Rationale of capital budgeting decisions

The rationale behind the capital budgeting decisions is efficiency. A firm has to continuously invest in new plant or machinery for expansion of its operations or replace worn out machinery for maintaining and improving efficiency. The main objective of the firm is to maximize profit either by way of increased revenue or by cost reduction. Broadly, there are two types of capital budgeting decisions which expand revenue or reduce cost.

1. Investment decisions affecting revenue: It includes all those investment decisions which are expected to bring additional revenue by raising the size of firm’s total revenue. It is possible either by expansion of present operations or the development of new product in line. In both the cases fixed assets are required.

2. Investment decisions reducing costs; It includes all those decisions of the firms which reduces the total cost and leads to increase in its total earnings i.e. when an asset is worn out or becomes outdated, the firm has to decide whether to continue with it or replace it by new machine. For this, the firm evaluates the benefit in the form of reduction in operating costs and outlays that would be needed to replace old machine by new one. A firm will replace an asset only when it finds it beneficial to do so. The above decision could be followed decisions following alternative courses: i.e., Tactical investment decisions to strategic investment decisions, as briefly defined below

3. Tactical investment decisions; It includes those investment decisions which generally involves a small amount of funds and does not constitute a major departure from what the firm has been doing in the past.

4. Strategic investment decisions: Such decisions involve large sum of money and envisage major departure from what the company has been doing in the past. Acceptance of strategic investment will involve significant change in the company’s expected profits and the risk to which these profits will be subject. These changes are likely to lead stock-holders and creditors to revise their evaluation of the company.

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