Question

What is capital budgeting? Why are capital budgeting decisions crucial to the long run financial health of a business enterprise? List Shortcomings of using the payback period as the only criteria in making capital budgeting decisions. Discuss Some capital investment projects in which non-financial factors may outweigh financial factors. (Include references)

Answer 1

Capital Budgeting decisions are concerned with decisions regarding investment of funds in fixed and current assets for getting returns for a number of years. If expenditure is incurred only after preparing capital budgt properly, than there is a possibilty of incresaing profitability of the firm.Capital Budgeting decisions are extremely difficult and complicated exercise for the management, These exercise require an over all assessement of future events.

Such decisions are extremely important for number of reasons :

a) Substantial sums of money involved

b) It may be difficult to reverse the decision as cost of reversing is huge

c) Such decisions have considerable impact on the future of a firm. Sometims the success or failure of the firm may depend upon a single investment decisions.

d) Such decisions involves risk that selected project may not bring expected return.

e)Such decisions involves permanent commitment of funds

Capital budgeting decisions are crucial to the long run financial health of a business enterprise as huge amount of funds are invested in long term assets which are expected to bring incomes in forms of returns. So, growth of firm depends on such decisions.

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Some of the Shortcomings of using the Payback period(PBP) as the only criteria in making capital budgeting decisions are-

a) PBP ignores time value of money in Capital budgeting decisions . However, such shortcomings can be rectified by using discounted PBP where we can discount all cash flows back to today and then see how soon we recover our initial investments.

b) No economic rationale for threshold or acceptable value. With NPV & IRR, there is an economic rationale for threshold values. Positive NPV means the project adds to shareholders wealth and negative NPV means reduces shareholders wealth. IRR greater than hurdle rate shows projects returns more than cost of capital and IRR less than hurdle rate shows projects returns less than cost of capital. However, there is no economic rationale for what is an expected Payback Period and is based on arbitary decisions.

c) It ignores cash flows once the initial investment is recovered. It is very problematic when the project requires additional investment or has large losses later in the life

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Capital Budgeting decisions cannot be purely based on financial decisions, there are other non financial aspects which needs thorough review . Non Financial Investment appraisal factors if not handled carefully will result in project failure & may even impact survival of the organisation. Non financial factors like employee satisfaction, customer retention are dimensions that cannot be quantified easily.

Some capital investment projects in which non-financial factors may outweigh financial factors:

1) Power Projects: Such companies considers Goverment directives for public interest as its core decision making criteria

2) Consumer Durables/ Tyre Companies: Availability of manpower, suitable technology are non financial consideration having weightage more than financial decisions