Meaning, Nature, and Importance of Capital Expenditure Decisions

It is the planning, evaluation, and selection of capital expenditure proposals, the benefits of which are expected to accrue over more than one accounting year. Capital expenditure decisions are just the opposite of operating expenditure decisions. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. So, what is discusses are: Meaning, Nature, and Importance of Capital Expenditure Decisions.

The Concept of Capital Expenditure Decisions is explaining in Meaning, Definition, Nature, Objectives, Difficulty, and Importance.

What is Capital Expenditure? A capital expenditure is the use of funds by a company to acquire physical assets to improve its value or increase its long-term productivity. Also known as capital expenses, capital expenditures include purchases such as buildings or warehouses, new equipment such as machinery or computers, and business vehicles. Many companies strive to maintain their historical capital expenditure levels in order to show investors that managers are investing adequately in the business.

Much of the discussion has focused on decisions relating to near-term operations and activities. But, managers must also ponder occasional big-ticket expenditures that will impact many years to come. The decision on long-term investments is quite pivotal due to many reasons. It is a part of the duties of an entity’s key management to affect most accurate the decision with respect to the long-term investments. The question of decisions is: What is the concept of financial decisions?

Such capital expenditure decisions relate to the construction of new facilities, large outlays for vehicles and machinery, embarking upon new product research and development, and similar items where the upfront cost is huge and the payback period will span years to come. A number of business factors combine to make business investment perhaps the most important financial management decision.

Meaning of Capital Expenditure Decisions:

The capital expenditure decision is the process of making decisions regarding investments in fixed assets which are not meant for sale such as land, building, plant & machinery, etc. Thus it refers to long-term planning for proposed capital expenditures and includes raising of long-term funds and their utilization. The key function of the finance manager is the selection of the most profitable project for invest­ment. This task is very crucial because any action taken by the manager in this area affects the working and profitability of the firm for many years to come.

Definition of Capital Expenditure Decisions:

Former is generally termed as ‘current’ expenditure and is ex­pected to result in benefits in a short period of less than a year. The latter is termed as ‘capital’ expenditure, and is expected to result in benefits in the future period of one or more years and is also known as capital budgeting decisions. Capital Expenditure Decisions Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions.

Although the tendency is to focus on the financial dimensions, such decisions are made even more complex because they usually involve a number of nonfinancial components as well. Thus, the final decision may involve consideration of architectural, engineering, marketing, regulatory, and numerous other variables.

These types of decisions involve considerable risk because they usually involve large amounts of money and extended durations of time. In addition, capital expenditure decisions (also called capital budgeting) are usually accompanied by a number of alternatives from which to choose. Sometimes, an option that is best in the long term may be the least desirable in the near term and vice versa.

Nature of Capital Expenditure Decisions:

Capital expenditure decisions involve the acquisition of assets that have a long life span and which provide benefits spread over a long period of time.

The nature of capital expenditure decisions can be explained in brief as under:

• Irreversible Decision: Capital expenditure decisions once approved represent long-term invest­ments that cannot be reversed or withdrawn at any time. Withdrawal or reversal of such decisions may lead to considerable financial losses to the firm.
• Maximization of Shareholder’s Wealth: It helps protect the interest of the shareholders as well as of the firm because it avoids over-investment and under-investment in fixed assets.
• Substantial Investments: Capital expenditure decisions involve large amounts of funds. Such decisions have its effect over a long span of time.
• Estimation of Future Cash Inflows: Preparation of capital expenditure budget involves forecast­ing of cash inflows over several years for evaluating the profitability of projects.

Objectives of Capital Expenditure Decisions:

Financing decisions are one of the most crucial and critical decisions of a firm as they have a significant impact on the profitability of the firm.

There is the number of objectives of capital expenditure decisions, some of which are:

• Cost Reduction: The existence of a firm depends on profitability, which in turn depends on the production of goods or services at a reasonable price. This is possible if over/under-investment in fixed assets is avoided.
• Providing Contemporary Goods: Consumer tastes change every day. To satisfy the new demands from customers, either proper utilization of existing facility or installation of the latest machinery is necessary—which is not possible without proper capital expenditure decision.
• Increasing Output: An output may be increased by utilizing the existing facility or through expansion by installing new plant and machinery.

The Importance of Capital Expenditure Decisions:

Here are understand about the importance of Capital expenditure and also know their Difficulty.

The following importance is:

• Effects in the Long Run: the consequences of capital expenditure decisions extend into the feature. The scope of current manufacture activities of a company governed largely by capital expenditures in the past. Likewise, current capital expenditure decisions provide the framework for future activities. Capital investment decisions have an enormous bearing on the basic character of a company.
• Irreversibility: The market for used capital equipment, in general, is ill-organized. Further, for some types of capital equipment, custom-made to meet the specific requirement, the market virtually be non-existent. Once such equipment is acquired, reversal of decision may mean scrapping the capital equipment. Thus, a wrong capital investment decision cannot be reversed without incurring a substantial loss.
• Substantial outlays: Capital expenditures usually involve substantial outlays. An integrated steel plant, for example, involves an outlay of several thousand million. Capital costs tend to increase with advanced technology.

The following difficulty is:

• Measurement problems: Identifying and measuring the costs and benefits of a capital expenditure proposal tends to be difficult. This is more so when a capital expenditure has a bearing o some other activities of the company like cutting into sales of some existing product or has some intangible consequences like improving the morale of workers.
• Uncertainty: A capital expenditure decision involves costs and benefits that extend far into the future. It is impossible to predict exactly what will happen in the future. Hence, there is usually a great deal of uncertainty characterizing the costs and benefits of a capital expenditure decision.
• Temporal Spread: The costs and benefits associated with a capital expenditure decision are spread out over a long period of time, usually 10-20 years for industrial projects and 20-50 years for infrastructural projects. Such a temporal spread creates some problems in estimating discount rates and establishing equivalence.

Capital Expenditure Decisions Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. Other examples include decisions involving significant changes in a production process or adding a major new line of products or services to the organization’s activities.

Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting decisions. Managers encounter two types of capital-budgeting decisions. Acceptance-or-Rejection Decisions In acceptance-or-rejection decisions, managers must decide whether they should undertake a particular capital investment project. In such a decision, the required funds are available or readily obtainable, and management must decide whether the project is worthwhile.

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