Factors affecting Capital Budgeting

Capital budgeting is a company’s formal process used for evaluating potential expenditures or investments that are significant in amount. It involves the decision to invest the current funds for addition, disposition, modification or replacement of fixed assets. The large expenditures include the purchase of fixed assets like land and building, new equipment’s, rebuilding or replacing existing equipment’s, research and development, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future profits since most companies are able to manage only a limited number of large projects at any one time.

Factors affecting capital budgeting decisions are;

Technological changes:

Before taking CBD, management must undertake in-depth study of cost of new product /equipment as well productive efficiencies of new as well as old equipment.

Demand forecast:

Analysis of demand for a long period must be undertaken before CBD.

Competitive strategy:

If a competitor is going for new machinery /equipment of high capacity and cost effective, we may have to follow that.

Minimum Rate of Return on Investment

Every management expects a minimum rate of return or cut-off rate on capital investment. It refers to the point of below which a project would not be accepted.

Legal Compulsions

The management should consider the legal provisions while-selecting a project. In the case of leather and chemical industries, there are number of legal provisions created to protect environment pollution. Now, the management gives much importance to legal provisions rather than cost and profit.

Type of management:

If management is innovative, firm may go for new equipment’s/ investment as compared to conservative management.  

Cash flow:

Cash flow statement or cash budget helps a firm in identifying time when a firm can make investment in CBD. All the projects are not requiring the same level of investments. Some projects require huge amount and having high profitability. If the company does not have adequate funds, such projects may be given up.

Other factors:

Like fiscal policy (tax concessions, rebate on investments) political stability, global situation etc.