CAPITAL BUDGETING

Author 1
Bhavishya Jumani

Student(b.com(H))
ARKA JAIN University, Jamshedpur, Jharkhand

Author 2
Mrs. Priya Raman

HOD/professor (b.com)
ARKA JAIN University, Jamshedpur, Jharkhand
 ABSTRACT
This study examines the evolution of the application of capital budgeting
techniques. Previous studies mostly used cross-sectional inquiries to
understand the capital budgeting practices of firms. Only a few researchers
have undertaken longitudinal studies to generalise the findings of the
individual cross-sectional studies to the wider population and to identify the
emerging trends in the use of capital budgeting techniques (CBTs). This
longitudinal study surveys 83 studies of capital budgeting practices across firms
in India, South Africa, the United Kingdom (UK) and the United States of
America (USA) for the period from 1966 to 2016. The findings show that six
capital budgeting techniques, namely, the net present value (NPV), the internal
rate of return (IRR), the payback period (PBP), the accounting rate of return
(ARR), the return on investment (ROI) and the real option valuation (ROV), are
the most popular methods for evaluating capital investments. Of these
techniques, the ROV is the least used, and a general lack of familiarity with this
technique and its complexity are the most commonly cited reasons for not
using it. Another method that is used less than the first four techniques is the
ROI. However, this technique is of growing significance and is mainly used in
the UK, followed by the USA, South Africa, and India. Firms in the USA and UK
have increased their use of the IRR as a primary method for evaluating capital
projects and have retained the PBP as an ancillary technique to strengthen the
available information when evaluating capital projects. Firms in India and
South Africa are increasingly excluding both the PBP and ARR methods and are
increasingly using the NPV when evaluating capital investments. Although this
development is in line with the theory, it limits the scope of the available
information when evaluating capital projects.
Keywords: Capital budgeting techniques, trends in capital budgeting
techniques, investment appraisal, longitudinal analysis
INTRODUCTION
Introduction to capital budgeting:
Capital budgeting:
An efficient allocation of capital is the most important finance function in
modern times. It involves decisions to commit firm’s funds to long-term assets.
Such decisions tend to determine the value of company firm by influencing its
growth, profitability & risk.
Investment decisions are generally known as capital budgeting or capital
expenditure decisions. It is clever decisions to invest current in long term
assets expecting long-term benefits firm’s investment decisions would
generally include expansion, acquisition, modernization and replacement of
long-term assets. Such decisions can be investment decisions, financing
decisions or operating decisions. Investment decisions deal with investment of
organization’s resources in long tern (fixed) Assets and Short term (Current)
Assets.
Decisions pertaining to investment in short term Assets fall under “Working
Capital Management”. Decisions pertaining to investment in long term Assets
are classified as “Capital Budgeting” decisions. Capital budgeting decisions are
related to allocation of investible funds to different long-term assets. They
have long term implications and affect the future growth and profitability of
the firm. In evaluating such investment proposals, it is important to carefully
consider the expected benefit so investment against the expenses associated
with it. Organizations are frequently faced with Capital Budgeting decisions.
Any decision that requires the use of resources is a capital budgeting decision.
Capital budgeting is more or less a continuous process in any growing concern.
It is one of the most important decisions that face the financial manager. Prior
studies spanning the past four decades show financial managers prefer
methods such as internal rate of return or non-discounted payback model,
present value; the model academics consider superior. Capital budgeting refers
to the process we use to make decisions concerning investments in the long
term assets of the firm. The general idea is that the capital, or long-term funds,
raised by the firms are used to invest in assets that will enable the firm to
generate revenues several years into the future. Often the funds raised to
invest in such as set are not unrestricted, or infinitely available; thus, the firm
must budget how these funds are invested. Capital budgeting decisions are
crucial to firm’s success for several reasons. First, capital expenditures typically
require large outlays of funds. Second, firms must ascertain the best way to
raise and repay these funds.
Somehow, capital budgeting projects can be classified into the following five
categories.
Replacement projects: If a piece of equipment is out-dated or hinders efficient
production, company’s usually tends to avoid over analysing whether to
replace the older equipment. This type of project is usually carried out without
detailed analysis.
Expansion projects: These projects expand the volume of the business product
lines, and more uncertainties of sales forecasts should be considered. Very
detailed analyses are usually involved in this instance.
New products and services: New products and services require more complex
decision-making processes, and careful capital budgeting decisions are
necessary.
Mandatory projects: These types of projects are required by the government,
an insurance company, or some other agency. These projects are usually
related to safety or the environment and are typically not revenue-generating.
Capital budgeting decisions are typically made to reach the objective at the
lowest cost to the company.
Other projects: Other capital budgeting projects not directly categorized under
the previous four fall under “other projects.” This may be a pet project of the
CEO, or Apple Computer allowing Steve Jobs to run the Macintosh team at a
remote office. These types of projects are not subject to capital budgeting
analysis.

OBJECTIVES
Objectives of making this dissertation is to get familiar with the basic concepts
of capital budgeting. Study the objectives and necessity of budgeting. Further it
researches over the several methods of budgeting, divided into two categories.
Findings are given below in which the process of making a budget is stated in
detail.
 REVIEW OF LITERATURE
In today’s business environment, making sound capital budgeting decisions is a
critical factor for survival and success (Bukvic, 2016; Hayward, Caldwell, Steen,
Gow, & 5 Liesch, 2017).
Due to the competitive nature of business, companies increasingly find
themselves facing many (and sometimes competing) capital investment
choices. Making optimal choices is essential for businesses to remain
competitive. To this end, firms often use capital budgeting techniques (CBTs)
to objectively identify which investment projects are worth pursuing (Cooper,
Morgan, Redman, & Smith, 2001; Correia, 2012; Neelakantam, 2015).
Although there are numerous CBTs, these techniques can be divided into
three categories, namely, non-DCF (non-discounted cash flow), DCF
(discounted cash flow) and alternative methods. What distinguishes the three
CBT categories is the extent to which each conforms to two concepts: the time
value of money and business uncertainty. Non-DCF methods do not include
either of these two concepts, DCF methods only incorporate the time value of
money concept, and alternative methods incorporate both the time value of
money and business uncertainty concepts. It is therefore evident that there
has been a steady theoretical development in CBTs, but it remains unclear
whether there are any emerging trends in the application of these methods by
firms in practice. It is also not yet evident whether the capital budgeting
processes of firms in developing and developed countries are similar or
different and whether practices are gradually converging. The next section
explores the evolution of the capital budgeting practices in developing and
developed countries to find answers to these questions.

RESEARCH GAP
Research has been done on various parts of the capital budgeting, considered
to be the necessary part of the company budgeting. Researches were done get
to know about the functioning of the budgets which are being prepared in the
companies and how it is apportioned as a budget. Dissertation includes,
introduction of decision making for capital budgeting, process of making a
capital budget, why is it important for an organisation, future directions for the
budgeting process, limitation for different process, conflicts and solution to the
conflict, etc. Thus, it is an helpful research paper for the users to read the
article and get to know about it.

RESEARCH METHODOLOGY
The research paper is an exploratory study to acquire in-depth knowledge and
information on advancement of capital budgeting. The study uses a systematic
review technique for the collection of secondary data. Several research papers
and articles are qualitatively analysed for the study.

FINDINGS
Determines Product Scope:
Capital budgeting lets project planners define the financial scope of a project.
Because capital budgeting begins long before the project begins, it spells out
how much money the business plans to spend on each individual aspect of the
project. For example, with a renovation, it determines how much it is willing to
spend on improving handicap accessibility or installing energy-efficient heating
units. Capital budgeting also determines the scope in terms of the length of
time the project will take as it also budgets for labour and potential downtime.
Determine Funding Sources:
While capital budgeting spells out the details of project expenses, it also details
where the money is coming from to pay for the project. These sources might
include a capital investment account, cash, bank loans, government or non-
profit grants or stock offerings. Most often, a project will require a mix of those
funding channels. The capital budgeting process identifies how much money
will be needed from each source and the costs associated with using that
funding method.
Determine Payback Method:
An important element of capital budgeting is determining the project's
payback time. Most businesses expect a new building, new equipment or
renovation to eventually pay for itself. Some projects will pay for themselves
quicker than others. As there are several ways of calculating payback method,
some involving the present value of money and inflation, the capital budget
will have to identify which method the company plans to use. It will also
include an estimate of how long it will take for the business to realize a return
on their capital investment.
Control Project Costs:
Capital budgets act as control documents throughout the life of the project. As
the project progresses, the project managers track costs and try to ensure that
the project stays within budget. When there is an overage or a significant
underage, the project managers must provide explanations for the variances
and the business must make sure it has money to complete the project.
Typically, a capital budget for a specific project is maintained until the payback
period is complete.
Ongoing Projects
Capital budgets are also used for ongoing capital purchases. These include
major repairs, rolling computer upgrades and preventive maintenance.
Because some of these types of expenses occur on an emergency basis.

Process of capital budgeting

Project identification and generation:

The company has various options for capital employment on a long-term basis.
In the initial stage, the management needs to analyse the strengths and
weaknesses of every project for foreseeing the potential of each option.
Evaluating and Assembling Investment Proposals:
In the next step, the management assembles and compiles all the investment
proposals on the grounds of cost, risk involvement, future profits, return on
investment, etc.
Project Selection:
Once the proposal has been finalized, the different alternatives for raising or
acquiring funds have to be explored by the finance team. This is called
preparing the capital budget. The average cost of funds has to be reduced. A
detailed procedure for periodical reports and tracking the project for the
lifetime needs to be streamlined in the initial phase itself. The final approvals
are based on profitability, Economic constituents, viability, and market
conditions.
Implementation:
After the apportioning of the long-term investment, the company comes into
action for the execution of its decision. To avoid complications and excess time
consumption, the management should lay out a detailed plan of the project in
advance.
Performance review:
The final stage of capital budgeting involves the comparison of actual results
with the standard ones. The management needs to measure and correlate the
actual performance with that of the estimated one to figure out the deviation
and take corrective actions for the same.

CONCLUSION
There are four main recommendations for future research.
First, more research is required to explore the continuing importance of the IRR
over the NPV. Moreover, there is a need to validate the assertion that the use
of the IRR is prevalent in private equity firms.
Second, there are few studies that explore the use of advanced alternative CBTs,
such as real options, Monte Carlo simulations, the EVA and the modified internal
rate of return in capital budgeting.
Third, the literature emphasises issues relating to the selection phases of the
capital budgeting process, but future research could focus on the control phases
of capital investment.
 FUTURE DIRECTIONS
Capital-intensive projects could be anything from opening a new factory to a
significant workforce expansion, entering a new market, or research and
development of new products. There should be the control system to control
the variances created after the actual compared with the budgeted. Future
directions includes how the cash flow will be based on opportunity cost. And
how cash flow is computed on after-tax basis
Whether such investments are judged worthwhile depends on the approach
that the company uses to evaluate them. This is where capital budgeting
comes in. For instance, a company may choose to value its projects based on
the internal rate of return they provide, their net present value, payback
periods, or a combination of such metrics.
Budget control
There should be a budgeting control, for the control of budget variance.
Budgetary control is about assessing actual performance against budgeted
performance and taking corrective action when necessary. The control system
is a systematic approach which tells managers whether or not they are
achieving what they planned to achieve. It focuses on total costs for a
department or business unit, and responsibility for these total costs is
allocated to an individual. If there are any differences between actual and
budgeted performance, the responsible individual can act to either correct the
budget or to take action to bring the cost back under control (whichever is
most appropriate)
There are two main types of control system:
 feedback control – in this system the aim is to correct problems that have
been discovered at the period end when the actual results are compared with
the budget.
It is defined as:
‘Measurement of differences between planned outputs and actual outputs
achieved, and the modification of subsequent action and/or plans to achieve
future required results. Feedback control is an integral part of budgetary
control and standard costing systems.’
Corrective action that brings actual performance closer to the target or plan is
called negative feedback.
Corrective action that increases the difference between actual performance
and the target or plan is called positive feedback.
 feedforward control – in this system the aim is to anticipate problems with
the aim of preventing them from occurring. Feedforward control should be
used in conjunction with feedback control.
Feedforward is more proactive and aims to anticipate problems and prevent
them from occurring.
It is defined as the ‘forecasting of differences between actual and planned
outcomes and the implementation of actions before the event, to avoid such
differences.’
Control reports
Feedback control reports and feedforward control reports might be presented
at the same time but they will have a different, layout, present different
information and have different uses in that:
 the feedback control report will look backwards at the performance for the
period and consider any difference from the planned performance for that
period
 the feedforward control report will look forward and create expectations
about expected future performance with the aim of identifying potential
future issues for resolution.

Best Practices in Capital Budgeting

While most big companies use their own processes to evaluate projects in
place, there are a few practices that should be used as “gold standards” of
capital budgeting. This can help to guarantee the fairest project evaluation. A
fair project evaluation process tries to eliminate all non-project related factors
and focus purely on assessing a project as a stand-alone opportunity.
Decisions based on actual cash flows
Only incremental cash flows are relevant to the capital budgeting process,
while sunken cost should be ignored. This is because sunk costs have already
occurred and had an impact on the business’ financial statements. As such,
they should not be taken into consideration when assessing the profitability of
future projects. Doing so could skew the perception of management.
Cash flow timing
Analysts try to predict exactly when cash flows will occur, as cash flows
received earlier in the life of projects are worth more than cash flows received
later. Congruent with the concept of the time value of money, cash flows that
are received sooner are more valuable. This is because they can be used right
away in other investment vehicles or other projects. In other words, cash flows
that occur earlier have a larger time horizon. This makes them more valuable
than cash flow that occurs at a later date. Cash flow considerations are an
important factor in capital budgeting.
Cash flows are based on opportunity costs
Projects are evaluated on the incremental cash flows that they bring in over
and above the amount that they would generate in their next best alternative
use. This is done to quantify just how much better one project is over another.
To calculate this, management may consider the difference in the NPV, IRR, or
payback periods of two projects. Doing so provides a valuable capital
budgeting perspective in evaluating projects that provide strategic value that is
more difficult to quantify.
Cash flows are computed on an after-tax basis
Since interest payments, taxes, and amortization and depreciation are
expenses that occur independently of a project, they should not be taken into
account when assessing a project’s profitability. Assuming that the company
will draw upon the same source of capital to finance such projects and that the
cash flows of all projects will be recorded in the same tax environments, these
considerations are essentially constants. Thus, they can be removed from the
decision-making process.
Financing costs are ignored from the calculations of operating cash flows
Financing costs are reflected in the required rate of return from an investment
project, so cash flows are not adjusted for these costs. The costs are typically
congruent with the company’s weighted average cost of capital which
represents the cost the company incurs to run its current capital structure.
During project valuations, the discount rate used is often the WACC of the
company. Therefore, this is another constant that can be ignored as well.

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