1.

Nature and
Importance
Capltal Budgeting of
1.1 Nature of Capital Budgeting
The term CapitalI Budgeting' is formed by a
Caoital'andthe other is Budgeting'. In combination of ftwo words-one is
capitalemployed in a busines. But in common parlance, capital refers the
to
required capital expenditure for Capital Budgeting. capital refers to the
udgeting refers to the process of undertaking- a proposed profect, Again,
preparation of budget. So, capital budgeting
meansthe process of preparation of
budgetDifferent
in orderto undertake a prop0sed project.
for the required expenditure
capitaldefined
experts have capital
budgetingin different ways. Afew of such definitions are iven below :
According to Charles T. Horngreen "Capital Budgeting is long-term
planning for making and financing proposed capital outlay"egbud
According to R. M. Lynch-"Capital Budgeting consists in planning for
dauelopment of avalable capital for the purpose of maximising the long-term
profitability (Heturn on Investment) of the firm."
According to Lawrence D. Schall and Charles W. Haley-The process of
determining both how much to spend on capital assets and which assets to
acquire is called Capital Budgeting."ans
In order to give clear concept regarding capital budget and capital
budgeting, Eugene F. Brigham and Louis C. Gapenski said that "the capital
budget is an outline of planned expenditures on fixed assets, and capital
budgeting is the whole process of analyzing projects and deciding whether they
should be included in the capital budget."
On the basis of above discussion, it can be said that the process of
funds for
preparing the long-term planning for the purpose of financingget returns
order to
required capital expenditure for a proposed project in
Irom the project over along period in future, is called Capital Budgeting.
below:
Ihe nature of capitalbudgeting is discussed
Budgeting, decisions are taken for
0 Capital Expenditure : In Capitalexpenditure which is incurred in order
incurring capital expenditure. The future is called,Capital Expenditure.
to get returns over a long period in
incurred for purchasing a new plants,
The expenditures which are accepting a new project etc. are the
feplacement of fixed assets,
examples of capital expenditure)
decisions are taken for getting benefits for a
Budgeting
) Heturn :Capital benefits are known as
returns.These benefits
long-term in future. Such revenues or reduced costs. As
for
of increased
may be either in form revenue is increased by Rs. 50,000 as a result
Instance, the amount of amount of Rs. 50,000 will be the
project. This
OT undertaking a new 317
 318 Financial Management

return of that new project. Suppose, the costnew

of production is
Rs. 10,000 as a result of installation of a
plant. In this case,the reduction of
cost of Rs.
plant in
place reduced
of by
10,000 will be an dt
the return
for such replacement expenditure. otigp? to eruto
budgeting is a
(ii) Decision making process : Capital decision making
taken whether a prop0sed pr
aano process by which decisions are
should be accepted by a firm or not. The investment decisions ofproj
afierctm
like expansion of a long-term fixed asset, acquisition,
nieDA replacement etc. are included in capital budgeting. modernisation.
(iv) High degree of risk :The effect of capital budgeting decision remains in
force over along period. Long period is uncertain i.e., many
Ioioao changed in long-term, which can not be predicted before things
hand. may
So, thebe
investment decision which is taken in capital budgeting is high risky.
s (v) Irreversible : The investment.decisions which are taken in canil
budgeting is irreversible. Aplant or capital goods once purchased, the
invested money can not be obtained back by selling them easily r
without causing a substantial loss because the market of such type of
capital goods is very limited.
(vi) Deferred Return : In capital budgeting, decisions are taken for incuring
ot ou capital expenditure in order to get returns over a long period. But such
returns can not be obtained immediately with the incurring of the
expenditure. In most of the cases, there is a long time lag between the
initial outlay and the anticipated returns.
(vii) Accept-reject Decisions : Capital budgeting is made for. taking decision
in respect of whether a proposed project will be accepted or rejected.
So, it is an accept-reject decision.
to (vii) Huge Investment : Capital budgeting decisions are taken for collecting
ebn or replacing capital assets. A huge amount of money is required or
autes such type of programme. So, the capital budgeting process ivolves a
pndopu huge investment in capital assets.

Capital Expenditure Return

Huge Inestment Decisions

makinc procesE
Nature of
Accept Beect Capital Budgeting High degree
Becislons oftisk

Deterred Return reversible

 ting 319
12 Importance of
Capital Budgeting
Gepital| budgeting decision is very
decisionistaken in the
capital important to a firm.
Because,
future. It is very important to thebudgeting,
the firm will bear if any wrong
firm because of the a heavy losses in
0 Long-term effect::The
effect of capital following reasons :
along-period. So, if any
capital budgeting wrong decisionbudgeting remains in force over
is taken by afirm through its
process,
period and as aresult of it, then the firm may suffer loss over a long
On the other hand, if the existence of the firm may be in danger.
be earned. So, it is correct decision is taken, then a lot of profit may
decision. necessary to think judiciously before taking sucn
m Heavy
Investment : A huge amount of money has to be
incurring long-term capital expenditure. So, a firm invested for
sufficient care betore taking has to takeup
such
investment decision and it has to take
advance arrangement for collecting required funds in order to finance
the capital expenditure.
(i) Irreversibility:The investment decisions which are
budgeting is irreversible. A plant or capital goods once taken in capital
purchased, the
invested money can not be received back by selling them easily or
without causing a substantial loss because the market of such
capital
goods is very limited.
(iv) Use of Scare Resources : Money is a scare, resource. So, it is
necessary to make the best use of it. If money is invested in a project by
takingwrong decision, then a firm does not only suffer losses, butit also
may be deprived of the profits that could be earned from an alternative
project. So, at the time of investing money in a project, sufficient care
needs to be taken.
) Complexity : With a hope of geting return in future, capital budgeting
decision is taken for incurring capital expenditure. So, before taking such
investment decision, it is necessary to forecast regarding future.
Because of uncertainty, the expected return may not be obtained. The
capital budgeting decision becomes complex due to its uncertainty. So,
Special method of appraisal needs to be applied before taking such
capital budgeting decision.
WAvoidance of Losses : Capital budgeting is necessary to avoid losses.
Afirm can take correct decision with the technique of capital budgeting.
losses.
AS a result of it. it is possible for the firm to avoid the expected
(vi) Avoidance of over and under-investment :Over or under-investment
in fixed assets is very dangerous for a firm. Because, unwanted
operating
nvestment in fxed assets may lead to unnecessary heavy
investment in fixed
COSts to the firm. On the other hand, inadequate
320 WFinancial Management
assets may make it difficult for the firm to complete successtully. So,
every firm should invest accurate amount of funds in the fixed aSsets. It
0s possible for afirm to determine the accurate amount of investment in
decisions.
the fixed assets through correct capital budgeting

Long-term effeet

Heavy Investment

Irreversibility

Use of Scareiases
Resource

Complexity

Avoidance of losses

Avoidance of over &

under-investment

Evaluation Criteria--Accounting Rate of Return

2. Payback Period, Net Present Value,
Internal Rate of l Keturn, Profftability Index
Gapital investment decision is taken through the capital budgeting process.
The effect of such capital So, if
any wrong decision is takeninvestment
by a firm, remains in force
it may have over aperiod.
for a long
to suffer long period
and as a result of it, the before
existence of the
firm may be in danger. For this,
investing in a proposed project, it is necessary to appraise the project properly.
 Capital Budgeting 321
_uchappraisalcan be done in different ways. The
capital
of stment are shown below withthe help different methods of appraisal
of the following
Method of Appraisal of Capital diagram-
Investment
21. Non-discounted Cash Flow Method 2.2. Discounted Cash Flow Method

2.1.a. Payback Period Method 2.1.b. Accounting

Rate of Return Method
or, ARR Method

22.a. Net Present 2.2.b. Internal Rate 2.2.c. Discounted Pay-. 2.2.d.
Value Method of Return Method back Period.Method
or, IRR Method
Profitability
Index Method
t o These methods are discussed below one by one.
2.1.