The resources of a business firm is invested in current and fixed assets. Current assets are acquired for the smooth running of business whereas fixed assets are purchased for generating revenue. The profitability of a firm depends upon the productive capacity of the fixed assets. Furthermore, the decision of investing in fixed assets has far-reaching impact because it requires huge capital for long period. The failure of any project may lead the firm in the door of liquidation. Therefore, the cost, benefit and probable risk of the proposed project should be analyzed systematically before making the investment.
Capital budgeting decision comprises of three words ‘Capital’, ‘Budgeting’ and ‘Decision’. Capital means the fund or resource available for investing. Budgeting is the numerical aspect of planning. Decision or decision making is the process of deciding whether alternative action is to be undertaken or not. In this way, capital budgeting decision is the process under which different investment alternatives are evaluated and the best alternative is selected. In other words, capital budgeting decision is concerned with the long-term investment decision i.e. making capital expenditure. The expenditure on fixed asset such as land and building, furniture and fixtures, plant and machinery etc. is called capital expenditure. The life of these fixed assets is more than one year. So, capital budgeting decision is concerned with long-term planning. Capital budgeting is also decision making process for an investment which includes the process of investment, evaluating, planning and financing major investment project of an organization.
Therefore, it can be said that capital budgeting is concerned with the allocation of the firm’s financial resources among the available investment alternatives. It is a part of long-term planning and comprises the evaluation and selection of investment projects.
Types of Capital Budgeting Decisions
A business organization has to quite often face the problem of capital investment decisions. Capital investment refers to the investment in projects whose results would be available only after a year. The investment in these projects are quite heavy and to be made immediately, but the returns will be available only after a period of time. The following are some of the cases where heavy capital investment may be necessary:
(i) Replacement: Replacements of fixed assets may become necessary either on account of their being worn out or becoming outdated on account of new technology.
(ii) Expansion: A firm may have to expand its production capacity on account of high demand for its products and inadequate production capacity. This will need additional capital investment.
(iii) Diversification: A business may like to reduce its risk by operating in several markets rather than in a single market. In such cases, capital investment may become necessary for purchase of new machinery and facilities to handle the new products.
(iv) Research and Development: In case of those industries where technology is rapidly changing, large sums of money may have to be expended for research and development.
(v) Miscellaneous: A firm may have to invest money in projects which do not directly help in achieving profit oriented goals. For example, installation of pollution control equipment may be necessary on account of legal requirements. Thus, funds will be required for such purpose also.