32 Project Budgeting/Capital Budgeting

Vishal Kumar

1. Learning Outcome

After completing this module students will be able to:

Understand the concept of a Project Budgeting/Capital Budgeting
Understand the importance and need of capital budgeting
Know about the types of capital expenditure
Understand the factors affecting capital investment decisions

2. Introduction

In the present scenario the efficient allocation of capital resources is a most important function of project management. This function involves firm’s decision to invest its funds in long-term assets like plant, machinery land, building, equipments etc. These assets are extremely important to the firm because the organizational profits are derived from the use of its capital investment in assets which represent a long term commitment of funds. The future development of an enterprise depends on the capital investment projects. These projects may be the replacement of existing capital assets which turns out to be less attractive to the firm or expansion of business for implementing new ideas and planning. Thus long term investment decisions of an enterprise fall within the definition of project budgeting or capital expenditure decisions. These decisions are concerned with the acquisition of assets in which funds will be invested by an enterprise. The assets of business include long term assets and short term assets. Long term assets will yield a return over a period of time whereas short term assets are those assets which are easily convertible into cash within one accounting period, normally a year. The long term investment decision is known as project budgeting/capital budgeting and the short term investment decision are identified as working capital management.

3. Meaning and Definition of Project/Capital Budgeting: ‘Capital Budgeting’ consists of two important terms, Capital and Budgeting. The concept of capital budgeting gets much clarified if these terms are properly understood. Capital refers to the total resources, other than human, which a business enterprise procures and utilises for productive or profit-earning purposes. Capital is relatively scarce and has many uses to which it can be put. Here, as a matter of fact, capital indicates capital expenditure or investments in fixed assets. Fixed assets are acquired to give service over a number of years. ‘Fixed assets are those that will provide service over a period of time. They are a deferred expense and determine the production capacity of a firm. A cash outlay is made at one point of time but the benefits accrue over a period of time.

Budgeting means the planning made before the actual expenditure is incurred. It prepares the blue print both in quantity and monetary terms and reflects the objectives of the firm. It involves collection of relevant data, analysis of the information available, preparation of various alternative plans and selection of the most profitable one.

Thus, the term Project Budgeting/Capital Budgeting refers to long term planning for proposed capital expenditure and their financing. It includes both raising of long-term funds as well as their utilization. It is defined as a firm’s formal process of investment in capital assets. Project budgeting is the decision making process by which a firm evaluates the acquisition of its major long term/fixed assets. It involves an enterprise’s decision to invest its current resources for addition, disposition, modification and replacement of fixed assets.

Project budgeting is a multifaceted activity. It contains searching for new and more profitable project proposals, investigating, engineering and marketing conditions to predict the consequences of accepting the project and making economic analysis to determine the profit potential of project proposal. Thus, Project Budgeting consists in planning the deployment of available capital for the purpose of maximising the long term profitability of an enterprise.

Some definitions of capital budgeting as given by certain eminent thinkers are reproduced below:

Capital budgeting is long term planning for making and financing proposed capital outlays. It is concerned with allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with immediate and subsequent streams of expenditure for it.

– T.Horngreen

Capital budgeting consists of in planning development of available capital for the purpose of maximizing the long term profitability of the concern.

– R.M. Lynch

Capital budgeting involves a current investment in which the benefits are expected to be received beyond one year in the future.

– James C.Van Horne

The capital budgeting decision, therefore, involves a current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits.

– G.D. Quirin

Capital budgeting refers to the total process of generating, evaluation, selecting and following up on 4 capital expenditure alternatives.

– Lawrence J.Gitman

4. Features of Capital Budgeting: Capital budgeting is said to be “budgeting with a difference “since it deals with unique problems-problems of capital investment. The other budgets do not have such a long range of futuristic view. They do not involve such huge investments of capital and they do not involve such an extent of risk as capital budgeting involves. Capital budgeting, thus, has certain basic feature or salient characteristics of its own. These are enumerated below:

1) Capital budgeting entails heavy investment of funds. It may run into lakhs and crores of rupees.

2) The effect of capital budgeting decisions-judicious or faulty goes to many years subsequent to the year of expenditure. A capital budget, thus, looks too much longer-range future than other budgets do.

3) There is greater uncertainty of the results. No doubt, every decision has an element of uncertainty but the element of uncertainty is much more potent here, since capital budgeting concerns distant future.

4) There is the anticipation of large benefits spread over quite a long period. Investment in fixed assets widens the base of activity and increases the profit-earning capacity of the concern.

5) Since a huge outlay is involved and outcome is shrouded in a high degree of uncertainty, the decisions of capital investments are taken over at the executive level i e. at a higher level of management. It requires all the business expertise, keen sense of judgment and analytical mind to arrive at judicious decisions about capital expenditure.

5. Importance and Need of Capital Budgeting: Capital budgeting, or in other words, making decisions regarding heavy investment in fixed assets sunk for a long time, is of utmost significance. Closely allied to a sound capital investment policy is the very success and standing of the business in time to come. A keen watchfulness and a positive awareness of capital expenditure needs: states J. Batty, ‘is essential at all times. The progressive business grows: it expands its fixed assets and other means of increasing the volume and improving the quality of the products made. Investment in fixed assets both for replacements and new projects goes hand-in-hand with progress.

The importance, near indispensability and necessity of having a systematic budgeting for capital expenditure is on account of the following factors:

1) Huge Investment of Funds’: Capital expenditure involves heavy investment. Acquisition of Land, construction of factory and administrative building, purchase of plant and machinery, office equipment, furniture & fixtures and other assets take away a major portion of the monetary resources mobilized by the business both externally and internally. A judiciously planned expenditure is thus imperative.

2) Reversal Causes Huge Losses: Before arriving at a decision on capital expenditure, all the pros and cons of such a step must be carefully analyzed. Any hasty purchase of a fixed asset may bring about sizable loss if that asset is resold in the market. There may be no demand for, say, a second hand plant or factory building. Moreover, the cost of installation and later on dismantling of the machines will be totally unrealizable. Capital budgeting, thus, becomes significant since budgeting always implies well thought out and properly planned course of action.

3) Factor of Obsolescence: While deciding to acquire a fixed asset, the likely time of its becoming obsolete must be taken into account. Technology is making rapid advances and more economical, speedier, less energy consuming and technically superior models are coming up- soon. An asset may otherwise be serviceable for another span of time, but continued use of the same in the face of latest and advanced equipment used by the competitors may put the business to a disadvantageous position. Moreover the possibility of the products becoming out style or out of fashion cannot be ruled out. Capital assets installed to manufacture such products obviously become obsolete, unless and until these very assets have multiplicity of uses.

4) Loss of Flexibility: Capital expenditure not only entails heavy investment but also makes the concern inflexible in its activities or at least less flexible than otherwise. Once the funds are committed to long term assets a particular line of products or a particular production technique has to be adopted. A change will be very difficult to make. So, advance planning is indispensable.

5) Essentials for Various Decisions and Forecasts: The necessity of well-designed system of capital budgeting is strongly felt for various and important decisions and forecasts, some of which are given below:

Formulation of Sound depreciation policy and the policy relating to replacement of assets.
Preparation of cash forecasts, i.e. the likely amounts of cash required in different years.
Decisions on replacing manual work by machines.
Introduction of automation in industry.
Formulation of Labour Welfare Policy- provisions of facility of housing, improvement of sanitation and working conditions, medical dispensary/hospital facilities, building of educational institution for worker’s children, etc.

6) Impact on Future Cost Structure: Capital expenditures have chain of subsidiary cost, called fixed expenses. Installation of major plant, for example, necessitates the incurring of certain expenses which are more or less fixed in nature. E.g. rent of the factory in which plant has been installed, technical staff expenses, insurance, etc. In case the acquisition has been done without judicious capital budgeting and the venture turns out to be flop, the concern will have to bear quite good amount of fixed expenses. Capital budgeting, thus, has importance, of its own and places a significant role in determining the future destiny of the business enterprise. Successive wrong decision on capital expenditure surely leads towards liquidation of the company.

6. Types of Capital Expenditure: Capital expenditure includes investment of funds in various fixed assets and different projects for development and expansion. Such expenditure is of long duration involving a number of years and commits the business concern to a particular pattern of activity.

There can be various types of capital investment, which are stated below:

1) Expenditure on General Improvement: Any expenditure which brings about the general improvement of the factory or establishment as a unit comes under this category, as, improving roads, laying severage lines, broadening parking space, providing rail sidings, making communication equipment more effective etc.

2) Replacement of existing Assets: Worn out and depreciated assts need replacement. Keeping and using a plant, for example, for a period more than its effective life entails excessive expenditure on repairs and maintenance. In such cases, the return is less than the expenditure. It is always advisable to replace such assets well in time so that the facilities should remain at their original state.

3) Addition in Capacity: The concern may like to add to the existing capacity of production due to increase in demand or due to the fact that the concern has captured some foreign market. Additions to existing plant, equipment, store house, sales counters or show rooms may be made entailing a sizable amount of capital.

4) Purchase of New Equipment: Sometimes, a manufacturing unit enters into the production of a new item, not hitherto produced. Altogether different plant and equipment may have to be acquired. New type of factory may have to be constructed. For example, production of wheat flour and allied products requires a vertical type of structure, while many of the production lines require horizontal structures.

5) Cost Reduction and Quality Improvement: Some expenditure may have to be incurred for acquisition of certain accessories or apparatus for checking wastage, defective production and improvement of quality.

6) Better Working Conditions: Long term investment of funds is also made in such equipment or projects which ensure better working conditions, more safety to the workers, fire fighting and control, and hygienic atmosphere. Provisions of the Factories Act, 1948 are to complied with in this respect. Provision of the relaxation rooms and creches for the babies of women workers is also made for the convenience of the workers.

7) Goodwill Projects: To win the goodwill of the public at large, certain projects are undertaken to provide amenities to the general public. Beautiful public parks, charitable hospitals, colleges, public libraries, temples, and community halls are some of the examples of these projects. These are sometimes called ‘Prestige value projects’.

7. Factors Affecting Capital Investment Decisions: Before making any capital investment, the management has to consider various alternate proposals thoroughly before taking such investment decisions. No doubt profitability and expected rate of return are the major considerations for the choice of the projects. However, there are other factors which the management cannot ignore. These have to be given due consideration before making a final decision on long term commitment of funds in a particular project. Sometimes the future rate of return on the investment made in these factors over rule the major consideration or rate of return on profitability. These factors are discusses as follows:

1. Urgency: Situation may arise when the acquisition of a fixed asset is urgently needed, otherwise there is going to be a great loss or damage. Installation of power generators, for example, may have to be undertaken at a short notice due to prolonged shedding of hydel power. Such decisions need not clear the rigours of profitability tests.

2. Technical Feasibility: Due consideration is to be given to the advice of the experts regarding the soundness of the project. The volume of production required for economic utilisation of the plant, power-consumption , overhead costs, running life, cost repairs and maintenance, availability of spare parts and availability of technical personnel-all these factors have to be carefully gone into to assess the technical worth of the project.

3. Amount and Availability of Capital: Most of the capital projects involve huge funds which have to be committed for a long term. It has to be ascertained what portion of funds would be available from internal resources and what portion is to be financed by borrowed funds. The rate of interest on such borrowings is also to be taken into account. A rate of interest higher than the rate of return from the proposed project would be a discouraging factor.

Moreover, cash required at the various stages of the construction or installation of the capital asset also needs consideration. The amount of working capital to be required to commission the asset and to keep it going also has to be determined. Non-availability of such capital may check the operation of the asset later as well.

4. Risk of Obsolescence: With rapid advancement in technology, the risk of a capital assets particularly plant and equipment going out of date too soon is always present. There may appear improved versions or innovations which would replace the existing equipment, though otherwise serviceable. Managements would, therefore, prefer such projects which would pay back the investment in a lesser number of years.

5. Cost of Production: Alternate projects may result in different costs of production, e.g. on cost of materials, productive wages, supervision, factory overheads, repairs and renewals, storage and cost of power.

6. Multiple uses of Assets: It should be seen whether a particular asset has more uses than one. It may be that the original plan of product lines falls through and if the asset purchased is suitable for only that product, there would be much loss on its sale in the second hand market. But if it has other uses as well, it can be profitably used.

7. Opportunity Costs: Opportunity costs refer to the loss of alternative income on account of a particular capital investment decision. Since the resources are limited, a choice out of alternatives is to be made. The comparison of the alternative yields has to be taken into account. The return which is likely to be received by the investment under consideration should be compared with return from an alternative project of the same cost.

8. Element of Interest: There is a lack of unanimity among the accountants whether interest should be taken as one of the costs, while calculating the cost of a unit of product. But, so far as the decisions of long-term investment in capital assets are concerned, the question of interest is very important. Since the funds invested are of a massive size, the amount of interest is also quite large. Ignoring interest will bring in an error of judgment.

9. Depreciation: While making a decision on a capital investment, a judicious view of depreciation is to be taken. The treatment here should differ from the cost accountancy procedure. To decide about the desirability of the replacement of a particular asset, the written down book value of the existing asset which is to be replaced, is not relevant. The existing asset is to be replaced because of the competitive conditions and the present book value, less realizable value, obviously is not recoverable. Rather the realizable (sale) value of the existing asset should reduce the cash outlay of the new asset. If the unrealized portion is added to the cost of the new asset, it would hamper the decision for replacement.

10. Other Considerations: Financial considerations are not the only considerations which influence the capital expenditure decisions. There are non- financial reasons which prompt the management to incur capital expenditure. There are certain prestige projects or goodwill projects which are undertaken to win the goodwill of the community, the government or the industry as a whole. Public parks, charitable hospitals, research institutes, community balls, educational institution, temples and other such projects are of this type.

8. Summary: The future development of an enterprise depends on the capital investment projects. These projects may be the replacement of existing capital assets which turns out to be less attractive to the firm or expansion of business for implementing new ideas and planning. Thus, long term investment decisions of an enterprise fall within the definition of project budgeting or capital expenditure decisions. These decisions are concerned with the acquisition of assets in which funds will be invested by an enterprise. The term Project Budgeting/Capital Budgeting refers to long term planning for proposed capital expenditure and their financing. It includes both raising of long-term funds as well as their utilization. Project budgeting is the decision making process by which a firm evaluates the acquisition of its major long term/fixed assets. It involves an enterprise’s decision to invest its current resources for addition, disposition, modification and replacement of fixed assets. Project budgeting is very important for an enterprise due to huge amount of investment, irreversible in nature, lack of flexibility, its impact on future cost structure etc. Before making any capital investment, the management has to consider various alternate proposals thoroughly before taking such investment decisions. No doubt profitability and expected rate of return are the major considerations for the choice of the projects. However, there are other factors which the management cannot ignore like urgency, availability of capital, risk of obsolescence, cost of production, opportunity cost etc.

Learn More

Suggested Readings:

Projects: Planning, Analysis, Selection, Implementation & Review, Prasanna Chandra, Tata McGraw-Hill Publishing
Project Management: A Managerial Approach, Jack R. Meredith, Wiley Publications
Project Management: A Development Perspective, Goyal B.B., Deep & Deep Publications.
Project Planning and Control, Mohsin M., Vikas Publishing House.
Project Management, Chaudhary, S., Tata Mc Graw Hill Publications.
Project Management, Maylor, Pearson Education
United Nations Industrial Development Organization, Guide to Practical Project Appraisal–Social Benefit Cost Analysis in Developing Countries, Oxford & IBH.

Points to ponder:

Project Budgeting refers to long term planning for proposed capital expenditure and their financing.
Project Budgeting includes both raising of long-term funds as well as their utilization
Capital budgeting entails heavy investment of funds.
Before arriving at a decision on capital expenditure, all the pros and cons of such a step must be carefully analyzed.
Before entering a new venture a person must look into the profit potential of that project and compare it with the other identified projects.