Budgeting is the most important factor while planning an organization. But capital budgeting is much more important when you find out that your company is investing in firms. Capital budgeting is actually the process of investment evaluation and also evaluation of several other expenses, just to gain knowledge on the best returns on investment.
This kind of budgeting occurs when a company gets on board with capital projects. Now, a capital project is like a project which has a lifetime of a year or more. This makes it very important for corporate companies. So, when the company decides to invest some amount of money in any idea, the process of capital budgeting makes sure that results would flow out after a period of a year or probably longer than that.
Capital budgeting decisions are important because –
- It decides the future of any company. Your capital revenue decides what your company would look forward to.
- Tasks like security analysis and portfolio management require the valuation principles used in capital budgeting.
- The principles of the process are used in so many other processes like leasing, working capital, etc.
Capital budgeting runs on cash flows, which indeed is a very complex process. This is a cost-benefit exercise. Every company that processes capital budgeting schemes work together
The company generates ideas from the top as well as the bottom level, so no one is discriminated against any idea they gather. Every idea is crucial.
While individual proposals are accepted, it actually helps gather information to predict and forecast cash flows for every project you allot. This comes under monitoring and post-auditing.
When a company plots its budget, the top things to do is to organize the profitable proposals and consider the timings of the projects.
Techniques of capital budgeting
- Net- Present Value: This method is the crucial part of a company budgeting because you analyze the time value of money. For example, a dollar spent today in India would cost you ₹74.47 in India, but might escalate the price range in the near future or probably two years later. So, the process of the Net-present value describes the value of a cash flow that would be present at the date of being checked.
- Total-Cost Approach: The creation of a pattern and routine of all the costs occurring to the owner, and also the budget set aside for an alternate decision taking place. This also follows the process of net-present value because it has to be adjusted to the present cash value.
Why is the time value of money vital? It is important because it lets the businesses be attuned to the cash flows which might or might not change with time. One thing to note is that it might be discounting the present value allotted to money. In simple words, it means that the value might not remain the same tomorrow.
- Incremental Cost Approach: This method is only a varied version of the Total-cost approach. This examines only the relevant costs. Relevant costs are the costs that occur that ‘differ’ between the alternatives. This technique is widely used by small businesses because this type of analysis helps them view if an order is beneficial for them, how to buy products, eliminate/discard something, etc.
- Payback method: When a company invests for the first time, this method helps it realize how much longer it would take to recover the investment amount. This method has two minor setbacks to it – it does not consider the time value of money; it considers the cash flows until the investment flows recovers.
Capital budgeting in Indian companies
According to research and surveys, it’s been proven that Indian companies actually work on academic theories, completely. The most popular techniques that are used by the companies are –
- Discounted Cash Flow Techniques – The techniques determine the current value of the future cash flows, and rule out the approximate money been received out of the investment. When you value a project based on the time value of the money being used, then it is determinable for the use of the project.
- Internal Rate of Return – Companies analyse their profit centres using IRR, and it also helps them decide between the capital projects. The rates of interest always bring a series of cash flows to NPV. When teh projects are simplified to a single representation, then it is easy to decide whether it is economically feasible or not. If the IRR is more than the desired interest rate, then the project tends to be completed.
- Risk-Adjusted Sensitivity Analysis – Assumptions during budgeting takes the form of variables – input and output. Sensitivity Analysis tests the different combinations of the input and output variables. The Risk-adjusted sensitivity analysis is also called a “what-if” analysis.
The observations that have been noted down as followed by Indian companies are –
- The firms that have a large presence, use the DCF techniques, i.e. NPV and IRR, which are the most used in investment practices.
- There is an increase in preference for NDFC over DCF.
- It shows that there is an increase in the cost of capital practices.
- The discount rate widely used in the companies is WACC.
- Presence of real options for a project in investment, where the higher power lies with the management.
Sophisticated investment practices approve that capital budgeting is a very complex process. It is a cost-benefit exercise. While in a competitive market, capital budgeting is a necessary tool used. The research mentions that capital budgeting companies were put into some rough groups for thorough analysis like replacement projects and expansion projects. This article comprises the techniques of capital budgeting and the style of capital budgeting in Indian companies. Concluding the written work with some points covered – Capital budgeting decisions cover cash flows, and the timing of the flows is very crucial in the company budget. Taxes are reflected on the cash flows approved in the capital budgeting process. The last point to be noted is that the costs of financing are always ignored while budgeting.