Types of Capital Budgeting. Capital Budgeting Capital budgeting is the process of deciding how to invest in long-term assets (like land, buildings, machinery, furniture, etc.) that won’t be sold but will bring in money for the business. It involves long-term planning and monitoring of capital expenditure, as well as examining each proposal in a very logical and scientific manner so as to finalize the best proposal. Capital spending is different from revenue spending in that the benefits of capital spending usually don’t show up for at least a year after the money is spent. With revenue spending, on the other hand, the benefits are made and used up within the same year. Some of the authors have defined “capital budgeting” as follows:
According to Charles T. Horngren, “capital budgeting is long-term planning for making and financing proposed capital outlays.”
Types of Capital Budgeting
The technique of capital budgeting is applied in respect of the following types of investments:
1) Expansion and Diversification:
These are explained below:
i) Expansion: At a certain phase, a company engaged in manufacturing activities may feel the need to enhance its capacity for manufacturing the same product, to meet the increased market demand. It may, therefore, decide to invest in plant and machinery with the objective of increasing the production of its product. To illustrate this, the example of a urea manufacturing unit (A) may be taken. If the capacity of that unit (A) is ‘X’ metric tonnes per annum and it (the unit) sees an increase in the demand for urea in the market, it may decide to invest in the acquisition of additional plant and machinery to increase the production of urea to the level of ‘X+’ in order to meet the market demand. Sometimes a company acquires another company to expand its business.
ii) Diversification: A company engaged in a particular line of business, may decide to diversify its activities into an altogether new line of business, because of better business opportunities in that field. Venturing into a new field necessitates investment in new techniques, manpower, etc., besides new plants, machinery and related equipment. For example, the Housing Development Finance Corporation (HDFC), engaged in the business of housing finance, decided to enter into the business of banking in 1993 (when the sector was opened by RBI) as it saw greater opportunity therein. HDFC Bank came into existence and today they are the leader amongst the private sector banks. A company decides to invest in order to diversify in a different field with the expectation of additional revenue.
2) Replacement and Modernisation:
A company may consider investing in modernisation and replacement of obsolete assets with a view to keep pace with the advent of new technology for improving operational efficiency and minimisation of costs, which results in a higher level of profits. Such investments require substantial capital investment (cash outflow) with no immediate return, but in the long run, the company is a beneficiary. For example, a huge investment is required in a paper-producing company to change its manual handling machine to fully automatic producing equipment. However, after some time the company starts reaping the benefits in the form of increased efficiency and an increase in its revenue. Investment for acquiring more efficient assets with features of advanced technology is also called cost-reduction investment.
3) Mutually Exclusive Investments:
If there are three choices for making investments for a similar objective, there will be a sort of competition amongst them and only one of them will be selected at a time and others will be logically rejected. This concept would be clear from an example if a company has two investment proposals to buy machinery for production: i) the First proposal is to buy a semi-automatic machine, which is labour intensive, and ii) The other one is to buy a fully automatic machine, which is capital intensive.
After applying the technique of ‘Capital Budgeting the company may decide in favour of one of the above proposals and the other one would be automatically rejected. There is an element of competition amongst such proposals.
4) Independent Investments:
As the nomenclature suggests, they are two independent investment proposals having different objectives. In contrast to ‘Mutually Exclusive Investments’, there is no element of competition amongst such proposals. For example, two independent proposals may be under consideration by the automobile company, one proposal may relate to the expansion of its plant capacity to manufacture family and office purpose cars, and the other one may relate to the addition of new production facilities to manufacture mobile set (a new product). The company may decide in favour of both proposals or both proposals may be turned down depending upon the outcome of capital budgeting.
5) Contingent Investments:
Investment in one project compels the business to spend additional funds related to that investment. So, the investments made on dependent projects are known as contingent investments. For example, the decision to start a medical college may be contingent upon a decision to establish a hostel for the students on the premises of the college.
6) Research and Development Projects: (Types of Capital Budgeting )
Most Indian companies conventionally believe that investing in Research and Development (R&D) projects are a waste of money. If they decide to make an investment in R&D, it forms a very small percentage of the total capital budget. Of late, the trend has started to change, as companies have realised the significance of R&D in modern business, especially those who are in knowledge-intensive industries. Allocation of funds for R&D projects has shown an increasing trend during the last few years. Evaluation of R&D projects is a complex process and involves a lot of decision-making. Discounted Cash flow (DCF) analysis is not applicable to such projects. Decisions to invest in these projects depend upon the opinion of top management. Mostly to assess such projects, companies depend on quantitative tools like decision tree analysis and options analysis.
7) Miscellaneous Projects:
Decisions to invest in projects such as recreational facilities, interior decoration, executive aircraft, and landscaped gardens. etc., are taken generally on the basis of Top Management’s personal choice. There are no specific techniques to evaluate these projects.
Components of Capital Budgeting