The rationale that goes behind capital budgeting is the efficiency of the process. A firm needs to invest in the business continuity and invest into new machinery and plants for expanding the business. There could also be the need to expand the operation or replace the old machines that are worn out. The main aim of any business is to maximize the profit which is done by increasing the revenue or by reducing the cost.
The investment decisions that affect the revenue of the business
This includes those decisions that there in order to bring additional revenue by raising the firm’s size of total revenue. This can be done by either expanding the present operations or by developing a new product line. In both of these cases, there is a requirement of fixed assets.
The investment decision that reduces cost
This includes all the decisions of a firm that reduces the cost of doing business and leads to increasing the total earnings of the business. Thus when the machinery or any other asset becomes old the firm needs to analyze whether to continue using it or replace it. The firm will need to evaluate the benefits of doing this and what it has to forego to replace the machine with a new one. The new machine will be replaced when the firm sees benefits in doing so. This is done through two ways which are tactical investment decision and strategic investment decision.
In the tactical investment decision, it refers to those investment decisions that require lots of funds and it does not let the firm do anything very different from what it has already been doing.
In the strategic investment decision, it involves spending huge amounts of money and it includes doing differently from what the firm has been doing in the past. The acceptance of having a strategic investment will involve changes in the companies accepted risk and profits. This could lead the stockholders to revalue the company.
Things that you need to know
The economic life and the annual cash flow in capital budgeting is just an estimation and the actual data could either be more or less. The estimation of the cash flow could also be different from the actuals. Thus having total control over the capital expenditures not possible.
The capital budgeting application is based on the presumption of cash inflow and outflow. The future is not certain and the inflows and outflows may not be exactly correct. Thus the selection could end up being wrong.