Hello finance students, future
finance managers and entrepreneurs!!!
The life of any business is its
growth and expansion, its survival and growth depends on its ability to improve
its products, produce new and better products, expand its operations and remain
competitive, all these tasks can be achieved after taking capital budgeting
decisions.
Suppose you are a finance manager and you have
to purchase new machinery for your company. Now what would you do? How would
you decide which one machine to purchase …………. that fits best, in the budget
and gives the better future returns to your company? This all issue is resolved
through utilizing the concept of Capital Budgeting.
For understanding capital
budgeting we need to understand capital expenditure….. So what is a capital expenditure? Capital means operating assets used in
production and expenditure mean
amount spent in getting operating assets. So they are the expenses incurred for
acquiring (purchasing) or improving long-term operating assets which generates
revenues for a long time period. It could be a purchase or improvement of
machines, equipments, land and building or undertaking a running business entity.
For incurring capital expenditure a manger has to make capital budgeting
decisions.
Now you understand the meaning of
capital let’s move on to budget. Budget means
a plan that shows the details of the
after effects of purchasing fixed asset (long-term assets)… so making the
decision for purchasing long-term assets involves capital budgeting. But only
acquiring long-term assets not the alone task of capital budgeting it can be
done for the replacement of old assets for business maintenance or cost
reduction purpose, expansion of existing products and markets, entering in new
products or markets, long-term contracts, projects and research and development
projects and so on.
It is the most important and
difficult task faced by the finance professionals “it involves the evaluation
and analysis of an expected investment in long-term assets whether financial or
other or considering a project”. In a real sense Capital Budgeting is the process which involves analysis of the
cost and future cash-flows of purchasing assets or starting projects and then
the decision is made whether buy asset or not and accept or reject the project.
The results of capital budgeting remains for
many years i.e. till the life of that acquired asset that is the reason mangers
have to be very careful in making these decisions, a wrong decision can costs
huge losses like high depreciation or obsolesce of machine and software, so it
requires accurate sales forecasting, right timing and funds lined up for
purchase. To make accurate decisions managers use these techniques:
1.
Payback period
2.
Discounted payback period
3.
Net present value (NPV)
4.
Internal rate of return (IRR)
5.
Modified internal rate of return (MIRR)
6.
Profitability index (PI)
Payback period calculate the number of years required to recover
the original investment. It facilitates us to know that how long the funds will
be tide up in the project, it indicates the riskiness of the project. For more details and examples click here
Discounted Payback period is same as the payback period but its
cash flows are discounted on the cost of capital and gives the period required
to recover the investment from discounted cash flows, in the project. But
payback period methods have deficiencies.
Net
present value (NPV) net
present value is the value comes from deducting the present value of outflow
from the present value of inflows coming from the project, it could be
positive, negative or zero. For more details and examples click here.
Hope you have find this helpful, if so please comment about your experience and queries regarding this.
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