After formulating strategy of capital budgeting and exploring ways to efficiently manage working capital (current assets and their supporting financing), the finance manager needs to turn his attention to decisions that involve long lived assets. These decisions involve both investment and financing choices.
When a business makes a capital investment, it incurs a current cash outlay in the expectation of future benefits. Usually, these benefits extend beyond one year in the future. Examples include investment in assets, such as equipment, buildings, and land, as well as the introduction of a new product, a new distribution system, or a new program for research and development. In short, the firmâ€™s future success and profitability depend on long term decisions currently made.
An investment proposal should be judged in relation to whether or not it provides a return equal to, or greater than, that required by investors. To simplify our investigation of the methods of capital budgeting in this article, we assume that the required return is given and is the same for all investment projects. This assumption implies that the selection of any investment project does not alter the operating, or business risk, complexion of the firm as perceived by financing suppliers. As a result, the selection of an investment project affects the business risk complexion of the firm, which in turn, may affect the rate of return required by investors.
Generating investment Project proposals
Investment project proposals can stem from a variety of sources. For purposes of analysis, projects may be classified into one of five categories:
1. New products or expansion of existing products.
2. Replacement of equipment or buildings
3. Research and development.
5. Other (for example, safety-related or pollution control devices)
Most firms screen proposals at multiple levels of authority. For a proposal originating in the production area, the hierarchy of authority might run (a) from section chiefs, (b) to plant managers, (c) to the vice president for operations, (d) to a capital expenditure committee under the financial manager, (e) to the president, and (f) to the board of directors. How high a proposal must go before it is finally approved usually depends on its cost.
The greater the capital outlay, the greater the number of â€œscreensâ€? usually required. Plant managers may be able to approve moderate-sized projects on their own, but only higher levels of authority approve larger ones. The administrative procedures for screening investment proposals vary from firm to firm it is not possible to generalize. The best procedure will depend on the circumstances. It is clear, however, that companies are becoming increasingly sophisticated in their approach to capital budgeting.