Table of Contents
- 1 Capital Budgeting Meaning
- 2 Importance of Capital Budgeting
- 3 Other Important Aspect of Capital Budgeting
Capital Budgeting Meaning
Capital budgeting is a process that helps in planning the investment projects of an organization in long run. It takes all possible consideration into account so that the company can evaluate the profitability of the project. It is useful for evaluating capital investment project such as purchasing equipment, the rebuilding of equipment etc. The benefit from an investment may be in form of a reduction in cost or in form of increased revenue. Importance of capital budgeting can be understood from its impact on the business.
Businesses exist to earn profit except for non-profit organization. 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 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. A wrong decision can be disastrous for the long-term survival of the firm. Capital budgeting has its effect in a long time span. It also affects companies future cost & growth.
Involvement of a Large Number of Funds
Capital Investment requires a large number of funds. As the companies have limited resources, the company has to make a wise & correct investment decision. The wrong decision would harm the sustainability of the business. The large investment includes the purchase of an asset, rebuilding or replacing existing equipment.
The capital Investment decisions are generally irreversible as it requires large amounts of funds. It is difficult to find the market for that asset. The only way remains with the company is to scrap the asset & incur heavy losses.
Monitoring & Controlling the Expenditure
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 the capital budgeting process.
Transfer of Information
The time that project starts off as an idea, it is accepted or rejected; numerous decisions have to be made at a various level of authority. The capital budgeting process facilitates the transfer of information to appropriate decision makers within a company.
Difficulties of Investment Decision
The long-term investment decisions are difficult because it extends several years beyond the current period. Uncertainty indicates a higher degree of risk. Management loses his flexibility and liquidity of funds in making investment decisions so it must consider each proposal very thoroughly.
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 wealth of the organization. Any expansion is fundamentally related to further sales and future profitability of the firm and assets acquisition decisions are based on capital budgeting.
Other Important Aspect 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, and that involves own set of risk. Project delay, cost overruns & regulatory restriction that 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 business considers & evaluates. So the capital investment decision must be taken considering both perspective 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 considers 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.1,2