Capital budgeting: Concept and Importance
Capital budgeting is the process in which a business determines and evaluates potential large expenses or investments. These expenditures and investments include projects such as building a new plant or investing in a long-term venture. Often, a company assesses a prospective project’s lifetime cash inflows and outflows to determine whether the potential returns generated meet a sufficient target benchmark, also known as “investment appraisal.”
Capital budgeting usually involves calculation of each project’s future accounting profit by period, the cash flow by period, the present value of cash flows after considering time value of money, the number of years it takes for a project’s cash flow to pay back the initial cash investment, an assessment of risk, and various other factors.
The Importance of Capital Budgeting
- Develop and formulate long-term strategic goals – The ability to set long-term goals is essential to the growth and prosperity of any business. The ability to appraise/value investment projects via capital budgeting creates a framework for businesses to plan out future long-term direction.
- Seek out new investment projects – Knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry.
- Estimate and forecast future cash flows – Future cash flows are what create value for businesses overtime. Capital budgeting enables executives to take a potential project and estimate its future cash flows, which then helps determine if such a project should be accepted.
- Facilitate the transfer of information – From the time that a project starts off as an idea to the time it is accepted or rejected, numerous decisions have to be made at various levels of authority. The capital budgeting process facilitates the transfer of information to the appropriate decision makers within a company.
- Monitoring and Control of Expenditures – By definition a budget carefully identifies the necessary expenditures and R&D required for an investment project. Since a good project can turn bad if expenditures aren’t carefully controlled or monitored, this step is a crucial benefit of the capital budgeting process.
- Creation of Decision – When a capital budgeting process is in place, a company is then able to create a set of decision rules that can categorize which projects are acceptable and which projects are unacceptable. The result is a more efficiently run business that is better equipped to quickly ascertain whether or not to proceed further with a project or shut it down early in the process, thereby saving a company both time and money.
Objectives of Capital Budgeting
- To find out the profitable capital expenditure.
- To know whether the replacement of any existing fixed assets gives more return than earlier.
- To decide whether a specified project is to be selected or not.
- To find out the quantum of finance required for the capital expenditure.
- To assess the various sources of finance for capital expenditure.
- To evaluate the merits of each proposal to decide which project is best.
Features of Capital Budgeting
The features of capital budgeting is briefly explained below:
- Capital budgeting involves the investment of funds currently for getting benefits in the future.
- Generally, the future benefits are spread over several years.
- The long term investment is fixed.
- The investments made in the project is determining the financial condition of business organization in future.
- Each project involves huge amount of funds.
- Capital expenditure decisions are irreversible.
- The profitability of the business concern is based on the quantum of investments made in the project.
Limitations of Capital Budgeting
- The economic life of the project and annual cash inflows are only estimation. The actual economic life of the project is either increased or decreased. Likewise, the actual annual cash inflows may be either more or less than the estimation. Hence, control over capital expenditure cannot be exercised.
- The application of capital budgeting technique is based on the presumed cash inflows and cash outflows. Since the future is uncertain, the presumed cash inflows and cash outflows may not be true. Therefore, the selection of profitable project may be wrong.
- Capital budgeting process does not take into consideration of various non-financial aspects of the projects while they play an important role in successful and profitable implementation of them. Hence, true profitability of the project cannot be highlighted.
- It is also not correct to assume that mathematically exact techniques always produce highly accurate results.
- All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not be practically true in some particular circumstances.
- The morale of the employee, goodwill of the company etc. cannot be quantified accurately. Hence, these can substantially influence capital budgeting decision.
- Risk of any project cannot be presumed accurately. The project risk is varying according to the changes made in the business world.
- In case of urgency, the capital budgeting technique cannot be applied.
- Only known factors are considered while applying capital budgeting decisions. There are so many unknown factors which are also affecting capital budgeting decisions. The unknown factors cannot be avoided or controlled.