Capital budgeting revolves around capital expenditures, including large inflow and outflow of money to finance investment projects. It is a process by which a company decides whether it should invest in a project or not. We should understand the advantages and disadvantages of capital budgeting as a technique to correctly interpret the results thereof.
Capital budgeting is largely used for long-term investment opportunities whose tenure is more than a year and fetches returns over several subsequent years. These investment opportunities could be for new plant & machinery, factory facilities, construction of a building, etc. Capital budgeting is a very important tool in finance, but it comes with merits and demerits.
Advantages of Capital Budgeting
- Capital budgeting helps a company understand the various risks involved in an investment opportunity. And how these risks affect the returns of the company.
- It helps the company to estimate which investment option would yield the best possible return.
- A company can choose a technique/method from various techniques of capital budgeting to estimate whether it is financially beneficial to take on a project or not.
- It helps the company to make long-term strategic investments.
- It helps to make an informed decision about an investment considering all possible options.
- All the techniques/methods of capital budgeting try to increase shareholders’ wealth and give the company an edge in the market.
- It helps a company in a competitive market to choose its investments wisely.
- Capital budgeting presents whether an investment would increase the company’s value or not.
- It offers adequate control over expenditure for projects.
- Also, it allows management to abstain from over-investing and under-investing.
Disadvantages of Capital Budgeting
- Capital budgeting decisions are for the long term and are majorly irreversible in nature.
- These techniques are mostly based on estimations and assumptions as the future will always remain uncertain.
- Capital budgeting still remains introspective as the risk factor, and the discounting factor remains subjective to the manager’s perception.
- A wrong capital budgeting decision can affect the company’s long-term durability. And hence it needs to be done judiciously by professionals who understand the project well.
Despite its limitations, as given above, capital budgeting still remains a necessary exercise for a company before it invests in any long-term project. Capital budgeting allows the management to choose wisely amongst the several investment opportunities available in the market.
The company can adequately and conveniently calculate suitable returns over the cost of capital and shareholders’ expected rate of return using the techniques/methods of capital budgeting. It also tells whether an investment would increase the company’s value or not, and hence it is widely used to evaluate projects in almost all fields.