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Meaning and Nature of Capital Budgeting

 *Dr.P.Shanmukha Rao  **Dr.N.V.S.Suryanarayana

The term Capital Budgeting refers to long term planning for proposed capital outlay and their financing. It includes raising long-term funds and their utilization. It may be defined as a firm’s formal process of acquisition and investment of capital. Capital Budgeting may also be defined as “The decision making process by which a firm evaluates the purchase of major fixed assets. It involves firm’s decision to invest its current funds for addition, disposition, modification and replacement of fixed assets.

 

It deals exclusively with investment proposals, which an essentially long term projects and is concerned with the allocation of firm’s scarce financial resources among the available market opportunities. Some of the examples of Capital Expenditure are

    (i) Cost of acquisition of permanent assets like land and buildings.

    (ii)           Cost of addition, expansion, improvement or alteration in the fixed assets.

   (iii)           Research and Development cost of projects.

Definitions

  ”Capital budgeting is long term planning for making and financing proposed capital outlays”.

T.Horngreen “Capital budgeting 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”.

 

In any growing concern, capital budgeting is more or less a continuous process and it is carried out by different functional areas of management such as production, marketing, engineering, financial management etc. All the relevant functional departments play a crucial role in the capital budgeting decision process of any organization, yet for the time being, only the financial aspects of capital budgeting decision are considered to discuss.

 

The role of a finance manager in the capital budgeting basically lies in the process of critically and in-depth analysis and evaluation of various alternative proposals and then to select one out of these. As already stated, the basic objectives of financial management is to maximize the wealth of the share holders, therefore the objectives of capital budgeting is to select those long term investment projects that are expected to make maximum contribution to the wealth of the shareholders in the long run.

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

           In the words of Charles T. Horngren  “Capital budgeting is a long term planning for making and financing proposed capital outlays”.

 

Significance of capital budgeting:

The financial management is essentially concerned with the planning and   controlling of the financial resources of a firm. It expresses the procurement of funds along with their efficient use in order to maximize the firm’s benefit. The assets have two broad classification viz.,

          a) Short term or current assets and

          b) Long term or fixed assets.

 

Features of Capital Budgeting

The important features, which distinguish capital budgeting decisions in other Day-to-day decisions, are:

Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future.
The future benefits are expected and are to be realized over a series of years.
The funds are invested in non-flexible long-term funds.
They have a long terms and significant effect on the profitability of the concern.
They involve huge funds.
They are irreversible decisions.  They are strategic decisions associated with high degree of risk.
Importance of capital budgeting:

 

The importance of capital budgeting can be understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the organization. The importance of capital budgeting arises mainly due to the following:

Large Investment

Capital budgeting decision, generally involves large investment of funds.  But the funds available with the firm are scarce and the demand for funds are exceeds resources.  Hence, it is very important for a firm to plan and control its capital expenditure.

 

Long Term Commitment of Funds

Capital expenditure involves not only large amount of funds but also funds for long-term or an permanent basis.  The long-term commitment of funds increases the financial risk involved in the investment decision.

 

Irreversible Nature

The Capital expenditure decisions are of irreversible nature.  Once, the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.

Long Terms Effect on Profitability

Capital budgeting decision has a long term and significant effect on the profitability of a concern.  Not only the present earnings of the firm are affected by the investments in capital assets but also the future growth and profitability of the firm depends up to the investment decision taken today. Capital budgeting decision has utmost importance to avoid over or under investment in fixed assets.

Difficulties of Investment Decision

The long terms investment decisions are difficult to be taken because uncertainties of future and higher degree of risk.

 

Notional Importance

Investment decision though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.

 

 

Commercial finance is one of the many options available to entrepreneurs seeking capital to start or grow an existing business. This sort of financing is also referred to as asset-based lending, meaning that it is a secured business loan. The borrower guarantees the loan by giving up business assets as collateral for the loan. Another popular phrase for commercial finance is asset-based finance.

Account receivable factoring is one form of commercial finance. This consists of selling open invoices for cash that can be used right away in the business. There are many benefits to this financing option including not giving up equity, being able to take advantage of early payment and volume discounts from your suppliers, you can actually purchase in greater volume from suppliers, and you also accrue no additional debt in your business.

Another popular commercial finance option is purchase order financing because it offers quick cash flow reserves. When any business is growing or expanding their business the cash flow simply isn’t there because of the money it takes to market and produce products. Suppliers also want to be paid with C.O.D. and your customers are on Net-30 terms; so you run into a cash flow problem. Purchase order financing solves this issue by paying for the costs of your goods directly to the supplier, thus giving you more cash to use on more critical business expenditures. To begin with purchase order financing simply obtain a purchase order from your customer, find an approved supplier, place the order through that supplier.

Asset based loans, an additional commercial finance option, provide a short term approach to maximizing cash flow within a business. This form of financing is used as test for a business to show how they would perform with a long term loan. The business who is receiving the asset based loan has a short window to prove that with the proper financing their business model is effective, and that a long term loan would ensure business growth over a long period of time. This form of financing is perfect for the business that can’t afford to wait to establish their business credit. The assets that are accepted as collateral for this type of loan include real property, accounts receivables, and completed inventory.

Other forms of commercial finance include bankruptcy reorganization, expansion financing, import and export financing, inventory loans, secured lines of credit, and merchant account advances. Financing a business is a difficult process, but if you utilize the financing resources available, your business have a much greater chance of success.

It is also good to work on establishing your business credit, ensuring that you separate your personal credit from your business credit. With good business credit scores obtaining large loans and other forms of capital is very simple, and you won’t be one of the 97 percent that actually have a loan application denied. One other strategy that is easy to do and beneficial on your quest for business capital is to use a free business capital search engine.

As business owners develop their small business loan plans for future financing and refinancing throughout the United States, there is an increasing awareness that there have been significant business finance changes that cannot be ignored. Some of these measures are likely to end up being permanent, and even the temporary commercial mortgage loan and working capital loan changes are expected to be in place for an extended time due to the severity of the current financial climate.

The net result from business finance changes has been a reduction in commercial lenders as well as stricter standards for acquiring commercial loans and commercial mortgages. Unfortunately there has also been no shortage of misinformation about the availability of commercial funding.

A significant reduction in business lending activity overall is perhaps the most dramatic change. This has been due to several events occurring almost simultaneously. Several major commercial lenders have gone out of business altogether. Even though they have continued consumer lending, many banks have stopped commercial finance lending. Numerous business lenders have enacted stricter standards for the commercial financing transactions they are still willing to consider.

It remains to be seen how many changes will be permanent or temporary. But from a practical perspective, commercial borrowers are left with no choice but to adapt to the changing business finance environment. Business owners must be prepared to operate within a more complicated climate for commercial mortgage loans and small business loans regardless of how long the changes might be kept in place.

What should borrowers do about this? A primary option that business owners should explore involves looking beyond their local market area for help with commercial loans. A commercial financing expert operating throughout the United States should be helpful in improving upon this situation.

In addition to fewer business lenders to choose from, there are two other significant changes which must be anticipated by business owners before seeking new commercial loans. First, commercial lenders are increasingly demanding more collateral for virtually all business finance funding. Second, most lenders have cancelled or are about to eliminate unsecured lines of credit (usually called working capital loans) for many businesses.

Considering a business cash advance program based on future credit card processing transactions is likely to be an effective commercial financing strategy for overcoming the combined obstacles of more collateral, reduced unsecured credit lines and fewer lenders. This is proving to be one of the few sources of business funding that has not been adversely impacted by recent events. It will be productive to discuss the potential with a business finance expert who can provide advice about small business financing solutions including business cash advances and other financial options.

It is increasingly obvious that many banks will continue to modify their business lending programs in response to changing conditions. This means that another key change issue for working capital financing and commercial mortgages is the likelihood that more changes will be forthcoming in the near future.

To adequately prepare for future commercial finance changes that might (or might not) occur is a daunting task for a business owner. A commercial financing expert familiar with Plan B contingency financing for small business loans will prove to be a valuable resource for any borrower wanting to seriously deal with both current and future changes impacting the financial health of their business. By having a candid conversation with a commercial loan expert, business owners should be more capable of implementing an appropriate strategy for the vast changes which have recently occurred or are about to become effective for most business financing and working capital finance funding.

Minister for Heavy Industries and Public Enterprises Vilasrao Deshmukh Thursday urged the finance ministry to impose 14 percent customs duty on capital goods import in a bid to provide a level-playing field to the domestic industry.