Sudha is an enterprising business woman who has been running a poultry farm for the past ten years.
Sudha is an enterprising business woman who has been running a poultry farm for the past ten years. She has saved Rs Four Lakhs from her business. She shared with her family her desire to utilize this money to expand her business. Her family members gave her different suggestions like buying new machinery to replace the existing one, acquiring altogether new equipments with latest technology, opening a new branch of the poultry farm in another city and so on. Since these decisions are crucial for her business, involve a huge amount of money and are irreversible except at a huge cost, Sudha wants to analyze all aspects of the decisions, before taking any final decision.
(i) Identify and explain the financial decision to be taken by Sudha.
(ii) Also, explain briefly the factors that will affect this decision.
2 Answers
(i) Investment decision/ Capital budgeting decision Investment/ Capital budgeting decision involves deciding about how the funds are invested in different assets so that they are able to earn the highest possible return for their investors.
(ii) Factors that affect capital budgeting decision are:
(a) Cash flows of the project
(b) Rate of return of the project.
(c) Investment criteria.
(1) The financial decision to be taken by Sudha is investment decision/capital budgeting decision.
Investment or capital budgeting decision refers to a decision as to how firm’s funds are invested in viable and profitable project i.e., long-term assets. For example, a decision to invest in plant and machinery. Investment decision requires evaluation of new investment proposals and selection of the best option on the basis of risk and return. This decision normally involves huge outflow of funds and is irreversible except at a huge cost. Hence, such a decision must be taken with utmost care.
(2) Following are the factors affecting capital budgeting decision :
(i) Cash flows of the project – The financial manager should carefully analyse the amount of cash flows i.e., cash receipts and payments over the life of investment before considering a capital budgeting decision.
(ii) rate of return – The financial manager should calculate the expected returns from each proposal and risk involved.
(iii) Investment criteria – The financial manager should evaluate investment proposals by applying capital budgeting techniques. These techniques involve a number of calculations regarding the amount of investment, interest rate, cash flows and rate of return.