The Role of Capital Budgeting
The financial term capital is broad in scope. It is applied to non-human resources, physical or monetary, short or long. Similarly, budgeting takes many forms but invariably comprises the detailed, quantified planning of a scarce resource for commercial benefit. It implies a choice between alternatives. Thus, a combination of the two terms defines investment and financing decisions which relate to capital assets which are designed to increase corporate profitability and hence value.
To simplify matters, academics and practitioners categorise investment and financing decisions into long-term (strategic) medium (tactical) and short (operational). The latter define working capital management, which represents a firm’s total investment in current assets, (stocks, debtors and cash), irrespective of their financing source. It is supposed to lubricate the wheels of fixed asset investment once it is up and running. Tactics may then change the route. However, capital budgeting proper, by which we mean fixed asset formation , defines the engine that drives the firm forward characterized by three distinguishing features:
Longer term investment; larger financial outlay; greater uncertainty.
Combined with inflation and changing economic conditions, uncertainty complicates any investment decision. We shall therefore defer its effects until Chapter Four having reviewed the basic capital budgeting models in its absence.
With regard to a strategic classification of projects we can identify:
- Diversification defined in terms of new products, services, markets and core technologies which do not compromise long-term profits.
- Expansion of existing activities based on a comparison of long-run returns which stem from increased profitable volume.
- Improvement designed to produce additional revenue or cost savings from existing operations by investing in new or alternative technology.
- Buy or lease based on long-term profitability in relation to alternative financing schemes.
- Replacement intended to maintain the firm’s existing operating capability intact, without
necessarily applying the test of profitability.
The financial term capital is broad in scope. It is applied to non-human resources, physical or monetary, short or long. Similarly, budgeting takes many forms but invariably comprises the detailed, quantified planning of a scarce resource for commercial benefit. It implies a choice between alternatives. Thus, a combination of the two terms defines investment and financing decisions which relate to capital assets which are designed to increase corporate profitability and hence value. To simplify matters, academics and practitioners categorise investment and financing decisions into long-term (strategic) medium (tactical) and short (operational). The latter define working capital management, which represents a firm’s total investment in current assets, (stocks, debtors and cash), irrespective of their financing source. It is supposed to lubricate the wheels of fixed asset investment once it is up and running. Tactics may then change the route. However, capital budgeting proper, by which we mean fixed asset formation , defines the engine that drives the firm forward characterized by three distinguishing features:
Longer term investment; larger financial outlay; greater uncertainty. Combined with inflation and changing economic conditions, uncertainty complicates any investment decision. We shall therefore defer its effects until Chapter Four having reviewed the basic capital budgeting models in its absence.
With regard to a strategic classification of projects we can identify:
- Diversification defined in terms of new products, services, markets and core technologies which do not compromise long-term profits.
- Expansion of existing activities based on a comparison of long-run returns which stem from increased profitable volume. - Improvement designed to produce additional revenue or cost savings from existing operations by investing in new or alternative technology.
- Buy or lease based on long-term profitability in relation to alternative financing schemes.
- Replacement intended to maintain the firm’s existing operating capability intact, without
necessarily applying the test of profitability.
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