The overall objective of capital budgeting is to maximise the profitability of a firm or the return on investment.
Kinds of Capital Budgeting Decisions
The overall objective of capital budgeting is to
maximise the profitability of a firm or the return on investment. This
objective can be achieved either by increasing the revenues or by reducing
costs. Thus, capital budgeting decisions can be broadly classified into two
1. Those which increase revenue, and
2. Those which reduce costs
The first category of capital budgeting decisions is expected to increase revenue of the firm through expansion of the production capacity or size of operations by adding a new product line. The second category increases the earnings of the firm by reducing costs and includes decisions relating to replacement of obsolete, outmoded or worn out assets. In such cases, a firm has to decide whether to continue with the same asset or replace it. Such a decision is taken by the firm by evaluating the benefit from replacement of the asset in the form of reduction in operating costs and the cost/cash outlay needed for replacement of the asset. Both categories of above decisions involve investment in fixed assets but the basic difference between the two decisions lies in the fact that increasing revenue investment decisions are subject to more uncertainty as compared to cost reducing investment decisions.
Further, in view of the investment proposals under consideration, capital budgeting decisions may also be classified as.
1. Accept / Reject Decisions
2. Mutually Exclusive Project Decisions
3. Capital Rationing Decisions.
(i) Accept / Reject Decisions
Accept / reject decisions relate to independent project which do not compete with one another. Such decisions are generally taken on the basis of minimum return on investment. All those proposals which yield a rate of return higher than the minimum required rate of return or the cost of capital are accepted and the rest are rejected. If the proposal is accepted the firm makes investment in it, and if it
is rejected the firm does not invest in the same.
Mutually Exclusive project Decisions Such decisions relate to
proposals which compete with one another in such a way that acceptance of one
automatically excludes the acceptance of the other. Thus, one of the proposals
is selected at the cost of the other. For example, a company may have the
option of buying a new machine, or a second hand machine, or taking an old
machine on hire or selecting a machine out of more than one brand available in
the market. In such a case, the company may select one best alternative out of
the various options by adopting some suitable technique or method of capital
budgeting. Once one alternative is selected the others are automatically
Capital Rationing Decisions
A firm may have several
profitable investment proposals but only limited funds to invest. In such a
case, these various investments compete for limited funds and, thus, the firm
has to ration them. The firm effects the combination of proposals that will
yield the greatest profitability by ranking them in descending order of their
Tags : Financial Management - Capital Budgeting – A Conceptual Framework
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