CH. 6 : CAPITAL BUDGETING - ESTIMATION OF CASH FLOWS
(iv) Contingent Decisions : Sometimes, a capital budgeting decision is contingent to some other decision. For example, computerization of a bank branch may require not only air-conditioning but also transfer of some staff member to other branches. Similarly, installing a project at some remote location may require expenditure or development of infrastructure also. Any capital budgeting decision must be evaluated by the finance manager in its totality. The contingent decision, if any, must be considered and evaluated simultaneously.
parameters and therefore, an almost infinite number of types or forms of capital budgeting decisions may occur. Even if the same decision being considered by the same firm at two different points of time, the decision considerations may change as a result of change in any of the variables. However, the different types of capital budgeting decisions undertaken from time to time by different firms can be classified on a number of dimensions. In general, the projects can be categorized as follows: From the Point of view of Firm’s existence : The capital budgeting decisions may be taken by a newly incorporated firm or by an already existing firm. (a) New Firm : A newly incorporated firm may be required to take different decisions such as selection of a plant to be installed, capacity utilization at initial stages, to set up or not simultaneously the ancillary unit etc. (b) Existing Firm : A firm which is already existing may also be required to take various decisions from time to time to meet the challenges of competition or changing environment. These decision may be : (i)
Replacement and Modernization Decision : This is a common type of a capital budgeting decision. All types of plant and machineries eventually requires replacement. If the existing plant is to be replaced because the economic life of the plant is over, then the decisions may be known as a replacement decision. However, if an existing plant is to be replaced because it has become technologically outdated (though the economic life may not be over), the decision may be known as a modernization decision. In case of a replacement decision, the objective is to restore the same or higher capacity, whereas in case of modernization decision, the objective is to increase the efficiency and/or cost reduction. In general, the replacement decision and the modernization decisions are also known as cost reduction decisions.
(ii) Expansion : Sometimes, the firm may be interested in increasing the installed production capacity so as to increase the market share. In such a case, the finance manager is required to evaluate the expansion program in terms of marginal costs and marginal benefits. (iii) Diversification : Sometimes, the firm may be interested to diversify into new product lines, new markets, production of spare parts etc. In such a case, the finance manager is required to evaluate not only the marginal cost and benefits, but also the effect of diversification on the existing market share and profitability. Both the expansion and diversification decisions may also be known as revenue increasing decisions.
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From the Point of view of Decision situation : The capital budgeting decisions may also be classified from the point of view of the decision situation as follows : (a) Mutually Exclusive Decisions : Two or more alternative proposals are said to be mutually exclusive when acceptance of one alternative result in automatic rejection of all other proposals. The mutually exclusive decisions occur when a firm has more than one alternative but competitive proposals before it. For example, selecting one advertising agency to take care of the promotional campaign out rightly rejects all other competitive agencies. Similarly, selection of one location out of different feasible locations is a mutually exclusive decision. (b) Accept-Reject Decisions : An Accept-Reject decision occurs when a proposal is independently accepted or rejected without regard to any other alternative proposal. This type of decision is made when (i) proposal’s cost and benefit neither affect nor are affected by the cost and benefits of other proposals, (ii) accepting or rejecting one proposal has not impact on the desirability of other proposals, and (iii) the different proposals being considered are not competitive.
CAPITAL BUDGETING DECISIONS AND FUNDS AVAILABILITY No business firm can possibly afford to undertake all the profitable proposals. The reason is obvious i.e., no firm has unlimited funds. Had the funds available been unlimited, the firms could have accepted and implemented all the projects which were expected to contribute to the wealth of the firm, however small such contribution was. But this is not so in actual practice. Every firm has only limited funds available and these funds are to be invested in such a way so as to bring maximum contribution to the wealth of the firm. Therefore, only those decisions are to be implemented which fulfil the following two conditions : (i)
The cost of the project does not exceed the funds available, and
