Resource constraint is a common phenomenon of all economic activities. Move over, sometimes when a firm is able to spend on certain items it is not willing to do so. So, a systematic screening process is employed to accept or reject the investment proposals. For the purpose, the investment proposals are broadly divided into two groups: (1) Mutually exclusive proposals and (2) Independent proposals.
Mutually exclusive proposals are nothing but the alternative methods of doing the same thing. If one method is selected, the other must be rejected; e.g. if in plant material handling facilities are needed, they can be arranged either through conveyor belt or through the fork-lift truck. The economic benefits of each of the proposals are evaluated and the one contributing maximum economic benefits is selected while the rest are rejected. Independent proposals are those items of capital expenditure that are being considered for different types of projects which are required to be accomplished. All independent proposals are independent of each other and are worthy to be implemented. However, due to certain financial constraints, priorities are assigned to each of the proposals according to the gravity of the need of the organization; e.g. along with the material handling facilities, the instruments may be required for weighing machines, stamping machines, packing machines etc. For the mutually exclusive proposals the decision criterion is accept or reject while for the independent proposals it is ranking. This decision is taken on the basis of the methods of evaluating the capital budgeting decisions.
The nature of the capital expenditure proposals are broadly classified thus: (1) Replacement, (2) Expansion, (3) Diversification (4) Strategic proposals.
Replacement: Capital expenditure involves the replacement of an old machine by a new one. The replacement becomes necessary due to wear and tear or due to obsolescence. It results in more production, better quality production and reduction in operating costs. As the investments are made in the same line of production, it is not exposed to business risks.
Expansion: This involves the capital expenditure to increase the production capacity in the same line of production. The investments are made in the known areas of activity as it involves lesser business risk as compared to diversification, however, a bit greater risk than replacement expenditure.
Diversification: Here the investments are made in a new line of production. Such investments are exposed to the greater degree of business risk due to the non-familiarity of the production and sale area.
Strategic Investments: These investments indirectly contribute to the revenues. Such investments may be of following nature:
i) Investments in plant services like material handling, storing facilities etc
ii) Investments in personal services like investments for provision of canteen, parking area, office air-conditioning etc
iii) Huge expenditure on advertisement campaign
iv) Expenditure on marketing of securities etc.
It should be noted that capital budgeting is customarily considered with reference to the investments in plant and machinery. However, principally it can be applied to all types of investments mentioned above.
Components of project evaluation: Capital budgeting decision involves the rigorous evaluation of each investment proposals in quantitative terms. The comparison is made between the cash inflows and the cash outflows of each proposal.
Cash Flows: In the capital budgeting decisions, cash flows out of the investments are considered rather than the accounting profits generated out of the investments. The cash inflow and the accounting profit do not represent the same figure because cash inflow is the excess of cash receipts over cash payments while accounting profit is a periodic profit ascertained on the basis of the accrual principle of accounting involving certain accounting adjustments; e.g. provision of depreciation on fixed assets reduce the accounting profits, but it is not an actual outflow of cash. Thus, the cash inflow and the accounting tally with each other. In the capital budgeting analysis, cash flows rather than the accounting profits are considered because for the purpose of making additional profits one must have cash to reinvest and there is no assurance that one will have the accountant’s reported profits available in the form of cash.