Rationale Of Capital Expenditure:

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The rationale underlying the capital budgeting decision is efficiency. Thus, the firm must replace worn and obsolete plants and machinery, acquire fixed asset for current and new products and make strategic investment decisions. This will enable the firm to achieve its objective of maximising profits either by way of increased revenues or by cost reductions. The quality of these decisions is improved by capital budgeting. Capital budgeting decisions can be of two types: (i) those which expand revenue, (ii) those which reduce costs.

 

(i)                 Investment Decisions Affecting Revenue:

Such investment decisions are expected to bring in additional revenue, thereby raising the size of the firm’s total revenue. They can be the result of either expansion of present operations or the development of a new product line. Both types of investment decisions involve acquisition of new fixed assets. Both types of investment decisions are income expansionary in nature in the case of manufacturing firm.

(ii)               Investment Decisions Reducing Costs:

Such decisions by reducing costs, add to the total earnings of the firm. The classic example of such investment decisions is the replacement proposals. When an asset wears out or becomes outdated, the firm must decide whether to continue with the existing asset or replace it. The firm evaluates the benefit from the new machine in terms of lower operating cost and the outlay that would be needed to replace the machine. An expenditure on a new machine may be quite justifiable in the light of the total cost savings that result.

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