Edited and reposted on August 19, 2021
The Capital Budgeting (also known as investment appraisal) is the process of project appraisal to decide whether the big investment in such a long term project is worth pursuing. The long term investment may be needed to a company for technology up gradations, purchase of new machinery, expansion programmes, planning creation of new products, research and development unit etc. The project appraisal will look into various factors involved in the budgeting such as the calculation of initial cash investment and the number of years it takes for a project’s cash flow to pay back the initial cash investment, future accounting profit, Net Present Value (NPV), Benefit to Cost Ratio, Internal Rate of Return (IRR), Accounting Rate of Return, calculation of discount rate/discount factor and Assessment of risk etc. A project is passed for implementation only if assessment satisfies that the proposed project adds value to the company in terms of rate of return on the cost of capital.
The risks involved in capital budgeting:
There are numerous risks involved in a venture which are taken into account while taking a business decision. Different techniques are used to evaluate the probable risks through sensitivity analysis, scenario analysis, and break-even analysis among others. In capital budgeting, following three types of risks viz. stand-alone risk, market risk and corporate risk are invariably assessed.
Stand-Alone Risk: The risks associated with the new projects are determined separately from the company’s other assets.
Market risk: Market risk refers to risk involved due to uncertainty in future market values. The volatility in the market may affect sales of the company, which in turn may affect the amount of operating leverage.
Corporate risk: Corporate risk concentrates on the analysis of the risk that might influence the project in terms of entire cash flow of the company. Corporate risk is also known as the projects’ risks of the company.
Cash Budget system:
Many readers have confusion over capital budgeting with cash budget system. This is a pattern of financing the peak cash deficit(s) is followed for industries dealing in seasonal products like sugar and tea, construction activities, film industries, order based activities etc. In the above type of industries, the requirement of finance may be peak during some calendar months whereas the realizations of sale proceeds take place at a length of time. Therefore, under Cash budget method, the bank finance is sanctioned based on projected monthly cash flows estimated by the borrower and approved by the bank. The current ratio for this kind of facility is normally 1.33: 1 (1.25:1 for MSE) as a benchmark. Some Banks consider lower ratio on the case-to-case basis depending upon components and quality of current assets and current liabilities.
Click here for the illustration of calculation of working capital requirement of a unit under Cash Budget pattern of financing
This post was originally published on October 24, 2017
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