Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    Chapter No. 11 – Capital Budgeting

Capital budgets as opposed to revenue budgets

    The assumption here is that the students understand the significance of the term “budgets”. To recap, “budgets” are

    essentially meant for:

    ? Allocation of scarce resources and

    ? Control and monitoring of expenses

    The budgets are of various kinds, depending upon the objectives in the organisation. The two major finance budgets

    that a business enterprise usually prepare are:

    ? Revenue budget – prepared on an annual basis with monthly break-up. Purpose is to control revenue expenses

    related to different activities in an organisation. There is a review process. The frequency of break-up could be

    less say a quarter. The frequency of review process and the period for which break-up is given like month or

    quarter synchronise with each other. If there is a monthly break-up of expenses, the review is also done on a

    monthly basis.

    ? Capital budget – prepared on an annual basis with once in a year review process. This budget is more meant for

    capital expenses for which the enterprise will be required to manage within its internal accruals and not depend

    upon external finance. External finance and shareholders’ capital are warranted only for major capital

    expenditure like expansion, diversification, modernisation etc. The students will appreciate that there is a

    difference between capital expenditure on routine items like say copier machine, furniture and fixtures, EPABX

    (telephone exchange) etc. which do not give any return unlike industrial projects. Industrial projects require a lot

    of funds and in turn, give positive cash flows (net cash flows being positive – difference between cash outflows

    and cash inflows)

    In this chapter we are going to learn about capital budgeting, a process of selection of projects and decision on

    alternative investment opportunities available to a business enterprise.

Different kinds of capital budgets – non-productive assets, improving operating efficiency and capital

    projects

    Just to link this point with what we have seen in the previous paragraph, we may state that there could be different

    kinds of capital budgets in an organisation like:

    1. Budgets for projects that involve huge capital outlays (cash outflows) but also bring in substantial net cash

    inflows

    2. Budgets for replacement of assets that bring in improved operating efficiency resulting in cost reduction that is

    indirectly cash inflow – this is different from the first one in requirement of funds also. Further this is done on an

    on going basis unlike industrial projects that happen once in a while

    3. Budgets for routine items that are fairly regular (examples given in the preceding paragraph) and involve only

    capital expenditure from internal accruals.

    We can see that the parameters for all the above three would be different for planning, resource mobilisation,

    resource allocation, monitoring and control. Let us see the differences in the following lines.

    1. Budgets for projects require in-depth and detailed planning like project report including report on marketing

    feasibility, technical feasibility, technological feasibility, financial feasibility etc. Resource mobilisation will be

    partly from equity of promoters and major portion will be in the form of debts like project loans, debentures etc.

    There will be a separate committee constituted in professionally run organisations called, “project committee”

    that takes the responsibility for the entire project. The committee is associated with the project right from the

    conception of the project till its completion and commercial production. One of the major functions of the

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Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    committee is “project review, monitoring and control”. Lenders go in depth into the risks associated with the

    projects and have a detailed appraisal before sanctioning the loans etc. The repayment of the external loans is

    spread over a fairly long period.

    2. Budgets for replacement may or may not be supported by external assistance. If the requirement is substantial

    due to a number of machines being replaced, although in a phased manner, external assistance may be called for

    in the form of loans; otherwise the resources could be “internal accruals”. If external loan is warranted, the

    planning process will be very much involved, although it will not be elaborate. The resource mobilisation will be

    fairly easy, easier than in the case of projects. The repayment period will be shorter than for projects in point no.

    1 above. The resource allocation, monitoring and control will also be fairly simple. 3. Budgets for routine items have to be met only from internal accruals. Rarely external assistance will be available

    for this as incremental income will be absent. Hence a lot of internal control is called for in this case. There will

    be constant demand from various departments within the organisation for funds and budgetary process is very

    much indicated here. Budget is for resource allocation, monitoring and control. Not much of planning is

    required and resources are available internally.

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