Generally, the capital budgeting decisions are related to long term investments. The general scope of capital budgeting decisions are discussed briefly below.
1. Mechanization of Process
The manual production process is replaced by mechanization of process. The very purpose of this type of change is to reduce costs. The future cash inflows on this investment are the savings resulting from the lower operating costs. Now, the company considers the worth of mechanization of process.
2. Expansion Decisions
Sometimes, a company can expand its operation by increasing production and sales. In this context, a company can acquire new machinery, construct additional building, merger or takeover of other business. They require huge amount and evaluate future earnings.
3. Replacement Decision
A company can replace an old machine with a new machine by considering latest technology. It brings down the operating expenses and increase the productivity. Such replacement decision will be evaluated in terms of savings in operating costs or the cash profits from additional volume of production by new machine or both.
4. Buy or Lease Decision
The fixed assets can be purchased or arranged on lease arrangements. The purchase of fixed assets requires huge amount initially. If the same asset is used on lease basis, the company requires less amount initially and heavy amount in total. Hence, a comparative study can be made with reference to future benefits from these two mutually exclusive alternatives.
5. Choice of Equipment
Two types of machines are available to perform a same work. The cost of each machine differ from one another. Moreover, pros and cons of buying each machine are evaluated and screened for selection of best one. Capital budgeting process helps a lot in such selections.
6. Product or Process Innovation
A new product may be find out or innovated. Sometimes, a new production process may be innovated. The research and development department of a company is finding a new product or innovation in a product or process. These require huge amount for implementation. In this case also, a comparative study of net cash outflow (costs of the project) and net cash inflow (i.e. future earnings) is highly useful for taking a decision. The decision is based on the profitability of the product or process.
7. Housekeeping Projects
These projects are creating an indirect impact on production. Such projects are legally required for implementation and useful for the boost up the morale and level of motivation among the employees. Health and safety projects, service department projects, welfare projects, education, training and development projects, status projects and research and development projects are the examples of Housekeeping Projects.
The financial feasibility, quantum of amount required, sources of finance and profitability of the housekeeping projects are not considered for implementation.
Process of Capital Budgeting
Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefits to be available in future. The process of capital budgeting is briefly explained below.
1. Search of Profitable Opportunities
There is a need of continuous searching for finding profitable opportunities. Such type of proposals may come from a rank and file worker of any department or from any line executive. Hence, the company can conduct review meeting periodically and discuss the matters relating to earning capacity of the company, expecting changes in the business world, cost of capital, capital investment made so far, production process, production technique, marketing strategies, product line and the like.
2. Long Range Capital Plans
Whenever a long term project proposal is submitted before the top management, they are considering the extent of consistency of new plans with existing plan before final selection. It requires the adherence of capital budgeting policies of the company.
3. Short Range Capital Budget
If the project has minimum period for execution and gets maximum priority than other projects, it should be listed on the one year capital budget as an indication of its approval.
4. Measurement of Project Worth
Small projects requires less amount for implementation. This type of project is approved and selected by the department head stage. In the case of large projects which require huge amount for implementation. Hence, the large projects should be ranked according to their profitability. Two or more capital budgeting techniques are used to find the profitability of each project.
Capital expenditure budget committee may screen the proposals to find out whether the proposals are as per the strategies, objectives and policies of the company. Moreover, the profitability of each proposal is also considered in screening stage. If the proposals are not fulfilling the minimum rate of return, objectives, strategies and policies of the company, the same proposal should be rejected immediately.
6. Evaluation of Proposals
The pros and cons of each proposal are properly evaluated before the selection. Moreover, the difficulties connected with each project while implementation are also properly highlighted. If the difficulties are properly anticipated, proper care can be taken by the company whenever such a project is selected for implementation.
7. Fixing Priorities
All the proposals are not profitable. At the same time, all the proposals cannot be rejected. Any one of the proposal should be selected at the cost of some other proposals. In other words, unprofitable and unacceptable proposals are rejected straight away. The remaining proposals are presented before the management in order of merit i.e. rank. The priorities of the proposal are fixed by considering urgency, risk and profitability.
8. Final Approval
The capital expenditure budget committee reviews all the projects in terms of capital expenditure and the sources of capital to meet them. Then, the committee presents the review before the top management for final approval. The top management gives final approval only on the basis of suggestions and reviews provided by the capital expenditure budget committee.
9. Forms and Procedures
This phase involves the preparation of reports for every other phase of the capital expenditure programme of the company.
10. Implementing Proposal
An individual is designated as project manager for project implementation. In this stage, proper authority is given to the project manager and fix the responsibility also. The time and costs are fixed so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as Program Evaluation and Review Technique (PERT) and Critical Path Method (CPM) can be applied to control and monitor the project implementation.
11. Performance Review
Project audit is conducted to review the performance of each project separately. The actual capital expenditure is compared with budgeted one. Likewise, actual rate of return is compared with anticipated rate of return. Factors responsible for unfavorable variances should be identified in order to take necessary corrective actions in the future.
12. Retirement and Disposal
This is the last stage of the project life cycle. The old fixed assets should be sold out and the realized amount was used for purchase of new fixed assets or implementing new project in the days to come.
13. Experience of Project Implementation
The future is uncertainty. A project is implemented with great expectation. All the expectations are not coming into true. Generally, the actual is differing from the anticipation. Sometimes, cash inflows is more than or less than the expectation. If so, the management can find the reasons for such variances.
Likewise, the actual expenses are more than or less than the allocated expenses. In this case also, the management gets maximum experience. These experiences are highly useful to the management for improving its capital budgeting programme in future.