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Capital Budgeting- Long Term Resource Planning

Capital Budgeting- Long Term Resource Planning

What is Capital Budgeting?

Capital Budgeting refers to the process of planning expenditures that give rise to revenues or returns over a number of years. The process of investment analysis is essential to have a sustainable advantage in the competitive market and to stabilize the profits through resourceful strategic business units.

The firm’s management must be on the alert to explore the opportunities present in the market. Obsolete product lines and changes in consumer tastes may present additional problems to a business enterprise affecting the profitability and growth. When a firm decides to venture into projects that demand huge investments, the management has to scrutinize the economic feasibility of such projects.

Capital Budgeting

The process of capital investment is also crucial because the projects are for the most part irreversible. Say, for example, if a business firm purchases a special type of machinery, and after installation, if the firm reverses its decision to sell the merchandise due to some technical reasons, it will have only a very small second hand value. Business firms based on the cash flow of the project and the capital recovery period do long-term investment.

Why do firms opt for capital budgeting. The reasons may be:

  • To replace worn out equipments that will affect the production efficiency
  • To replace obsolete equipments to install new and more efficient ones
  • To expand production facilities in lieu of increasing demand for the firm’s products and to capture new markets
  • To divest the surplus funds from other business units and to rotate the funds, as idle funds will not generate any revenue
  • To develop new products
  • Research and development
  • Investments made to comply with government regulations, such as projects undertaken to meet government’s health and safety regulations, pollution control and to satisfy other legal requirements.
Capital Investment Cycle

Install. Produce. Sell. Purchase. Equipment. Cash Outflow. CASH. Operating Cycle.

People Involved

The proposals for new projects come from the internal environment, such as department heads, executives, employees and of course the management. Experts in product development, marketing research, industrial engineering examine the investment proposals and they may regularly meet with the heads of other divisions in brainstorming sessions to zero in on the proposals.

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Departments Involved

While the firm’s top management makes the final say or decision to undertake or not a major investment project, the process is likely to involve most of the firm’s divisions. Each department has to present its view on the feasibility and viability of the project.

  1. The marketing department- on the demand for the new or modified products that the firm plans to sell
  2. The production, engineering, personnel and purchasing departments- on the estimation and cost of the investment projects
  3. The financing department on- how the required investments funds have to be raised.

Thus, the process of expenditure analysis can truly be said to integrate the operation of all the major divisions of the firm.