One of the most important decisions that confront the executive of a business enterprise relate to the replacement, renewals and expansions of the facilities that exist in the form of fixed assets. These all are commonly known as capital expenditure decisions. Capital budgeting is the making of long-term planning decisions for capital investments and their financing.
In order to make scientific and advantageous capital expenditure decisions, the management must have all possible relevant information and that information should be analyzed in a meaningful and objective manner.
Required Information For Capital Expenditure Decisions
The following financial data are required in planning for capital expenditure decisions :
(i) The Cash-outlay of the Project or Asset.
(ii) The estimated economic life of the project or asset.
(iii) The estimation of salvage value at the end of the economic life of the asset.
(iv) The estimation of annual cash-inflows and their pattern during the economic life of the project.
(v) The estimation of additional working capital requirement, if any.
(vi) Estimates of opportunity cost.
(vii) Desirable Minimum Rate of Return.
(viii) Estimated figures of annual depreciation.
(ix) Estimated rate of income tax on operating income, capital gains, etc.
(x) Total funds available at the disposal of the firm which may be/or will be invested by the firm.
Uncertainty is an umbrella under which all firms operate and the pretention of its non-existence when making a capital expenditure decision is a serious and cowardly error. The series techniques described in my previous article to incorporate the element of uncertainty into the Capital Budgeting Decision are not independent methods of evaluation, but are supplements to the basic methods. They attempt to measure risk and uncertainty quantitatively to help the management to assess the expected impact of an investment decision on the firm’s profitability. These techniques are not fool-proof as uncertainty is caused by a host of problems.
Nevertheless, they do provide insight to the important dimensions of uncertainty and these dimensions should not be ignored in capital budgeting simple because evaluating them is difficult. There are other mathematical techniques like stimulation models, linear programming, etc., used for analyzing and incorporating risk and uncertainty which have for not yet become very popular among businessmen. The entire analysis is applicable only to those investments the benefits from which can be quantified.