Jahan University

Faculty of Management Sciences

Department of BBA

Subject: Financial Management

Lecture# 5
Lecturer: Mr. Hayatullah Momand (MS- Finance)

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 Objectives
At the end of this lecture students will be able to know:
1. Introduction to capital budgeting

2. Features and Significance

3. Capital budgeting process

4. Types of Capital budgeting/investment decisions

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 Outline
I. Introduction to capital budgeting

II. Features and Significance

III. Capital budgeting process

IV. Types of Capital budgeting/investment decisions

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 Introduction
 Capital budgeting decisions are related to the allocation of funds to different long term assets.

 The capital budgeting decisions involve the entire process of decision making relating to acquisition of long
term assets whose returns are expected over a period beyond one year.

 Some of the capital budgeting decisions may be as follow.

• Buying land, building or plants

• Research and development

• Diversify into a new product line

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Features and Significance of capital budgeting
 Capital budgeting decisions are those decisions that involve current outlay in return for a series of
benefits in coming years. Hence following are the significance of capital budgeting.
• capital budgeting decisions have long term effects on the risk and return
Long term effects composition of the firm.

Large amount of funds involved • these decisions involve large investment in long term assets.

• these decisions involve risk and uncertainty associated with future cash
Risk involved flow of the project.

• these decisions once taken are not easily reversible without incurring
Irreversible decision heavy losses..

Affect the capacity and strength to • firm may lose competitiveness if the decision to modernize is delayed
compete or not rightly taken.

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 Capital budgeting process
Stage 1 : Project Planning
• Project planning involves the identification of potential investment opportunities after carrying out SWOT
analysis.
Stage 2: Project Screening
• (a) determination of cash inflows and outflows of each proposal.
• (b) selection of capital budgeting technique.
• (c) appraisal of the projects using capital budgeting techniques selected.
Stage 3: Project Selection
• Project selection involves making choice of the project so as to maximize the shareholders’ wealth.
Stage 4: Project Implementation
• Project implementation involves the raising of funds, purchase of required assets and deployment of assets to
carry out the project.
Stage 5: Project Control
• Project control involves monitoring the project with the help of feedback reports (performance reports).
Stage 6 : Project Review
• Project review involves reviewing the entire project to explain its success or failure. It may have implications for
planning and evaluation.

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Types of Capital budgeting decisions

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 Types of Capital budgeting decisions
Replacement decision
• Meaning: replacing a fixed asset due to
expiry of economic life of the asset is
known as replacement decision.
• Purpose: the purpose of replacement is to
improve operating efficiency and to reduce
cost.
• Example: replacement of a machinery on
the expiry of its useful life.
• Who takes: the existing firms take such
decisions.
Modernization decision
• Meaning: replacing a fixed asset due to
technological obsolescence is knows as
modernization decision.
• Purpose: the purpose of modernization
decision is to improve operating efficiency
and reduce cost.
• Example: replacement of a Pentium
computer.
• Who takes: the existing firms take such
decisions.
Expansion decision
• Meaning: increasing existing production
capacity is knows as expansion decision.
• Purpose: the purpose of expansion decision
is to avoid shortage or delay in the delivery
of products/services and meet growth in
demand of products/services and to increase
revenue thereby.
• Example: Increasing Oil Refining Capacity
from 1000 tons to 2000 tons.
• Who takes: The existing firms take such
decisions.
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 Types of Capital budgeting decisions
Diversification Decision
• Meaning: commencing new
products/service lines is knows as
diversification.
• Purpose: the purpose is to reduce
the risk of reduction in revenues of
existing products/service lines or to
capture the new investment
opportunities and to increase
revenue thereby.
• Example: starting an insurance
business by Alokozay.
• Who takes: the existing firms take
such decision.
Mutually Exclusive Decision
• Meaning: the decisions are said to
be mutually exclusive if two or
more alternative proposals are such
that the acceptance of one proposal
will exclude the acceptance of the
other alternative proposals. These
proposals compete with each other.
• Example: a firm is considering the
purchase of Machine A or Machine
B. Firm’s decision to purchase
Machine A will exclude acceptance
of Machine B
Accept-Reject Decisions
Independent Decisions
• Meaning: the decisions are said to
be accept-reject decisions if two or
more independent proposals are
such that they do not compete with
each other and any one or more of
these proposals which meet
decision criterion adopted by the
firm can be accepted subject to
availability of funds.
• Example: project A, B and C are
generating return of 20%, 18% and
14% respectively.
Contingent / Complimentary
Decisions
• Meaning: the decisions are said to
be contingent/complimentary
decisions if two or more
independent proposals are such
that the acceptance of one proposal
requires the acceptance of one or
more other proposals.
• Example: if a company accepts a
proposal to set up a factory in
remote area, it may have to invest
in other infrastructure proposals
e.g. building of roads, houses of
employees etc.
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 Capital Budgeting-Assumptions
Certainty with • However, for a capital budgeting decision, it is assumed
respect to cost and that accurate forecasts of cost and benefits of a proposal
are available for the entire economic life of the proposal.
benefits

• another assumption is that the capital budgeting decisions

Profit motive are taken with a primary motive of increasing the profit of
the firm.

• the capital budgeting decisions being discussed here

No capital rationing assume that there is no scarcity of capital funds and the
firm is not faced with capital rationing.

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 Conclusion
Introduction to capital budgeting

Features and Significance

Capital budgeting process

Types of Capital budgeting/investment decisions

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 References
1. Hand book of Financial Management

2. Fundamental of financial management by Rustagi

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