Thursday, December 27, 2012

Capital Budgeting

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The term capital budgeting means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. 

It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives. The finance manager has various tools and techniques by means of which he assists the  management in taking a proper capital budgeting decision. 

Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. 

Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate. Also as business is a part of society, it is its moral responsibility to undertake only those projects that are socially desirable. Capital budgeting decision is an important, crucial and critical business decision due to :

1) substantial expenditure :
capital budgeting decision involves the investment of substantial amount of funds and is thus it is necessary for a firm to make such decision  after a thoughtful consideration, so as to result in profitable use of scarce resources. Hasty and incorrect decisions would not only result in huge losses but would also account for failure of the firm.

2) long time period :
capital budgeting decision has its effect over a long period of time, they affect the future benefits and also the firm and influence the rate and direction of growth of the firm.

3) irreversibility :
most of such decisions are irreversible, once taken, the firm may not been in a position to reverse its impact. This may be due to the reason, that it is difficult to find a buyer for second-hand capital items.

4) complex decision :
capital investment decision involves an assessment of future events, which in fact are difficult to predict, further, it is difficult to estimate in quantitative terms all benefits or costs relating to a particular investment decision. 
Read Also :
various types of capital investment decisions
there are various ways to classify capital budgeting decisions, generally they are
classified as :

1) on the basis of the firm's existence :
              capital budgeting decisions are taken by both newly incorporated and existing firms. New firms may  require to take decision in respect of selection of plant to be installed, while existing firms may require to take decision to meet the requirements of new environment or to face challenges of competition. These decisions may be classified into:

i) replacement and modernisation decisions : replacement and modernization decisions aims to improve operating efficiency and reduce costs. Usually, plants require replacement due to they been economically dead i.e. no more economic life left or on they becoming technologically outdated. The former decision is of replacement and latter one of modernization , however, both these decisions are cost reduction decisions.

ii) Expansion decision : existing successful firms may experience growth in demand of the product and may experience shortage or delay in delivery due to inadequate production facilities and thus, would consider proposals to add capacity to existing product lines.

iii) Diversification decisions : these decisions require evaluation proposals to diversify into new product lines, new markets, etc. to reduce risk of failure by dealing in different products or operating in several markets. expansion and diversification decisions are revenue expansion decisions.

2) on the basis of decision situation :

i) mutually exclusive decisions : decisions are said to be mutually exclusive when two or more alternative proposals are such that acceptance of one would exclude the acceptance of the other.

ii) Accept-Reject decisions : the accept-eject decisions occurs when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which have a higher return than certain desired rate of return are accepted and rest rejected.

iii) Contingent decisions :
contingent decisions are dependable proposals, investment in one requires investment in another.
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