What is capital budgeting ? Explain its significance. What are the various kind of capital budgeting decisions


The efficient allocation of funds is among the main functions of financial management. Allocation of funds means investment of funds in assets or activities. It is also called investment decision because we have to select the assests in which investment has to be made. These assets can be classified into two parts :-
i) Short-term or Current Assets.
ii) Long-term or Fixed Assets.
A capital budgeting decisions may be defined as the firm’s decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. In other words, “capital budgeting is used to evaluate the expenditure decisions such as acquisition of fixed assets, changes in old assets and their replacement.” Activities such as change in the method of sales distribution or undertaking an advertisement campaign or a research and development programme have
long-term implication for the firm’s expenditure and benefits and therefore, they may also be evaluated as investment decisions.
Features of Capital Budgeting Decisions
Following are the features of investment decisions
􀂾 Investment of fund is made in long-term assets.
􀂾 The exchange of current funds for future benefits.
􀂾 Future profits accrue to the firm over several years.
􀂾 These decisions are more risky.
It is significant to emphasise that expenditure and benefits of an investment should be measured in cash. In the investment analysis, it is cash flow which is important, not the accounting profit. It may also be pointed out that investment decisions affect the firm’s value. The firm’s value will increase if investment are profitable. Investment should be evaluated on the basis of a criteria on which it is compatible with the objective of the shareholder’s wealth maximisation. An investment will add to the shareholder’s wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of
capital.
 Importance of capital expenditure decision
Investment decisions require special attention because of the following reasons :
1. Growth :- The effects of investment decisions extend into the future and have to endured for a longer period than the consequences of the current operating expenditure. A firm’s decisions to invest in long-term assets has a decisive influence on the rate direction of its growth. A wrong decisions can prove disastrous for thecontinued survival of the firm.
2. Risk :- A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become very risky.
3. Funding :- Investment decisions generally involve large amount of funds. Funds are scarce resource in our country. Hence the capital budgeting decision is very important.
4. Irreversibility :- Most investment decisions are irreversible
5. Complexity :- Investment decisions are among the firm’s most difficult decisions. They are concerned with assessment of future events which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of investment.
Objectives of Capital Budgeting Decision
Capital budgeting helps in selection of profitable projects. A company should have system for estimating cash flow of projects. A multidisciplinary team of managers should be assigned the task of developing cash flow estimates. Once cash flow have been estimated, projects should be evaluated to determine their profitability. Evaluations criteria chosen should correctly rank the projects. Once the projects have been selected they should be monitored and controlled. Proper authority should exist for capital spending. Critical projects involving large sum of money may be supervised by the top management. A company should have a sound capital budgeting and reporting system for this purpose. Based on the comparison of actual and expected performance, projects should be reappraised and remedial action should be taken.
Kinds of capital expendikinds of capital expenditure decisions
Capital expenditure decisions are of following types :
Expansion and diversification
A company may add capacity to its existing product lines to expand existing operations. For example, a fertilizer company may increase its plant capacity to manufacture in more areas. Diversification of a existing business require investment in new product and a new kind of production activity within the firm. Investment in existing or new products may also be called as revenue-expansion investment.
Replacement and modernisation
The main objective of modernisation and replacement is to improve operating efficiency and reduce costs. Assets become out dated and obsolete as a result of technological changes . The firm must decide to replace those assets with new assets that operate more economically. If a cement company change from semi-automatic drying equipment  to fully automatic drying equipment to fully automatic drying equipment, it is an example of modernisation and replacement. Yet an other useful way to classify investment is as follow :
􀂾 Mutually exclusive investments
􀂾 Independent investments
􀂾 Contingent investments
Mutually exclusive investment
Mutually exclusive investment serve the same purpose and compete with each other. If one investment is selected other will have to be rejected. A company may, for example,either use more labour-intensive, semi-automatic machine or employ a more capital intensive, highly machine for production.
Independent Investment
Independent investment serve different purposes and do not compete with each other. For example a heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and adding new production facilities to manufacture a new product - Light commercial vehicles. Depending on their profitability and availability of funds, the company can undertake both investment.
Contingent Investment

Contingent investment are dependent projects. The choice of one investment necessitates under taking one or more other investments. For example, if a company decided to build a factory in a remote backward area, it may have to invest in houses, road, hospitals, schools etc. The total expenditure will be treated as one single investment.

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