components of capital budgeting. The exercise of “capital budgeting” analysis involves the following essential components:
1) Cash Outflows:
The initial investment in a project, as well as subsequent investments at various stages, must be carefully estimated. Besides the cost of the core assets required for the project, other miscellaneous expenses involved in the project implementation, like transportation charges, installation cost, working capital requirements, etc. are equally significant and are required to be estimated in a cautious manner.
2) Cash Inflows:
This is the most important aspect of a project, as the viability of a project hinges upon the stream of cash inflows accruing as the return on the investment made in the project. As the cash inflows can only be projected on the basis of certain historical data, its estimation requires an extremely cautious approach. The benefits reaped by the investing entity depend upon the difference between the cash outflows (initial as well as the subsequent outflows at various stages of the project) and the estimated cash inflows likely to accrue during the lifetime of the project.
3) Cut-Off Rate:
This is the minimum level of return (rate of return) expected for the investment in the proposed project and must be decided in advance. Normally, the ‘Marginal Cost of Capital of a company is the ‘Cut-Off Rate’.
4) Ranking the Proposals:
In case of the availability of numerous investment avenues at the same time and apparently, all looking equally attractive, it becomes necessary to undertake the ranking. After evaluation, all the investment proposals are ranked in the order of their viability and their merit on the basis a of cost-benefit analysis. This enables the management to take suitable decisions without any hassle, especially in a situation of limited financial resources.
5) Risk and Uncertainty: ( Components of Capital Budgeting.)
Unpredictable future and inherent risk embedded therein suffer major during the exercise of ‘Capital challenge during Budgeting’. Proper assessment of risks involved in a project and their effective mitigation should be part of the evaluation of the profitability and viability of the project. An ideal method is to assign probabilities to different expected net cash inflows.
However, probabilities are difficult to ascertain, as various underlying factors, viz., economic conditions in general, economic conditions specific to the industry/investment, competition in the market, technological aspects, fast and ever-changing consumers likings, availability of manpower and other resources, etc. play an important role, making it difficult to forecast the future. Therefore, efforts should need to be made to examine all the aspects and take necessary steps to overcome the problems faced during the ‘Capital Budgeting of investment proposals.
6) Non-Monetary View: ( Components of Capital Budgeting.)
Besides the monetary view of a project, there are certain non-monetary view also (e.g. goodwill and reputation of the company in the market), which may lead to erroneous conclusions, if they are not taken into consideration while evaluating a project.
Importance of Capital Budgeting – Click here