Question

“A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer?

Answer 1

Yes, capital budgeting decision is a very essential decision which needs to be taken carefully. It has the capability of changing the financial fortunes of a business. Capital budgeting decision refers to the decisions regarding the allocation of fixed capital to different projects. Such decisions involve investment decisions regarding attainment of new assets, expansion, modernisation and replacement. Such long term investments include purchasing plant and machinery, furniture, land, building, etc. and also expenditure as on launch of a new product, modernisation and advertising, etc. They have long term implications on the business and are irrevocable except at a huge cost. They affect a business’ long term growth, profitability and risk.

The following are the factors that highlight the importance of capital budgeting decisions.

1. Long Term Implications :- Investment on capital assets (long term assets) yield return in the future. Thereby, they affect the future prospects of a company. A company’s long term growth prospects depend on the capital budgeting decisions taken by it.

2. Huge Amount of Funds :- Investing in fixed capital involves a large amount of funds. This makes the capital budgeting decisions all the more important as huge amount of funds remain blocked for a longer period of time. These decisions once made are difficult to change. Thus, capital budgeting decisions need to be taken carefully after a detailed study of the total requirement of funds and the sources from which they are to be raised.

3. High Risk :- Fixed assets involve huge amount of money and thereby, involve huge risk as well. Such decisions are risky as they have an impact on the long term existence of the company. For example, decision about the purchase of new machinery involves a risk in terms of whether the return from the machinery would be greater than the cost incurred on it.

4. Irreversible Decisions :- These decisions once made are irrevocable. Reversing a capital budgeting decision involves huge cost. This is because once huge investment is made on a project, withdrawing it would mean huge losses.