Capital Budgeting Meaning
Capital budgeting is a process that helps in planning the investment projects of an organization in the long run. It takes all possible considerations into account so that the company can evaluate the profitability of the project. It is useful for evaluating capital investment projects such as purchasing equipment, rebuilding equipment, etc. The benefit from an investment may be in the form of a reduction in cost or in the form of increased revenue. The importance of capital budgeting can be understood from its impact on the business.
Businesses exist to earn profit except for non-profit organizations. Capital budgeting is very important for any business as it impacts the growth & prosperity of the business in the long term. It creates accountability & measurability. Some of the popular capital budgeting techniques are net present value, internal rate of return, payback period, accounting rate of return & profitability index.
Importance of Capital Budgeting
For the growth & prosperity of the business, long-term goals are very important for any organization. Every investment carries risk and uncertainty. And the longer the investment period, the more is the risk and uncertainty. A wrong decision can be disastrous for the long-term survival of the firm. Capital budgeting has had its effect over a long time span. It also affects companies’ future costs & growth. It assists the management in understanding the complications and challenges of long-term proposals.
Involvement of a Large Number of Funds
Capital Investment requires a large number of funds. As the companies have limited resources, the management has to make wise & correct investment decisions. The wrong decision would harm the sustainability of the business. The large investment includes the purchase of an asset and rebuilding or replacing existing equipment.
Capital investment decisions are generally irreversible as they require large funds. It isn’t easy to find the market for that asset. The only way remains with the company is to scrap the asset & incur heavy losses. A good project can turn bad if there is no control over the costs.
Monitoring & Controlling the Expenditure
The capital budget carefully identifies the necessary expenditure 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 capital budgeting.
Transfer of Information
The time that project starts off as an idea, 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 appropriate decision-makers within a company.
Difficulties of Investment Decision
Long-term investment decisions are difficult because it extends several years beyond the current period. Uncertainty indicates a higher degree of risk. Management loses its flexibility and liquidity of funds in making investment decisions, so it must thoroughly consider each proposal. This is because management has an assurance that capital budgeting will assist them in making better decisions. And these decisions would eventually help to maximize the shareholders’ wealth.
Maximization of Wealth
Long-term investment decision of the organization helps in safeguarding the interest of the shareholder in the organization. If the organization has invested in a planned manner, the shareholder would also be keen to invest in that organization. This helps in the maximization of the wealth of the organization. Any expansion is fundamentally related to further sales and future profitability of the firm, and asset acquisition decisions are based on capital budgeting.
Other Important Aspects of Capital Budgeting
Capital budgeting involves two important decisions at once: a financial decision and an investment decision. By taking the project, the business has agreed to make a financial commitment to a project which involves its own set of risks. Project delay, cost overruns & regulatory restrictions can all delay & increase the cost of the project.
In addition to a financial decision, a company is also making an investment in its future direction and growth. It is likely to have an influence on future projects that the business considers & evaluates. So the capital investment decision must be taken considering both perspectives, i.e., financial & investment.
In December 2009, ExxonMobil, the world’s largest oil company, announced that it was acquiring XTO Resources in the U.S. for $41 billion. It was one of the largest natural gas companies. That acquisition was a capital budgeting decision, one in which ExxonMobil made a huge financial commitment. But in addition, ExxonMobil was making a significant investment decision in natural gas. Essentially positioning the company to also focus on growth opportunities in the natural gas arena. That acquisition alone will have a profound effect on future projects that ExxonMobil will consider and evaluates for many years to come.
It can be said that running a business is nothing more than a constant exercise in capital budgeting decisions. Understanding that both a financial and investment decision is useful for making successful capital investment decisions.
Continue reading – How can a Capital Budgeting Decision Go Wrong?