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94 Financial Management

Meaning, Importance, rationale of capital budgeting, nature of investment decision, the

administrative framework, Methods of Appraisal, Capital Rationing, Inflation and capital

budgeting, Capital Budgeting under Risk and Uncertainties

Meaning, Importance & Rationale of Capital Budgeting

A firm conducts its business in a rapidly changing and highly competitive environment.

The changing environment poses both opportunities and threats for the company. For

example, change in Government policy may cause change in prices of inputs and outputs,

demand and supply of products/services. Similarly, technology change may cause the

production cost change. Also the cash inflows and outflows cannot be ascertained with

accuracy. Therefore, evaluation of investment projects under uncertainty and risk become

important.

Characteristically, a capital budgeting decision involves largely irreversible commitment

of resources that is generally subject to a significant degree of risk. Such decisions have

far reaching effects on a company's profitability and flexibility over the long-term, thus

requiring that they be part of a carefully developed strategy that is based on reliable

forecasting procedures.

Capital Budgeting

Capital budgeting may be defined as the decision-making process by which, firms

evaluate the purchase of major fixed assets, including buildings, machinery, and equipment

It also covers decisions to acquire other firms, either through the purchase of their

common stock or groups of assets that can be used to conduct an ongoing business.

Capital budgeting scribes the firmís formal planning process for the acquisition and

investment of capital and results in a capital budget that is the firmís formal plan for

the expenditure of money to purchased assets.

A capital-budgeting decision is a two-sided process. First, the analyst must evaluate a

proposed project to calculate the likely or expected return from the project. This

calculation generally begins with expenditure of the projectís service life and a stream

of cash flowing into the firm over the life of the project. The calculation of expected,

turn may be done by two methods: a internal rate of return, or (b) net present value,

These two methods are discussed later in this unit.

Chapter-4

Capital Budgeting