Historically the role of accountants remained limited to clerical work where they were meant to manage day-to-day accounting matters and record keeping. When the economic horizons expanded and firms stretched out operations beyond the boundaries of their homeland and prolonged their investments in long-term projects and ventures wrapping over many years the role of typical accountants became worthless and new approaches emerged in the field of accounting and finance. Though great many developments were made and new techniques were adopted in the reporting mechanism for the limited financial period typically one year or less but they were not acquainted with the feasibilities, financial viabilities and assessing economic benefits from long lasting undertakings. To cope with the dearth of this matter a very comprehensive technique has been materialized in the community of financial managers called capital budgeting.
Capital budgeting or investment appraisal as the name suggests concerns with the capital investments where the financial feasibility of a long-term project is determined. Capital budgeting is quite a profound subject and forms part of financial curriculum and financial management all over the world.[linkunit]This technique of determining financial viability attracts the investor due to the fact that it takes into account cash flow streams over the life of the project and exclude any non-cash expenditure such depreciation etc. Moreover cash flows are discounted to the present value at the investors’ required rate of return hence taking into account time value of money. The above exceptional qualities of capital budgeting make it superior to any other approach to the acceptance/rejection criterion of a project.
Investment appraisal is fundamental to an understanding of financial management. It involves the process of planning for decision on capital expenditures based on the concept of wealth maximization for shareholders. This process requires:
• Ability to rank investment projects in a meaningful order of profitability
• Ability to provide a cut off point beyond which no further investment is worthwhile
• Consistency with corporate objectives
In effectively managed firms this is a fundamental requirement that decisions should be based on knowledge and efficiency. Countless decisions of capital nature have to be taken by the management such as replacement of worn and obsolete machinery, acquire fixed assets, and appraise strategic investment proposals. Capital budgeting decisions are of two types:
Expansion of Revenue
Decisions taken for the sake of expanding operations with the intentions to enhance revenues of the firm. Usually the firms purchase new assets, expand operations, and invest in new projects to increase the revenue base. The additional revenues are compared with additional costs and are evaluated using the capital budgeting techniques.
Reduction in Costs
Some times the firms have to face the dilemma of increasing cost of production. To curtail the cost the firms have to take decisions to replace the old plant and machinery. They must decide whether to continue with the existing assets or to replace them to reduce costs. The benefits from new assets are evaluated through the extensive use of capital budgeting techniques.