Capital Budgeting

Capital budgeting refers to the investment decisions of current finances most efficiently in long-term productive activities with expectations of flow of benefits over a long period of time. The decision of "where to invest" is significant for several reasons.

1.       Funds available to a firm are limited.

2.       There are a variety of options to invest the available funds.

3.       Investment decisions have long-term impact on the investor and the society.

4.       Long-term capital decisions are mostly irreversible. 

Types of Capital Projects

Capital projects are those that are expected to generate returns for more than one year. Capital budgeting is the process of planning capital projects, raising funds and efficiently allocating resources to those capital projects. In general firms classify investment projects into following categories:

1.       Replacement: Investments to replace equipment that is worn out in the production process.

2.       Cost reduction: Investments to replace working but obsolete equipment with new and more efficient equipment, expenditures for training programmes aimed at reducing labour costs, and expenditures to move production facilities to areas where labour and other inputs are cheaper.

3.       Output expansion of traditional products and markets: Investments to expand production facilities in response to increased demand for the firm's traditional products in traditional or existing markets.

4.       Expansion into new products and/or markets: Investments to develop, produce, and sell new products and/ or enter new markets.

5.       Government regulations: Investments made to comply with government regulations. These include investment projects required to meet government health and safety regulations, pollution control, and to satisfy other legal requirements. 

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