Kinds of Capital Budgeting
Kinds of Capital Budgeting
*Dr.P.Shanmukha Rao**Dr.N.V.S.Suryanarayana
Every capital budgeting decision is a specific decision in the given situation, for a given firm and with given parameters and therefore, an almost infinite number of types or forms of capital budgeting decisions may occur. Even if the same decision being considered by the same firm at two different points of time, the decision considerations may change as a result of change in any of the variables. However, the different types of capital budgeting decisions undertaken from time to time by different firms can be classified on a number of dimensions. Some projects affect other projects the firm is considering and analyzing. At the other extreme, some proposals are pre-requisite for other projects. The projects may also be classified as revenue generating projects or cost reducing projects. In general, the projects can be categorized as follows:
From the point of view of firm's existence: The capital budgeting decisions may be taken by a newly incorporated firm or by an already existing firm.
a) New Firm: A newly incorporated firm may be required to take different decisions such as selection of a plant to be installed, capacity utilization at initial stages, to set up or not simultaneously the ancillary unit etc.
b) Existing Firm: A firm which is already existing may also be required to take various decisions from time to time to meet the challenges of competition or changing environment. These decision may be :
(i) Replacement and Modernization Decision:This is a common type of a capital budgeting decision. All types of plant and machineries eventually require replacement. If the existing plant is to be replaced because the economic life of the plant is over, then the decisions may be known as a replacement decision. However, if an existing plant is to be replaced because it has become technologically outdated (though the economic life may not be over), the decision may be known as a modernization decision. In case of a replacement decision, the objective is to restore the same or higher capacity, whereas in case of modernization decision, the objective is to increase the efficiency and/or cost reduction. In general, the replacement decision and the modernization decisions are also known as cost reduction decisions.
(ii) Expansion:Some times, the firm may be interested in increasing the installed production capacity so as to increase the market share. In such a case, the finance manager is required to evaluate the expansion program in terms of marginal costs and marginal benefits.
(iii) Diversification:Some times, the firm may be interested to diversify into new product lines, new markets, production of spare parts etc. In such a case, the finance manager is required to evaluate not only the marginal cost and benefits, but also the effect of diversification on the existing market share and profitability. Both the expansion and diversification decisions may also be known as revenue increasing decisions.
From the point of view of decision situation: The capital budgeting decisions may also be classified from the point of view of the decision situation as follows:
Independent Project Decision:
This is a fundamental decision in Capital Budgeting. It is also called as accept- reject criterion. If the project is accepted the firm does not invest in it. In general all these proposals, which yield a rate of return greater, than ascertain required rate of return on cost of capital, are accepted and the rest are rejected. By applying this criterion all independent project with one another in such a way that the acceptance of one precludes the possibility of acceptance of another. Under the accept-reject decision all independent projects that satisfy the minimum investment criterion should be implemented.
Mutually Exclusive Projects Decision:
Mutually Exclusive projects are those, which compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen. Suppose a company is intending to buy a new machine, there are three competing brands, each with a different initial investment adopting cost, and the three machines represent mutually exclusive alternatives as only one of these can be selected. Here it may be noted that the mutually exclusive alternatives, as only one of these can be selected. It may be noted that the mutually exclusive project decisions are not independent of the accept reject decisions.
Capital Rationing Decisions:
In a situation where the firm has unlimited funds all independent investment proposals yielding return greater than some pre-determined levels are accepted. However this situation does not prevail in most of the business firms in actual practice. They have a fixed capital budget. A large number of investment proposals compete for these limited funds the firm must therefore ration them. The firm allocates funds to projects in a manner that it maximizes long run returns this, capital rationing refers to a situation in which a firm has more acceptance investment than it can finance. It is concerned with the selection of a group of investment proposals acceptable. Under the accept-reject decision capital rationing employees ranking of the acceptable investments projects. The projects can be ranked on the basis of a predetermined criterion such as the rate of return. The projects are ranked in the descending order of the rate of return.
Kinds of Capital Budgeting
By: S.R.PADALA & NVS SURYANARAYANA
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