CHAPTER ONE

INTRODUCTION

1.1     Background of the Study

Capital budgeting is the process by which firms determinehow to invest their capital. Included in this process are the decisions toinvest in new project, reassess the amount of capital already invested inexisting projects, allocate and ration capital across divisions and acquireother firms. In essence, the capital budgeting process defines the set and sizeof a firm’s real assets, which in turn generate the cash flows that ultimatelydetermine its profitability, value and viability. In principle, a firm’sdecision to invest in a new project should be made according to whether theproject increases the wealth of its shareholders.

Efficient allocation of capital usually referred to ascapital budgeting is one of the most important functions of financial managementin modern times. This function involves the firm’s decision to commit its fundsin long- term assets and other profitable activities. The firm’s decision toinvest funds in long-term assets is of considerable significance since theytend to influence its wealth, determine its size, set the pace and direction ofits growth and affect its business risk, Pandey (1981).

Capital budgeting addresses the question of how a companydecides to make investments in additional capacity or in new products and toreplace worn-out fixed assets. Awomewe and Ogundele, (2008), in their thesis“The importance of the payback method in capital budgeting decision”, submittedto the school of management, Blekinge Institute of Technology, wrote: “thecapital budgeting decision has been a very topical issue in the sustenance of acompany. Several companies have lost their identity or liquidated due to wrongcapital budgeting decision they made at one particular time or the other. Basedon these prevalent problems in industries and the effect of globalisation onindustries, it is important to use effective method to analyze investmentbefore decision is made. Capital budgeting is extremely important because thedecision made involves the direction and opportunity for future growth of theorganisation.”