Capital Budgeting
Unit – II
Introduction: An efficient allocation of capital is the most important finance function in the modern times. It
involves decisions to commit the firm’s funds to the long term assets. Capital budgeting or investment decisions
are of considerable importance to the firm since they tend to determine its value by influencing its growth,
profitability and risk.
Capital Budgeting: Capital budgeting is the process of making investment decision in capital expenditure. The
investment decisions of a firm are generally known as the capital budgeting or capital expenditure decisions. A
capital budgeting decision may be defined as the firms 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. The long term
assets are those that affect the firm’s operations beyond the one year period. The firm’s investment decisions
would generally include expansion, acquisition, modernization and replacement of the long term assets.
Capital budgeting may also be defined as “The decision making process by which a firm evaluates the purchase
of major fixed assets.”
The term 'Capital Budgeting' is used interchangeably with capital expenditure management, capital expenditure
decision, long term investment decision, management of fixed assets, etc. It may be defined as “planning,
evaluation and selection of capital expenditure proposals”. Capital budgeting involves a current outlay or serves
as outlays of cash resources in return for an anticipated flow of future benefits.
Lynch - "Cash budgeting consists in planning, development of available capital for the purchase of maximizing
the long term profitability in the concern”.
Importance
Capital budgeting is of paramount importance in financial decision making. Special care should be taken in
making these decisions on account of the following reasons:
1. Such decisions affect the profitability of the firm. They also have bearing on the competitive position of the
enterprise. This is mainly because of the fact that they relate to fixed assets. The fixed assets represent in a sense,
the true earning assets of the firm. They enable the firm to generate finished goods that can ultimately be sold for
a profit. However, current assets are not generally earning assets. They provide a buffer that allows the firm to
make sales and extend credit. Capital budgeting decisions determine the future destiny of the company. An
opportune investment decision can yield spectacular returns. On the other hand an ill advised and incorrect
investment decision can endanger the very survival even of large sized firms. A few wrong decisions and a firm
can be forced into bankruptcy. Capital budgeting is of utmost importance to avoid over-investment and under-
investment in fixed assets.
2. A capital expenditure decision has its effect over a long time span and inevitably affects the company's future
cost structure. To illustrate, if a particular plan has been purchased by a company to start a new product, the
company commits itself to a sizable amount of fixed assets in terms of supervisors, salary, insurance, rent of
buildings and so on. If the investment in future turns out to be unsuccessful or yields less profit than anticipated,
the firm will have to bear the burden of fixed costs unless it writes off the investment completely. In short, a
firm's future costs, break-even point, sales and profits will all be determined by the firm's selection of assets i.e.,
capital budgeting.
Long term investment decisions are more difficult to take because:
Decision extends to a series of years and beyond the current accounting period;
Uncertainties of future and
Higher degree of risk
3. Capital investment decision once made is not easily reversible without much financial loss to the firm. It is
because there may be no market for second hand plant and equipment and their conversion to other uses may not
be financially feasible.
4. Capital investment involves cost and the majority of the firms have scarce capital resource. This underlines the
need for thoughtful, wise and correct investment decisions as an incorrect decision would not only result in
losses but also prevent the firm from earning profits from other investments which could not be undertaken for
want of funds.
, 5. Over / under capacity: To improve timing and quality of asset acquisition, the capital expenditure decision
must be carefully drawn. If the firm has invested too much in assets, it will incur unnecessary heavy expenditure.
If it has not spent enough on fixed assets, two serious problems may arise
(i) The firm’s equipment may not be sufficiently modern to enable it to produce competitively.
(ii) If it has inadequate capacity it may lose a portion of its share of market to its rival firm. To regain lost
customers it would require heavy selling expenses, price reduction, product improvement, etc.
6. Investment decision though taken by individual concerns is one of national importance because it determines
employment, economic activities and economic growth.
CAPITAL BUDGET DECISION
Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital
expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals.
Basically the firm may be confronted with three types of capital budgeting decisions.
1. Accept / Reject decision: This is the fundamental decision in capital budgeting. If the project is accepted, the
firm invests in it. If the proposal is rejected the firm does not invest. In general all those proposals which yield a
rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected.
By applying this criterion, all independent projects are accepted. Independent projects are projects that do not
compete with one another in such a way that acceptance of one preclude the possibility of acceptance of another.
Under the acceptance decision, all the independent projects that satisfy the minimum investment criteria are
implemented.
2. Mutually exclusive project decision: Mutually exclusive projects are projects which compete with other
projects in such a way that the acceptance of one will exclude the acceptance of other projects. The alternatives
are mutually exclusive and only one may be chosen. It may be noted that the mutually exclusive project
decisions are not independent of accept / reject decision. Fr example, a company has an option of buying a
component from outsider or manufacturing with in the firm. In this situation the company may accept the most
profitable decision, based on purchase price or manufacturing cost whichever is less. Selection of one option
leads to the rejection of another.
3. Capital rationing decision: This situation arises, when a firm has limited funds several profitable investment
projects. Capital rationing situation arises when the various profitable investment proposals compete for limited
funds at a time. Company selects a combination of profitable proposals that will earn higher profits by ranking
them in descending order of their profit earning capacity. A large number of investment proposals compete in
these limited funds. The firm allocates funds to projects in a manner that it maximizes long run returns. Thus
capital rationing refers to the situation where the firm has more acceptable investments requiring a greater
amount of finance than is available with the firm. It is concerned with the selection of a group of investment
proposals acceptable under the accept / reject decision. Ranking of the investment project is employed. In capital
rationing, projects can be ranked on the basis of some predetermined criterion such as the rate of return .The
project with highest return is ranked first and the acceptable projects are ranked thereafter.
4. Contingent Investment: Contingent project are dependent investments, acceptance of one option needs to
undertake one or more other projects. For example, location of factory in backward area, instead industrial areas
of urban, it may need to construct roads, quarters to employees, hospitals, schools, without which it is vary
difficult to attract employees.
Importance of Investment Decisions / Capital Budgeting Decisions:
1. They influence the firm’s growth in the long run
2. They affect the risk of the firm
3. They involve commitment of large amount of funds
4. They are irreversible, or reversible at substantial loss
5. They are among the most difficult decisions to make
Growth: The effects of investment decisions extend into the future and have to be endured for a longer period
than the consequences of the current operating expenditure. Unwanted or unprofitable expansion of assets will
result in heavy operating costs to the firm.
Unit – II
Introduction: An efficient allocation of capital is the most important finance function in the modern times. It
involves decisions to commit the firm’s funds to the long term assets. Capital budgeting or investment decisions
are of considerable importance to the firm since they tend to determine its value by influencing its growth,
profitability and risk.
Capital Budgeting: Capital budgeting is the process of making investment decision in capital expenditure. The
investment decisions of a firm are generally known as the capital budgeting or capital expenditure decisions. A
capital budgeting decision may be defined as the firms 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. The long term
assets are those that affect the firm’s operations beyond the one year period. The firm’s investment decisions
would generally include expansion, acquisition, modernization and replacement of the long term assets.
Capital budgeting may also be defined as “The decision making process by which a firm evaluates the purchase
of major fixed assets.”
The term 'Capital Budgeting' is used interchangeably with capital expenditure management, capital expenditure
decision, long term investment decision, management of fixed assets, etc. It may be defined as “planning,
evaluation and selection of capital expenditure proposals”. Capital budgeting involves a current outlay or serves
as outlays of cash resources in return for an anticipated flow of future benefits.
Lynch - "Cash budgeting consists in planning, development of available capital for the purchase of maximizing
the long term profitability in the concern”.
Importance
Capital budgeting is of paramount importance in financial decision making. Special care should be taken in
making these decisions on account of the following reasons:
1. Such decisions affect the profitability of the firm. They also have bearing on the competitive position of the
enterprise. This is mainly because of the fact that they relate to fixed assets. The fixed assets represent in a sense,
the true earning assets of the firm. They enable the firm to generate finished goods that can ultimately be sold for
a profit. However, current assets are not generally earning assets. They provide a buffer that allows the firm to
make sales and extend credit. Capital budgeting decisions determine the future destiny of the company. An
opportune investment decision can yield spectacular returns. On the other hand an ill advised and incorrect
investment decision can endanger the very survival even of large sized firms. A few wrong decisions and a firm
can be forced into bankruptcy. Capital budgeting is of utmost importance to avoid over-investment and under-
investment in fixed assets.
2. A capital expenditure decision has its effect over a long time span and inevitably affects the company's future
cost structure. To illustrate, if a particular plan has been purchased by a company to start a new product, the
company commits itself to a sizable amount of fixed assets in terms of supervisors, salary, insurance, rent of
buildings and so on. If the investment in future turns out to be unsuccessful or yields less profit than anticipated,
the firm will have to bear the burden of fixed costs unless it writes off the investment completely. In short, a
firm's future costs, break-even point, sales and profits will all be determined by the firm's selection of assets i.e.,
capital budgeting.
Long term investment decisions are more difficult to take because:
Decision extends to a series of years and beyond the current accounting period;
Uncertainties of future and
Higher degree of risk
3. Capital investment decision once made is not easily reversible without much financial loss to the firm. It is
because there may be no market for second hand plant and equipment and their conversion to other uses may not
be financially feasible.
4. Capital investment involves cost and the majority of the firms have scarce capital resource. This underlines the
need for thoughtful, wise and correct investment decisions as an incorrect decision would not only result in
losses but also prevent the firm from earning profits from other investments which could not be undertaken for
want of funds.
, 5. Over / under capacity: To improve timing and quality of asset acquisition, the capital expenditure decision
must be carefully drawn. If the firm has invested too much in assets, it will incur unnecessary heavy expenditure.
If it has not spent enough on fixed assets, two serious problems may arise
(i) The firm’s equipment may not be sufficiently modern to enable it to produce competitively.
(ii) If it has inadequate capacity it may lose a portion of its share of market to its rival firm. To regain lost
customers it would require heavy selling expenses, price reduction, product improvement, etc.
6. Investment decision though taken by individual concerns is one of national importance because it determines
employment, economic activities and economic growth.
CAPITAL BUDGET DECISION
Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital
expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals.
Basically the firm may be confronted with three types of capital budgeting decisions.
1. Accept / Reject decision: This is the fundamental decision in capital budgeting. If the project is accepted, the
firm invests in it. If the proposal is rejected the firm does not invest. In general all those proposals which yield a
rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected.
By applying this criterion, all independent projects are accepted. Independent projects are projects that do not
compete with one another in such a way that acceptance of one preclude the possibility of acceptance of another.
Under the acceptance decision, all the independent projects that satisfy the minimum investment criteria are
implemented.
2. Mutually exclusive project decision: Mutually exclusive projects are projects which compete with other
projects in such a way that the acceptance of one will exclude the acceptance of other projects. The alternatives
are mutually exclusive and only one may be chosen. It may be noted that the mutually exclusive project
decisions are not independent of accept / reject decision. Fr example, a company has an option of buying a
component from outsider or manufacturing with in the firm. In this situation the company may accept the most
profitable decision, based on purchase price or manufacturing cost whichever is less. Selection of one option
leads to the rejection of another.
3. Capital rationing decision: This situation arises, when a firm has limited funds several profitable investment
projects. Capital rationing situation arises when the various profitable investment proposals compete for limited
funds at a time. Company selects a combination of profitable proposals that will earn higher profits by ranking
them in descending order of their profit earning capacity. A large number of investment proposals compete in
these limited funds. The firm allocates funds to projects in a manner that it maximizes long run returns. Thus
capital rationing refers to the situation where the firm has more acceptable investments requiring a greater
amount of finance than is available with the firm. It is concerned with the selection of a group of investment
proposals acceptable under the accept / reject decision. Ranking of the investment project is employed. In capital
rationing, projects can be ranked on the basis of some predetermined criterion such as the rate of return .The
project with highest return is ranked first and the acceptable projects are ranked thereafter.
4. Contingent Investment: Contingent project are dependent investments, acceptance of one option needs to
undertake one or more other projects. For example, location of factory in backward area, instead industrial areas
of urban, it may need to construct roads, quarters to employees, hospitals, schools, without which it is vary
difficult to attract employees.
Importance of Investment Decisions / Capital Budgeting Decisions:
1. They influence the firm’s growth in the long run
2. They affect the risk of the firm
3. They involve commitment of large amount of funds
4. They are irreversible, or reversible at substantial loss
5. They are among the most difficult decisions to make
Growth: The effects of investment decisions extend into the future and have to be endured for a longer period
than the consequences of the current operating expenditure. Unwanted or unprofitable expansion of assets will
result in heavy operating costs to the firm.
