Capital Budgeting 101

Nature of Investment Decision

Typical examples of capital budgeting decisions are:

expansion projects;

replacement projects;
selection among alternmatives; and
buy or lease decisions.

Good capital budgeting decisions, based on sound investment appraisal procedures,

should improve the timing of capital acquisitions as well as the quality of capital
acquisitions.

Investment in expansion/ modemisation is one of the main sources ofeconomic growth,

since it is required not only to increase the total capital stock of equipment and buildings,
but also to employ labour in increasingly productivejobs as old plant is replaced by new.

The Administrative Framework

Successful administration of capital investments by a company involves

1. Generation of investment proposals

2. Estimation of cash flows for the proposals

3. Evaluation of cash flows

4. Selection of projects based upon an acceptance criterion

Continual reevaluation of investment projects after their acceptance

Depending upon the firm involved, investment proposals can emanate from various
sources. For purposes of analysis, projects may be classified into one of five categories.

1. New products or expansion of existing products

2. Replacement of equipment or buildings

3. Research and development

4. Exploration
5. Others

The fifth category comprises miscellaneous items such as the expenditure of funds to
comply with certain health standards or the acquisition of a pollution-control device.
For a new product, the proposal usually originates in the marketing departıment. On the
other hand aproposal to replace a piece of equipment with a more sophisticated model
usually emanates from the production area of the firm, in each case, efficient
administrative procedures are needed for channeling in-

Most firms screen proposals at multiple levels of authority. For a proposal originating
in the production area, the hierarchy of authority might run from (1) section chiefís to