Question

Why is capital budgeting important? Why is the stage of the business cycle an important component in a capital expenditure policy?

Answer 1

Capital budgeting is a process of evaluating the capital expenditure decision. A capital expenditure is featured by initially huge cashout flow ( which is certain ) but followed by regular or irregular periodical cash inflows ( which are uncertain). Thus all capital budgeting decisions involve risk.

While the component of risk is involved in every aspect of business but when it matters capital budgeting decisons the impact of such risk is some thing that cannot be reversed easily by the company. Most of the companies finds it difficult to find a turnaround strategy when ever they had taken a worse capital budgeting decision.

Thus a decision in respect of Investment decisions demands a lot of care and top level management involvement.

Importance of stage of business cycle:

When an entity enters into a project at right phase of a business cycle, we will have normal cash flows that are expected from an Investment decision. In such situation various method of capital budgeting that had advocated acceptence and rejection rules works in perfection. On the other hand entering into a project without timing with business cycle shall have orthodix cash flows being generated by the project. Especially when using conventional methods like payback period a wrong timing at depresion stage ........ can avoid such project even when it may have high profitabilty in the time of recovery and expansion.