Capital budgeting is seen as one of the methods for assessing the strategic value of investing in assets like plants and machinery. This is important since there occurs a fund lockup due to money invested in assets and the management needs to assess the benefits derivable from the use of machinery as against its costs and benefits. In this context, it is also seen that the funds that could be invested in the purchase of assets could be either the company’s own funds or loan funds. If loan funds are used, the element of interest and servicing of loans are also important considerations, since they impinge upon final costs.
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Complexities of Capital budgeting
The complexities with respect to capital budgeting could arise due to either over investments in assets or under investments in assets. Both these aspects need careful consideration. If there are over investments, there would be more loan interest servicing to be done, if outside funds are used for asset acquisition. In case internal funds are used, it would deplete the funds due to stakeholders for future dividend payouts.
Again over investments in assets bring in more charges on the Depreciation account and Asset Maintenance / servicing account. (Brigham and Ehrhardt, P 502).
This would further erode profits and reduce dividends to stakeholders. Also, assets may not be fully utilized and therefore, the idle capacity of assets may results.
This is because the use of assets is almost as important as its acquisitions.
If asset purchase is lower than required, this would also be detrimental to the financial interests of the company, in that competitors may gain benefit out of using the latest machines and the competitiveness of this company may be lost. By acquiring the latest technology in the field, rivals may gain market share of the company, which has desisted from making adequate investments in assets.
Forecast capital asset requirements
It is also necessary that firms be able to forecast the need for capital assets, well in advance of actual requirements in order that planned and well-organized capital asset installation could be made.( Brigham and Ehrhardt, P 502).
There are also aspects that “returns on projects should be measured based on cash flow generated and the timing of these cash flows. They should also consider both the positive and negative side effects of these projects.” (Damodaran).
Uses of CB
Capital budgeting is also important since the quantum of funds required for it is very high and could be used for a variety of purposes.
Capital budgeting could be used internal, for:
- Replacement of idle and useless machines
- Expansion of business and markets
- Research and development needs
- Performance of long terms contracts that could be lucrative for business and provide employment and income opportunities to the local population.
There are many aspects to be considered before launching a capital budgeting program in terms of costs, benefits, and cost-benefit analysis. However, it is also necessary to “consider alternative uses of capital and resources as costs to the capital budgeting project or investment. “ (The Top 10 Things to Consider When Making a Capital Budgeting or Investment Decision).
Inflationary impacts on the cost of capital and future cash inflows
The aspects of future inflationary erosion on future cash flows cannot be circumvented. This is because inflation could: firstly, increase the acquisition costs of future assets
secondly, also reduce the actual value of inflows of revenues or savings. An asset that costs $100,000 today may cost more during later years, and therefore an aspect of inflationary accounting also has to be considered during capital budgeting programs.
Again, if one were to consider cash inflows, with inflationary impacts, the actual worth of inflows could be much lower than their book values, since the value of $ would have fallen in later years due to inflationary and fuel pricing. These aspects also need to be considered.
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But it needs to be mentioned that this should not vitiate the implementation of NPV or WACC schemes because these schemes should build inflation premium into the interest rates not for a particular year, but throughout the duration of the investment project and should be the “average rate of inflation expected over the security’s lifetime.” (Brigham and Ehrhardt, P. 175).
Thus it could be said that the determinants of capital budgeting would need to be seen on a case-to-case basis and the financial analyst needs to consider the totality of the case before making informed judgments. In the case of capital budgeting, the main aspect to be considered is whether an asset could be acquired or not; a project is financially viable or not. The modalities of the purchase could be taken at later stages as per the directives of the Board of Directors.
Brigham, Eugene F., and Ehrhardt, Michael C. Importance of capital budgeting: Theory and Practice. Financial Management, P. 502.
Brigham, Eugene F., and Ehrhardt, Michael C. Theory and Practice: The Determinants of Market Interest Rates. Inflation Premium (IP). Financial Management, P. 175.
Capital Budgeting: Net Cash Flows. Studyfinance. 2008. Web.
Damodaran, Aswath. (2005). Picking the Right Projects: Investment Analysis. Back to the first principles. Web.
The Top 10 Things to Consider When Making a Capital Budgeting or Investment Decision. Coachville Coach Training Resource Center. 2001. Web.