Capital Budgeting

Topics: Net present value, Internal rate of return, Investment Pages: 24 (5557 words) Published: June 28, 2012
Capital budgeting is the making of long term planning decision for investment fixed assets and their financing. Capital budgeting decision is concerned with current investment that will pay for itself and yield an acceptable rate of return over its life span. Hampton (1992) defines capital budgeting as the decision making process by which firms evaluate the purchase of major fixed assets, including buildings, equipment. It also covers decisions to acquire other firms, either through purchase of their common stock or groups of assets that can be used to conduct an on-going business. It is a process used to evaluate capital expenditures. The primary objective in capital budgeting decision is to add to the value of a business by selecting investments that meet the goals of the organization and provide the highest possible rates of return.

The capital investment decision is one of the most significant decision areas. It might have effect on future profitability either because it might result in an increase in revenue or because it can cause an increase in efficiency and reduction in costs

The following factors may influence capital budgeting decisions.

i. Economic change: The economic condition is highly dynamic, it is never static. As such it is always important to try and foresee future economic developments. One development that must quickly be detected is the emergence that must be quickly detected is the emergence of new competitors and new markets.

ii Technological change: Nowadays change in the technological field is very rapid. Faster communication, increasing automation, new forms of materials and the endless products of more and more research and development makes it essential that any plan spanning the years predicts the broad development in r technology.

iii. Socio-political change: The societal values, norms and orientations do change even though not as rapid as the economic and technological changes. Changes in the societal norms and values would greatly influence consumers' preferences and tastes, which will affect future demands of goods and services of the firm. Therefore, management should anticipate such changes and incorporate them in the long-term plan (i.e., the capital budgeting).

(iv)Future prospects: The current decision on capital budget should be taken with provision for future growth or expansion in terms of future additional equipment that will be needed to meet the future demand, reacting to new challenges and opportunities etc.

(v) Financing: In all capital budgeting decisions one ultimately arrives at the question of how will needs (i.e., projects) be financed? This depends very much on the financing policy of the enterprise, either by using equity or debt capital or a combination of both.

The important steps in the decision process are:
i. Identify possible investment projects: This is the project ideas can originate from any level within the organization. It can be from the operator in the factory or supervisor or production manager or managing director, ii. Acquiring relevant data on the projects under consideration: This stage involves finding all the relevant data on the projects under consideration. This task should be carried out without bias, iii. Evaluating the projects from the data assembled: This stage involves carrying out a financial evaluation of the projects based on the criteria the firm uses, iv. Identifying possible alternative to the projects being evaluated. The board of Directors will usually take the decision on projects to be selected. v. Project selection: This is a stage where a final decision on projects to be selected, vi. Project implementation: this involves implementing the decision taken on the projects selected. Efforts should be made as much as possible to...
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