What is Capital Budgeting in Corporate Finance?

What is Capital Budgeting in Corporate Finance_

What is Capital Budgeting in Corporate Finance?

If you are a business owner, you will agree with me that most of your everyday decisions are typically operational. For example, how to arrange your store, how many product/service units to sell, how much to charge your customers, how many employees to schedule, etc.

Yet, in the background, you are subconsciously making decisions to determine the most suitable projects or tasks to fund to ensure that your business is growing and making profit. In layman’s terms, such decisions, altogether, point towards capital budgeting of your business’ finances.

So, what is Capital Budgeting?

Capital budgeting is a combination of two key terms: “capital” and “budgeting.”

Capital refers to the funds you set aside to make huge expenditures, such as buying raw materials, purchasing fixed assets, disbursing payroll, repairing equipment, research and development, expansion, etc.  

Budgeting refers to setting targets for projects to ensure you achieve maximum profitability.

Therefore, capital budgeting is the planning process for evaluating investments and huge expenses in various projects with the intention of obtaining maximum returns on investment.   

Your business will always experience challenges in choosing between two projects/investments or making a decision to buy or replace items. In an ideal world, many firms would choose to invest in all profitable projects, but due to limited capital, they are always forced to abandon the less profitable ones.

Since the concept of capital budgeting affects our daily lives, let’s take an ordinary example.

Unexpectedly, your car breaks down! Now, you are torn between two choices: spend some money on repairing it or buying a new one. If you go for repair, your reason would be that it increases the lifespan of the car. Yet, the cost of buying a new car would possibly be lesser than its repair costs. So, you go for replacement and start shopping for different cars as per your budget!

Objectives of Capital Budgeting

Unless it’s a non-profit organization, all businesses exist to earn profit. Capital budgeting is extremely important since it affects the long-term growth and prosperity of your business.

Since the capital expenditures are huge and have a long-term effect, it is important to consider.

Selecting Profitable Projects

Your business will frequently come across a number of profitable projects. However, due to capital restrictions, you must choose the right combination of profitable projects to ensure your shareholders enjoy a higher return on their investment. 

Capital Expenditure Control

Even though capital budgeting aims to choose the most profitable investment, you must also focus on controlling capital costs. Since a good project can lead to financial losses if you fail to control and monitor expenditures, forecasting and making accurate provisions for capital expenditure ensures that no investment opportunities are lost. 

Soliciting for Funds from Right Sources

Capital investment requires a huge funding. Since your firm has limited financial resources, determining the sources for procuring the more funds is an extremely important objective of capital budgeting. Capital budgeting calls for finding the right balance between the cost of borrowing and returns on investment. 

Capital Budgeting Process

To carry out effective capital budgeting, the following are the necessary steps of a standardised process.

Step 1: Identify Investment Opportunities

Looking for an investment opportunity is the first step towards capital budgeting. Your organization can pinpoint various opportunities, such as product expansion, a new business line, or buying a new asset. 

Step 2. Evaluate Investment Options

After picking an investment opportunity, you must examine various investment options. For instance, if you decide to buy new assets, maybe vehicles, the next step would be deciding on how to acquire these assets. Some of the ways of acquiring them could be importing them from abroad, or purchasing them from the local market.

Step 3: Select a Profitable Investment

Once you have evaluated all investment options, you need to choose the most profitable investment, that is, the one that brings the highest return on investment. While deciding on a particular project, use the capital rationing technique, which ranks the projects as per returns by introducing a sense of strict budgeting of available resources. For example, your company would decide to either choose between importing the vehicles from abroad and buying them from local manufacturers. Probably you decide to buy them locally to avoid high taxes.

Step 4: Capital Budgeting and Allotment

After you have selected the project, the funding is now required. The funding process requires you to identify the sources of funds and allocate it accordingly. The sources of these funds could be reserves, investments, loans or any other available channel.

Step 5: Performance Review

Reviewing your chosen investment is the final step in the capital budgeting process. Initially, you selected a specific investment for because you predicted a better return for your business. Therefore, your performance review will compare the expected performance to the actual performance of the investments. In our example, you would have worked out an expected return while evaluating for the most profitable investment. Once you made the investment, you received the vehicles, and sold them to various customers in the market. The profits you earned from its sales should be compared to the set expected returns to conclude the performance review.

Conclusion

Capital budgeting is a key factor in streamlining your management decisions. The right decisions can take your business to incredible heights, while only one wrong decision can even force your business to shut down. This always trickles down to the amount of funds involved as well as the tenure of your selected projects.

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