Page 2 - Lesson Note 2

Factors affecting Capital Budgeting Decision

A number of projects are often available to a business to invest in. But each

project has to be evaluated carefully and, depending upon the returns, a
particular project is either selected or rejected. If there is only one project, its
viability in terms of the rate of return, viz., investment and its comparability with

the industry’s average is seen. There are certain factors which affect capital
budgeting decisions.

(a) Cash flows of the project: When a company takes an investment decision

involving huge amount it expects to generate some cash flows over a period.
These cash flows are in the form of a series of cash receipts and payments over
the life of an investment. The amount of these cash flows should be carefully

analyzed before considering a capital budgeting decision.

(b) The rate of return: The most important criterion is the rate of return of the
project. These calculations are based on the expected returns from each proposal

and the assessment of the risk involved. Suppose, there are two projects, A and B
(with the same risk involved), with a rate of return of 10 per cent and 12 per cent,
respectively, then under normal circumstance, project B should be selected.

(c) The investment criteria involved: The decision to invest in a particular project

involves a number of calculations regarding the amount of investment, interest
rate, cash flows and rate of return. There are different techniques to evaluate

investment proposals which are known as capital budgeting techniques. These
techniques are applied to each proposal before selecting a particular project.

Financing Decision

This decision is about the quantum of finance to be raised from various long-term

sources.

Short-term sources are studied under the ‘working capital management’. It
involves identification of various available sources.

The main sources of funds for a firm are shareholders’ funds and borrowed
funds.