Capital Budgeting is a process of evaluating and selecting long-term investments
Capital Budgeting is a process of evaluating and selecting long-term investments that are consistent with maximizing company goals. Definition of Capital Budgeting “Capital Budgeting is the Process of evaluating and selecting long-term investment consistencies with the firm’s goal of owner wealth maximization”. Investment also means current expenditure and the expected return on those expenditures will only be received more than one year later.
The definition of Capital Budgeting is as follows: “Capital Budgeting involves the entire process of planning whose returns are expected to extend beyond one year” (Chuka Info).
As a consequence, companies need certain procedures to analyze and select several investment alternatives that exist. The decision regarding investment is difficult because it requires an assessment of the situation in the future, so assumptions that are based on estimates of the situation that most closely might be possible, both internal and external situations of the company are needed.
The investment must be calculated in accordance with the company’s cash flow and must be the most appropriate decision to avoid the risk of loss on the investment. “As time passes, fixed assets may become oblique or may require an overhaul; at these points, too, financial decisions may be required “. Companies usually make various alternatives or variations to invest in the long term, namely in the form of additional fixed assets such as land, machinery and equipment. These assets are potential assets, which are potential sources of income and reflect the value of a company.
Capital budgeting and financial decisions are treated separately. If the proposed investment has been determined to be accepted, the financial manager then chooses the best financing method.
A budget is a detailed plan that projects cash inflows and outflows over several periods in the future. Capital budget is an outline of fixed-asset expenditure plans. Capital budgeting is a comprehensive process of analyzing projects and determining which are included in the capital budget.
The process of collecting, evaluating, selecting, and determining investment alternatives that will provide income for the company for a period of more than 1 year.
The Importance of Budgeting
1. Decision of capital deployment will affect for a long time so that the company loses its flexibility.
2. Effective capital budgeting will increase the timeliness and quality of adding assets.
3. Capital expenditure is very important
Basic Principles of the Capital Budgeting Process
Capital budgeting is basically the application of the principle that says that a company must produce output or conduct business activities in such a way that the product’s marginal revenue is the same as its marginal cost.
This principle in the framework of capital budgeting means that companies must make additional investments in such a way that the return on investment is equal to the cost of the add.
The list of various investment projects from highest to lowest returns reflects the company’s need for capital for investment.
The incremental costs from the various investment lists provide a clue about the company’s efforts to obtain additional capital to finance investment. Cost of capital added means a number of costs that must be borne by the company to obtain funds from outside (for example borrowing or selling shares and the cost of the opportunity / opportunity cost of the funds that can be obtained
Independent project: a project or investment that is independent (will not affect other project proposals).
Mutually exclusive project: a project that has the same function (selecting a project will eliminate the possibility of other projects).
Availability of Funds
If the fund is NOT LIMITED, then the company can select all independent projects that are in accordance with the expected expected return.
If funds are LIMITED, the company needs to do capital rationing by allocating funds only to projects that provide maximum return
Capital Budgeting Process
The Capital Budgeting process consists of 5 interrelated steps, namely:
(1) Making a Proposal
Capital goods budgeting proposals are made at all levels in a business organization.
To stimulate the flow of ideas, many companies offer cash awards for several proposals adopted.
(2) Study and Analysis
Capital goods budgeting proposals are formally reviewed in order to (a) achieve the company’s main objectives and plans and most importantly (b) to evaluate their economic capabilities. The proposed costs and estimated benefits are converted into an appropriate cash flow. Various capital budgeting techniques can be applied to the cash flow to calculate the level of return on investment. Various aspects of risk are associated with the proposal to be evaluated. After the economic analysis has been made complete, it is accompanied by additional data and recommendations aimed at decision makers.
(3) Decision Making The amount of funds spent and the importance of capital goods budgeting illustrates the specific level of organization that makes budgeting decisions. Companies usually delegate the authority of capital goods budgeting according to the amount of money spent. In general, the board of directors provides the final decision on a certain amount of capital expenditure budgeting
(4) Implementation When a proposal has been approved and the funds are ready, the implementation phase starts immediately. For small expenses, budgeting is made and direct payments are made. But for large amounts of budgeting, strict supervision is needed.
(5) Follow Up After being implemented it is necessary to monitor during the operational phase of the project.
Comparison of existing costs and expected profits from various previous projects is very vital. When the costs incurred exceed the stipulated budget, immediate action must be taken to stop it, whether by increasing benefits or possibly stopping the project. Every step in the process is important, especially at the stage of study and analysis, and decision making (steps 2 and 3) which requires the most time and energy. The final step, follow-up, is also important but is often ignored. The step was taken to maintain the company to be able to improve the accuracy of the estimated cash flow.
Types of Investment
Investment can be carried out by the company depending on the company’s basic motives, namely the higher rate of return on the investment. These investments consist of various types that are tailored to the objectives of the company.
The investment definition is as follows: “The commitment of funds to one of more assets that will be held over some future time period”. The definition means that investment is a commitment of a number of funds to become one or more assets that will be carried out in a certain period in the future. Next Jones classifies the types of investment as follows: a. Financial Assets. Pieces of paper evidencing a claim on some issues. Real Assets. Physical assets, such as gold or real estate. Marketable Securities. Financial assets that are easily and cheaply traded in organized markets.
Rationalization of Capital
The problem of capital rationalization (capital rationing) will arise if there are limited funds available and faced with a portfolio of investments. Therefore we need to choose a number of investment alternatives that can be achieved from the available budget with a fairly high level of profit. For this reason, two general characteristics of the various investments need to be considered, including the following: a. Independent projects are projects whose cash flow is not related or independent of one project to another.
Acceptance of one project for some reason will not eliminate the other project. If a company has a lot of budget funds available to invest, acceptance criteria for the project will be easier. All investment choices that generate the greatest return will be immediately accepted. B. Mutually exclusive project is a project that has the same function and competes with each other. Acceptance of a project will eliminate other equivalent projects.
Cash Flow and Investment Methods
a. Initial Investment
The initial investment limit is very relevant to the amount of cash out flow that is considered when evaluating the prospective budgeting of capital goods. Initial investment (initial investment) is carried out at zero time (time zero), ie the time when the budget is issued. The initial investment is calculated by reducing all cash inflow that occurs at time zero with all cash outflows that occur at time zero. The basic formula for determining initial investment is the cost of purchasing a new asset plus the cost of the installation minus the sales tax on the old asset.
The basic format of determining Initial Investment is as follows: “The basic Format for Determining Initial Investment Installed cost of new assets = Cost of new assets + installation costs – after-tax proceeds from sale of sold assets “. With the initial investment will affect and will change the Net Working Capital (NWC) of a company. If a company intends to buy vessels in the context of expansion, both the level of production, or the level of cash, accounts receivable, inventory, and trade debt will increase.The difference between changes in current assets and changes in current debt is a change in Net Working Capital.In general, if current assets increase greater than current debt will result in an increase in NWC, and vice versa.
b. Cash flow
One important thing in the matter of investment policy is to estimate the expenditure of money that will be received from the investment in the future. To evaluate various alternative capital / investment goods budgeting, companies must determine the appropriate cash flow, namely data on the net cash flow of an investment. For the purpose of valuing an investment that is fully financed by its own capital net cash flow (cash flow) is before the depreciation charge and calculated after tax.
However, if financed with loan capital, net cash flow is before being charged with depreciation, interest and calculated after tax. Further understanding of cash flow “The neutral net cash, as opposed to accounting net income, that flows into (or out of) a firm during some specified period “. The company’s cash flow analysis can be used as a basis for research to see the extent to which business activities can accumulatively cover the funds invested to drive the company’s operational activities. Every cash flow from a project has a conventional pattern because in it there are 3 basic components namely ( 1) initial investment, (2) Cash inflow and (3) cash flow terminal.
According to (Bambang Rijanto, 1995) every proposal for capital expenditure always contains two kinds of cash flows, namely: 1. Net outflow of cash is what is needed for new investment.2. Net annual cash inflows (Net Annual Inflow of Cash), which is as a result of these new investments, which are often also called “Net Cash Proceeds” or simply by the term “Proceeds”. Cash flow for capital budgeting purposes is defined as cash flow after tax on all company capital. In algebra, the definition is the same as earnings before interest and taxes, minus income tax if the company has debt, plus non-cash depreciation expense.