Capital Budgeting. Capital budgeting is probably the most crucial financial decision of a firm. It release to the selection of an. asset or investment proposal or course of action whose benefits are .likely to be available in future over the lifetime of the project. The long-term assets can be either new or old/existing ones. The first aspect of the capital budgeting decision relates to the choice of the new asset out of the alternatives available or the reallocation of capital when an existing asset to justify the funds committed. Whether an asset will be accepted or not will depend upon the relative benefits and returns associated with it. The measurement of the worth of the investment proposals is therefore, a major clement in the capital budgeting exercise. This implies a discussion of the methods of appraising investment proposals.
The second element of the capital budgeting decision is the analysis of risk and uncertainty. Since the benefits from the investment proposals extend into the future, their accrual is uncertain. They have to be estimated under various assumptions of the physical volume of sale and the level of prices. An element of risk in the sense of uncertainty of future benefits is thus, involved in the exercise. The return, from capital budgeting decisions should, therefore, be evaluated in relation to the risk associated with it.
Finally, the evaluation of the worth of a long-term project implies a certain norm or standard against which the benefits are to he judged. The requisite norm is known by different names such as cut-off rate, hurdle rate, required rate, minimum rate of return and so on. This standard is broadly expressed in terms of the cost of capital. The concept and measurement or the cost of capital is thus, another major aspect of capital budgeting decision. In brief the main elements of capital budgeting decisions are: (i) the long-term assets and their composition, (ii) the business risk complexion of the firm, and (iii) the concept and measurement of the cost of capital.