from, operation department to replace a plant, research and development department for development of new products any board members may have reason to make investment in some profitable sector or may decide to expand the business. Proposals of investment are generated in this step of capital budgeting process. Reasons may be either not deniable or may be progressive for organization.
2. * Estimation of cash flow of proposal: Cost and benefit of investment proposal with the time and effort required are measured in terms of cash flow. Expected cash flows of the proposed projects over the project period are estimated in this step. Firstly, Net cash outlay (initial investment) is estimated and annual cash flow which is the difference of incoming and outgoing cash from the investment on the proposal is predicted. Lastly, terminal cash flow which is the net cash flow at the end of the project is calculated.
3. * Evaluation of the proposal: After the estimation of the cash flows of the proposals or projects the next step is the evaluation of the proposal. There are some methods to evaluate the proposal it can be done both by discounted cash flow method, non-discounted cash flow method or combination of both. Discounted cash flow method includes net present value method, internal rate of return method, modified internal rate of return method, and profitability index. Payback period calculation is commonly used non-discounted cash flow.
4. * Post completion audits of proposal: The proposal is not passed or approved without full understanding and passing through different level of authority. The level of authority depends upon the organizational hierarchy, organizational size and number of authority holders. Usually, the entire capital budgeting proposal reaches to the president of the organization. Proposed projects are launched after getting due approval and acceptance from the authority. Finally, capital budgeting is done after.
These are the fundamental steps for capital budgeting that you can go through. Now, let us know about the projects and its classifications. As above I have already stated proposal may come from any sources. Those proposals after passing the steps or process of capital budgeting becomes a project. The projects are classified as independent projects, dependent projects, mutually exclusive projects, replacement projects, expansion projects and diversification projects. They are further described below:-
a. # Independent projects: Independent projects are those type of projects in which, selection of one project does not prevent the selection of next or other projects. Approval of one project does not hamper the other project. For example installation of petrol pump and construction of mall are independent projects.
b. # Dependent projects: dependent projects are those projects whose cash flows affect each other. The selection of one project directly affects the other or cannot neglect other project. For example construction of housing colony and land plotting are dependent projects.
c. # Mutually exclusive projects: A project is said to be mutually exclusive projects if selection of one project neglects or rejects the other projects. For example construction of hotel or hospital in a land.
d. # Replacement projects: Replacement project replaces the old project with the new one. Because of many reasons a project may not function well here replacement projects are necessary. For example replacement of old machines with new one due to wear and tear.
e. # Expansion projects: expansions projects are those projects that are approved to expand the business. Expansion of business to new geographical area, opening new retail outlet are some examples of expansion projects.
f. # Diversification projects: The projects that diversify the business are diversification projects. For example new product development or getting into new markets.
Capital budgeting should be done appropriately to gain profit from the business and have successful business. If you have any question relating capital please comment.
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