Capital budgeting revolves around capital expenditures which include 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 have a correct interpretation of 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 facility, construction of a building etc. Capital budgeting is a very important tool in finance but it comes with its own merits and demerits.
Advantages of Capital Budgeting:
- Capital budgeting helps a company to understand 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 taking into consideration all possible options.
- It helps a company in a competitive market to choose its investments wisely.
- All the techniques/methods of capital budgeting try to increase shareholders wealth and give the company an edge in the market.
- 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 long-term and are majorly irreversible in nature.
- Most of the times, these techniques are based on the estimations and assumptions as the future would 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 taken can affect the long-term durability of the company and hence it needs to be done judiciously by professionals who understands 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 the fields.