According to R.M. Lynor, “Capital budgeting consists in planning the development of available capital for the purpose of maximizing long-term profitability (return on investment) of the firm”. Capital budgeting involves mainly three problems:
1. Demand for capital.
2. Supply of capital.
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3. Rationing of capital.
1. Demand for capital:
The starting point for capital budgeting is a survey of the need of capital for the company. The discovery and development of good investment proposals require efforts and as such an imaginative search for such opportunities is very important part of the programme.
The activities of research and the industrial engineering group in reducing costs and improving products also results from research and competition in the equipment industries who are keen to promote their sales by creating obsolescence.
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Survey of explicit capital requirements generally, confined to one year or two years at the most. The capital projects of distant future cannot be visualized accurately.
Further, when projects are foreseeable it is, hardly possible to visualize their earnings, for those depend upon unknown technical advances, market developments and changes in relative prices.
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2. Supply of capital:
This is a problem to find out where from the money will came. The distinction between internal and external sources of funds must be made.
The chief internal sources are-
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(i) Depreciation charge, and
(ii) Retained earnings.
The external sources arc mainly the issue of shares and debentures to the public. It is very important to correctly forecast (i) how much cash will be generated internally and (ii) to decide how much cash is to be paid out of dividend and (iii) also to decide how much of the remainder may be tied up in long-term projects.
The capital expenditure in some firm are confined completely to the amount available internally.
The amount that can be expected from accumulated depreciation and retained earnings are the most important part of capital expenditure budgeting.
Generally these estimates are confined to one year or two years. Such projection’s are not matter of forecasting the level of prices and costs; they also involve management decision on the adequacy of depreciation charges, the level of dividend and the necessary degree of liquidity.
Thus, as a source of capital funds, plough back policy forms an integral part of capital budgeting. The problem of how much to plough back can be guided by a number of principles.
Regarding the external sources much depends upon the state of capital market and sound financial position and goodwill of the company
3. Capital rationing:
Capital is a scarce resource and is therefore, it has a cost. The return on investment must be more than the cost of capital.
Only that investment should be considered for acceptance which yields a rate of return in excess of cost of capital.
The cost of capital sets the minimum rate that the investment must promise to return. This is in fact, a way to determine the cutoff point in capital budgeting. The basic aim of capital to maximize the firm long run profit potentials.
All profitable investments cannot be accepted because the firm has limited supply of capital. In such a situation, it has to choose out the project which is the most profitable.
To conclude, capital budgeting consists of (i) determining the cost of capital (ii) determining the rate of return on different investment proposals under consideration; and (iii) ranking the proposals on the basis of their profitability.