Capital budgeting in operations


The essence of the business activity is to spend money on certain heads with a hope to realize some returns out of such investments. The spending activity which is popularly known as investment function is broadly divided into two parts:

(a) Operating expenditure, the benefits of which are expected to be realized within a short span of time, usually not more than a year, e.g. expenditure on materials, labor etc.;

(b) Capital expenditure, where benefits are realized over a period longer than a year e.g. Expenditure on purchase of a machine, construction of a building etc.

It should be noted that the choice of one year is arbitrary and it is considered as a convenient cut-off time for distinguishing between the operating and the capital expenditure.

Capital budgeting fundamentally deals with the planning of the capital expenditure. As the time horizon extends beyond a year, capital budgeting decisions involve long-range planning.

Capital budgeting is an important area of financial management. Financial management manages the “financing decisions� (i.e. fund raising functions) and the “investment decisions� (i.e. the decisions about the application of funds). The financing decisions prescribe the “cost of capital�, while the investment decisions consider the “rate of return on investments�. Both these decisions are important as well as interrelated. The wealth of the owners can be maximized by reducing the cost of capital or by increasing the rate of return on investment. Capital budgeting is an integral part of the investment decisions. Only those capital expenditure proposals are entertained whose rate of return on investment exceeds or at least equates the cost of capital.

Capital expenditure means to spend something today with a view to get benefits out of it in future. It is the present sacrifice for future returns. Thus, in capital budgeting decision, substantial cash outflow occurs today and cash inflows occurs gradually in future years; e.g. when a decision to buy a machine is taken, we pay the price of the machine today, and yield the benefits out of this
machine over a period of time. Such decision is known as capital budgeting decision.

The following definitions will clarify the meaning of the term “capital budgeting�.

(a) “Capital budgeting involves the entire process of planning expenditure whose returns are expected to extend beyond one year.�

(b) “Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities.�

The consideration of investment opportunities involves “the comparison of the expected future streams of earnings from the project with the immediate and subsequent streams of expenditure for it.�

Significance of capital budgeting:

The capital budgeting decision is considered to be one of the most important and strategic managerial decisions due to the following elements, involved in it.

(a) It involves huge initial cash outflow. This necessitates the arrangement of financial resources affecting the capital structure and the resultant financial risk of the unit.

(b) The initial cash outflows (i.e. the investments) are certain while the cash inflows (i.e. future returns arising out of the investments) are uncertain.

(c) It is a long-term commitment and the decision once taken cannot be reversed or can be reversed at a great loss.

(d) The capital budgeting decision changes the overall risk taking of the firm. The capital expenditure made on expansion and diversification is exposed to certain types of business risks.

(e) The investments in fixed assets like plant and machinery are subject to the obsolescence losses caused by the technological development.

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