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mba assignment smu 2012 2nd sem Q1. Examine the importance of capital budgeting

Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into:

• Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions
• Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution
• Decisions for production of new goods or rendering of new services
• Decisions on penetrating into new geographical area
• Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act
• Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are:
• These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.
• For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box
Ltd found itself that the market for its metal boxes has declined drastically.
The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions.
• Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders.
The best example is the Reliance Group.
• Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness.
• Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors.
• Long time investments of the funds sometimes may change the risk profile of the firm.
• Most of the capital budgeting decisions involve huge outlay. The funds required during the phase of execution must be synchronised with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run.
These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project.
Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a company’s operation unproductive.
• Capital budgeting decisions involve assessment of market for company’s product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment.
If a firm were to realise after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the
equipments bought specifically for implementing the decision taken.
Sometimes these equipments will be specialised costly equipments.
Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are:
·                     cost
·                     quality
·                     timing
Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability.
• Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE to sell its products in India at a rate less than the rate at which Indian companies sell cannot be ignored.
Therefore, the growth and survival of any firm in today’s business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth.
• The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex.
• Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project.
Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today.

1 comment:

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