Importance and difficulties of Capital expenditure



Here you can understand about the importance and difficulties of Capital expenditure.

Importance

Capital expenditure decisions represent the most important decision taken by a company. Their importance from three inter – related reasons.

  1. 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 frame work for future activities. Capital investment decisions have an enormous bearing on the basic character of a company.
  2. Irreversibility: The market for used capital equipment in general is ill-organized. Further, for some types of capital equipment, custom-made to meet 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.
  3. Substantial outlays: Capital expenditures usually involve substantial outlays. An integrated steel plant, for example, involves an outlay of several thousand millions. Capital costs tend to increase with advanced technology.

Difficulties

While capital expenditure decisions are extremely important, they also pose difficulties which supported from three principal sources:

  1. 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.
  2. Uncertainty: A capital expenditure decision involves costs and benefits that extend for into future. It is impossible to predict exactly what will happen in future. Hence, there is usually a great deal of uncertainty characterizing the costs and benefits of a capital expenditure decision.
  3. 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.