Page 138 - DMGT409Basic Financial Management

Unit 7: Capital Budgeting

7.4 Summary Notes

Modern financial manager’s function is efficient allocation of capital among available
investment opportunities. The investment opportunity may be long-term investment or
fixed assets; short–term or current assets.

One of the important problems confronting the top management of a firm is to determine

whether the firm should invest funds in fixed assets. Fixed assets may be tangible as well as

intangible. While the former represent assets like land and buildings, plant and machinery

and, furniture and fixtures, the latter group consists of copyrights, patents and goodwill.

Capital budgeting is 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.

Capital budgeting decisions are important since growth of the firm depends on fi xed assets,

it is a more risky decision as huge investments are involved, an irreversible decision, it has
effect on other projects too, a and difficult decision (became the decision is based on future

years cash inflows, and involves uncertainty of future and hence more risk).

Capital budgeting decisions are very important, but they pose difficulties, which shoot
form three principle sources: measurement problem, uncertainty, and temporal spread.
The capital budgeting process may be more or less depended on the type of the project. So
firm normally classify the projects into different categories. It may differ from one fi rm to

another firm, but the most important classification of projects are: new projects, expansion

projects, diversification projects, replacement and modernization projects, research and

development projects, interior decoration, recreational facilities, executive aircrafts,
landscaped gardens etc.
A wide range of criteria has been suggested to judge the worthwhileness of investment
projects. They are divided into two broad categories, viz., (I) Traditional techniques or non-
discounted techniques and (II) Modern techniques or discounted cash fl ow techniques. The
traditional techniques are further subdivided into two, such as (a) Pay back period, and
(b) Accounting rate of return or average rate of return (ARR). The discounted cash fl ow
techniques are again subdivided into three, such as (A) Net present value (NPV) technique,
(B) Internal rate of return (IRR) or trial and error technique, and (C) Profitability Index (PI)

of Benefit Cost Ratio (BCR).

7.5 Keywords
Capital Budgeting: It refers to planning and deployment of available capital for the purpose of
maximizing long-term profitability of the fi rm.

Contingent Investment Proposals: There are certain projects which are contingent upon the
acceptance of others.

Mutually Exclusive Investment Proposals: Those proposals which represent alternative methods
of doing the same job.
Replacement Investment: The investments, which are contemplated for replacing, old and
antiquated equipment so that the job could be performed more efficiently, are termed as

replacement investment.

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