CAPITAL BUDGETING DECISION

CAPITAL BUDGETING DECISION

Capital budgeting is the 'oldest' area of the recent thinking in finance. It relates to the allocation of capital and involves the decisions to commit funds to long-term assets which would yield benefits in future. Its one very significant aspect is the task of measuring the prospective profitability of new investment. Future benefits are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, capital budgeting decision involves risk. The investment proposals should, therefore, be evaluated in terms of both expected return and the riSk associated with the return. Besides a decision to commit funds in new investment proposals, capital budgeting also involves the question of recommitting funds when an old asset becomes non-profitable.

The other major aspect of capital budgeting theory relates to the section of a standard rate against which the expected return of new investment can be made. There is broad, but not yet universal agreement, that the correct standard to use for this purpose is the company's cost of capital. Though there is broad agreement about how the cost of capital should be conceived, important problems emerge when the cost of capital has actually to be measured from available data.

FINANCING DECISION.

The second important decision to be performed by the financial manager is the financing decision. Broadly, he must decide when, where and how to acquire funds to meet the firm's investment needs. The central issue before him is to determine the proportion of equity capital and debt capital. The use of debt capital affects the return and risk of shareholders. The return on equity will increase, but also the risk. A proper balance will have to be struck between return and risk. When the shareholders' return is maximised with minimum risk, the market value per share will be maximised and firm's capital structure would be optimum. Once the financial manager is able to determine the best combination of debt and equity, he must raise the appropriate amount through best available sources.

DIVIDEND DECISION

The third major financial decision related to firm's dividend policy. The financial manager must decide whether the firm should distribute all profits or retain them, or distribute a portion and retain the balance. The dividend policy should be determined in terms of its impact on the shareholders' wealth. The optimum dividend policy is one which maximises the market value of share. Thus, if the shareholders are not indifferent to the firm's dividend policy, the financial manager determines the optimum dividend-payout ratio. He should also consider the questions of dividend stability, stock dividends and cash dividends.

LIQUIDITY vs PROFITABILITY | MAXIMISATION OF RETURN | WEALTH MAXIMISATION | Constraints - Policy Decisions - Profitability | IMPLICATIONS OF WEALTH MAXIMISATION | Suppliers of Loan Capital | RELEVANCE OF WEALTH MAXIMISATION | Retaining earning and Undistributed profits | Managerial finance function | Functions of Financial Management | FINANCIAL FORECASTING | MANAGEMENT OF CORPORATION ASSET STRUCTURE | THE MANAGEMENT OF INCOME | MANAGEMENT OF CASH | DECIDING OUT NEW SOURCES OF FINANCE | CONTACT AND CARRY NEGOTIATIONS FOR NEW FINANCING | ANALYSIS AND APPRAISAL OF FINANCIAL PERFORMANCE | INCIDENTAL OR ROUTINE FUNCTIONS | CAPITAL BUDGETING DECISION | CURRENT ASSET MANAGEMENT | Maximisation of Share Value | RESPONSIBILITIES OF FINANCIAL MANAGEMENT IN THE FIRM | Functions of the Treasurer and Controller | TASKS OF FINANCIAL MANAGEMENT | CHALLENGES OF FINANCIAL MANAGEMENT | Gross and Net Savings | Household Savings | How to politely win when credit disputes and problems arise