Question

Investigate how corporations allocate capital budgets. How do these methods impact the decisions made on investing or not investing in new projects?Explain in details

Answer 1

Before coming to how corporations allocate capital budgets let just discuss what is actually Capital Budgeting

Capital budgeting is the process in which a business determines and evaluates potential expenses or investments that are large in nature. These expenditures and investments include projects such as building a new plant or investing in a long-term venture.

Now let's discuss the process of Capital Budgeting

1. Identification of Investment Proposals:
The capital budgeting process begins with the identification of investment proposals. The proposal or the idea about potential investment opportunities may originate from the top management or may come from the rank and file worker of any department or from any officer of the organisation.For any given initiative, a company will probably have multiple options to consider.

2. Screening the Proposals:
The Expenditure Planning Committee screens the various proposals received from different departments. The committee views these proposals from various angles to ensure that these are in accordance with the corporate strategies or selection criterion of the firm and also do not lead to departmental imbalances.

3. Evaluation of Various Proposals:
The next step in the capital budgeting process is to evaluate the profitability of various proposals. There are many methods which may be used for this purpose such as payback period method, rate of return method, net present value method, internal rate of return method etc.
For example, if a company is seeking to expand its warehousing facilities, it might choose between adding on to its current building or purchasing a larger space in a new location. As such, each option must be evaluated to see what makes the most financial and logistical sense. Once the most feasible opportunity is identified, a company should determine the right time to pursue it, keeping in mind factors such as business need and upfront costs.

4. Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. But it may not be possible for the firm to invest immediately in all the acceptable proposals.

5. Final Approval and Preparation of Capital Expenditure Budget:
Proposals meeting the evaluation and other criteria are finally approved to be included in the Capital Expenditure Budget. However, proposals involving smaller investment may be decided at the lower levels for expeditious action. The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.

6. Implementing Proposal:
Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorize to go ahead with the implementation of the project. A request for authority to spend the amount should further be made to the Capital Expenditure Committee which may like to review the profitability of the project in the changed circumstances.

Further, while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs.

7. Performance Review:
The last stage in the process of capital budgeting is the evaluation of the performance of the project. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one, and also by comparing the actual return from the investment with the anticipated return.

The unfavourable variances, if any should be looked into and the causes of the same be identified so that corrective action may be taken in future.

Now how Capital Budgeting affect the decision made on investing or non investing in new projects

There are some factors which affect in these types of investments, the first thing is in capital budgeting high amount of cash outflow is there so a firm should have adequate cash flow after capital budgeting because this will affect in investing decision in new projects also another thing is if a company does capital budgeting then the company should ensure that assets in which company has invested give a good return on regular basis by this company can also focus on investing in new projects and at the end company should have sound liquidity.