INVESTMENT DECISIONS:

  1. Involves decision regarding short term (working capital) required for operational and day-to-day activities
  2. Long-term (capital budgeting) investment in assets requires funds for the setting of new projects or expansion and modernization.

Capital budgeting:

Refers to investment in long-term assets e.g. plant and machinery, furniture and fixture, land and building, expenditure on acquisition, expansion, modernization.

  • Capital budgeting affects the growth, and profitability of the business in the long run.
  • Must be financed through long-term sources of capital such as equity debentures, and long-term loans.

Why capital budgeting decision is considered a risky decision?

Capital budgeting decisions are important for the following reasons:

  1. Funds involved are large:
  • Involves a large portion of  funds
  • Requires a lot of financial planning
  1. Irreversible decisions:
    • Decisions once taken are not reversible without incurring heavy losses.
    • Cancellation of a project is quite costly in terms of waste of funds.
  2. Returns/profits come in long run:
    • The fixed assets are invested for the long term and earnings come after a long duration.
    • It is difficult to measure the benefits as the future is uncertain due to political, legal, and technological changes.
  3. Effects on Long-term growth and profitability:
  • The direction of growth depends on capital expenditure.
  • If the decision goes in the right direction profitability increases.
  • If goes wrong, it is harmful to growth and profitability.

Factors affecting capital budgeting decisions:

  1. Rate of return:-
    • Expected rate of returns from each proposal should be compared with the risks associated with the projects before taking an investment decision.
    • E.g If there are two investment proposals A and B with a rate of return of 10% and 12%, the project B should be selected. 
  2. Investment criteria involved:
  • All projects are to be considered based on the amount of investment, interest rate, cash flows and rate of return
  • Ranking the projects, according to their profitability by using various capital budgeting techniques like;-Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period
  1. Cash Flows Of The Project:
  • Cash is likely to generate when invest in fixed assets
  • Company must analyze the duration in which the cash is likely to generate
  • Projects like hydro-power, telecom longer time
  • Eatables generate quick cash