Page 161 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Objectives Notes

After studying this unit, you will be able to:
 Explain the meaning and process of Capital budgeting
 Describe the methods of analyzing capital budgeting decisions
 Define the conception of capital rationing
 Discuss capital decision under risk and uncertainty
Introduction

As part of long range planning process decision is taken on the programme, the organization
will undertake and the appropriate resources that will be allocated to each programme over the
next few years. Hence, management’s decision to expand or diversify emerges from the exercise
of strategic planning. The techniques of capital budgeting are used to take such decisions.

9.1 Capital Budgeting Characterization

Definition
Capital budgeting may be defined as the decision-making process by which firms evaluate the
purchase of major fixed assets such as machinery, equipment, buildings, acquisition of other
firms either through the purchase of equity shares or group of assets to conduct an on-going
business. Capital budgeting describes the firm’s formal planning process for the acquisition and
investment of capital and results in a capital budget i.e., the firm’s formal plan outlay for
purchase of fixed assets.

Importance
Preparation of the firm’s formal capital budget is necessary for a number of reasons:
1. It affects profitability: Capital budgeting decisions affect the profitability of the firm.
They also have a bearing on the competitive position of the firm. They 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 the large sized firms.
2. Effects are felt over long time periods: The effects of capital spending decisions will be felt
by the firm over extended periods of time, e.g., construction of a factory affects the
company’s future cost structure.
3. It involves substantial expenditures: Capital expenditure may range from a single piece
equipment costing thousands of rupees to complete. Profit and other physical facilities
costing crores of rupees.
4. Not easily reversible: Capital investment decisions once made, are not easily reversible
without much financial loss to the firm, since there may be no market for second hand
plant and equipment, or conversion to other uses may not be financially feasible.
5. Based on long-term policy decisions: Capital budgeting decisions should be based on long-
term policy decisions and should rest firmly on organisation policies on growth, marketing,
industry share, social responsibility and other matters and not taken on ad hoc basis.
6. Scarce capital resources: Capital investment involves cost and the majority of the firm’s
resources are limited. This underlines the need for thoughtful and correct investment decisions.
7. Difficulties in evaluation: Evaluation of capital investment proposals is difficult since the
benefits from investment are received in some future period. Hence there is a substantial

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