Capital budgeting refers to that technique using which a company identifies and evaluates the project where the cash flow of the company will be higher and greater than any other project under consideration. It can be better understood with the help of a example suppose a company has 3 projects under consideration all requiring expenditure of $100000, now suppose project A has estimated cash flow of $200000 in 5 years, project B has estimated cash flow of $150000 in 5 years and project C has estimated cash flow of $250000 in 5 years then out of the above three projects company would choose project C because it has the highest cash flow among the three projects. Above example was simple and in real life many other factors come into play when company makes capital budgeting decisions. Given below are some of the features of capital budgeting –
- Capital budgeting decisions are based on cash flows and not on accounting income concept so for example if company spends $20000 on a project of 4 years then in normal accounting this expense would be accounted as $5000 every year assuming company uses straight line method of depreciation whereas in case of capital budgeting it would be taken into account immediately and shown as $20000 expense.
- Capital budgeting are affected by externalities, externalities are the effects of acceptance of a project has on other project cash flows. For example if a project has very good cash flow but if due to acceptance of that project cash flows of current projects of the company are reduced than chances are that project will not be undertaken and some other project will be selected.
- While making capital budgeting decision opportunity cost should be included in project cost so for example if company has project which requires initial outlay of $50000 and if the interest rate of fixed deposit is 8 % then while making any decision company should take into account the loss of 8 % which the company is incurring by not investing in fixed deposit.
- Time value of money is another important feature which should be taken into account because while making capital budgeting decision company is likely to favor those projects which start generating cash flows quickly because cash flows received earlier are worth more than cash flow received later due to time value of money.
- Capital budgeting decision are taken by top level management because these decisions are for long period of time usually more than a year and cost of asset or project is very high and hence any mistake done can lead to locking of capital of the company for long period of time and also can result in big losses for the company in the long run.
As one can see from the above that capital budgeting decisions are not that simple and it requires specialized knowledge and expertise because any mistake in this regard can lead to major loss for the company.