MGT201 Module 9 Topics 146-185 Preparation

In Capital Budgeting, we talk about such huge amounts which we invest in our business for longer period, for long term. It means that these amounts are too big and also their time period is also longer.

Because of huge and large amounts and longer time period, the risk level is very high. So, it is very important for every business to plan all those investments, all those amounts which are to be put into investment for longer period of time very carefully.

Capital Budgeting:

The topic of Capital Budgeting is actually related to the purchases of large assets meaning that such fixed assets which are of bigger amount i.e., plant, machinery, equipment etc. in which a lot of cash outflow will be needed and this amount is invested for many years.

So, when we are planning to see that what amount is required for the purchase of new assets or fixed assets or we can say that we want to start a new factory or new production plant so, this is called the Capital Expenditure.

And planning these Capital Expenditures is called Capital Budgeting.

Whenever we make a plan for the future activities, it is called a Budget where the plan contains the figures, the amounts in rupees and dollars or in some monetary terms.

Concept of Capital Budgeting:

Whenever we are planning to invest in a new plant or machinery or any new production line where a huge amount of money will be invested, we need to do some calculations with reference to how much amount of money will be required for that investment and what will be the return from that investment and what time period will be required to get those returns on our investment. Then we have certain benchmarks or levels with which we compare the findings or the results of our calculations and we make a decision.

In simple words, we can say that if we want to start a new project and we want to make decision that if we have to invest money in this project or not then Capital Budgeting helps us to make this decision. Obviously that decision will be based on the view point whether it will be giving us enough return or profit that we anticipate from this project.

Significance of Capital Budgeting:

The significance of Capital Budgeting is huge as we have said that there is a huge amount involved in it. If we get wrong about any small expense then its significance is very small or its impact on business is very less and we use a term for this kind of expense that is called Immaterial meaning that there has not been effect on our business by doing such small wrong expense.

But if we are making our wrong decision about a huge sum of money that we are putting in some project and it becomes a failure so, a lot is lost and the business might have to discontinue.

Techniques of Capital Budgeting:

So, it is extremely important that how do we perform this process of Capital Budgeting. We have some Capital Budgeting techniques and we will see these techniques one by one i.e., Internal Rate of Return, Net Present Value, Payback Period, Profitability Index. These are such techniques that we use in the process of Capital Budgeting.

Criteria of Capital Budgeting:

There is a criteria of decision making in Capital Budgeting where criteria means that how we will make decision that one project is acceptable for us or not. Or in other words, if we are financial experts and we have advice the management that whether the project should be considered for investment or not then how would that decision be made. What are that criteria of selection/rejection or acceptance/rejection on the basis of which we will make decision. So, these criteria are also related to the techniques that we will be talking about that we name them Discounted Cash flow methods that we will discuss in detail in next lectures.

On the basis of Discounted Cash Flow methods or such techniques, we have built criterion related to every method which will tell us that result in such a way that we should accept or not.

Cashflows of Capital Budgeting:

The whole process of Capital Budgeting is related to Cashflows meaning that this is not related to profit but Capital Budgeting’s whole calculation is based on the Cashflows and this is something which is very important to understand.

Cashflows are actually the actual amounts of money received or paid but profit is a difference of revenue and expenditures. There is a possibility to manipulate the amount of profit in any given year but there is no possibility to manipulate the amount of cash.

So, we need to remember that all these Cashflow techniques are based on the actual Cashflows that we will have. So, when we do the process of Capital Budgeting in which we will anticipate the Cashflows. And these are the same Cashflows as we have discussed earlier that how much will be cash inflows and how much will be cash outflows.

We can conclude our discussion that Capital Budgeting is extremely important because this is about long term investment and huge amounts are involved and to do Capital Budgeting we utilize cash inflows, we project these cash inflows and then apply certain techniques which are called Discounted Cashflow methods in order to decide about the accepting or rejecting a certain proposal of a new project.