L - 2 Capital Budgeting

Capital Budgeting
What is Capital Budgeting?

Capital budgeting is crucial for businesses as it involves the process of making
investment decisions about long-term assets. The main motive is to decide whether
or not to invest in a particular project. Because most investment decisions are not
always rewarding. The manager has the task of choosing a project that gives a high
return on investment more than the cost allotted to the particular project. Hence,
the manager must review projects based on cost and benefit. Let us take other
examples, assessing the need for funding before approval or rejection by
management is a common practice for initiatives such as establishing a new facility
or acquiring a significant share in an external venture, which falls under the realm of
capital budgeting. Within the context of capital budgeting, an organization may
analyze the anticipated long-term cash inflows and outflows of a potential project.
This analysis aims to ascertain if the projected returns align with a predefined target
benchmark deemed satisfactory. Capital Budgeting can also be called investment
appraisal.
Given below is the list of projects that can be analysed using a capital budgeting
process −
1. Decisions regarding buying new machinery.
2. Business expansion in new geographical zones.
3. Obsolete equipment replacement.
4. Launching new products, innovation or market development etc.
5. Why is capital budgeting a significant task for the business? The first thing to know
is that capital budgeting is undertaken by a financial manager. Its importance is listed
below —
6. It is responsible for the purchase of long-term assets and the decision regarding its
purchase influences the future success of the company.
7. Decisions regarding these investments maximize the shareholders’ value.
8. The principles that are relevant to the capital budgeting process are equally
applicable to other corporate choices, such as the management of working capital.
Importance of Capital Budgeting

The following are the points describing the importance of Capital Budgeting:
1. Calculation of future cash flows: Capital Budgeting process takes into account
the expected future cash inflows and the expected future cash outflows of the
project by taking into account the discounted rate of return and following the
various techniques like calculation of net present value, considering the
internal rate of return, payback period, profitability index, and accounting rate
of return Thus, the organization get the idea about present investment’s
future total value and the net profitability by using the process of capital
budgeting.
2. Helps in the long term goals of the organization: Capital Budgeting process
helps the organization for the long term decision making as well as in making
the long term goals as it provides the idea of future costs and growth taking
into account the expected future cash flows. The making of long term goals is
the most important and sensitive area for any organization and any wrong
decision taken in this area can adversely affect the long term profitability of
the organization.
3. Control of Expenditure: The capital budgeting process gives the idea of the
expected future cash inflows as well as expected future cash outflows. It takes
into account the investment cost for the project considering the other related
expenditures like Research & Development costs, running costs of the project,
etc. So, with this information, the organization can monitor the total costs and
have control of its future costs. The proper management and control of the
total costs is a very important factor for the growth and efficiency perspective
of the company.
4. Helps in Permanent Decision Making: Generally, the Capital related decisions
are the permanent decisions taken by the organization as it involves the large
amount of investments and funds. Such decisions cannot be reversed back in
the future once they are taken. Hence, the process of capital budgeting helps
in effective decision making for such permanent decisions of the organization.
5. Wealth Maximization: The interest and the investment decisions of the
shareholders in the company depend on its long term investment decisions. If
the investments in the capital or other long term investments are done by the
company in the proper and planned manner, the confidence of the
shareholders gets boost up and thus they become more interested in investing
in the company thus resulting in the company’s wealth maximization.
6. Flow of information within the departments: The entire process of capital
budgeting involves numerous steps and ideas and a number of decisions are
taken by the different levels of the company. This allows the flow and
exchange of information within the various departments and thus increases
the connectivity between them.
7. Protection to the large funds involved: As discussed above, there involves a
large amount of funds by the company in the acquisition of the capital assets.
Thus with the process of capital budgeting, that large financial investment or a
large amount of funds invested by the company gets protected to a certain
extent against any uncertainty in future.
8. Protection against future risks: There are various risks that are associated
with capital acquisitions by the company as they all are related to some future
events and uncertainty. Thus, the capital budgeting process helps the
organization in the advance assessment of those risks involved, and the
management of the company plans for the protection of such risks well in
advance to minimize its impact.
9. New Opportunities in the market: With the introduction of the new project in
the market, there arises many job opportunities for the new employees as
well as the existing ones. This gives rise to the economic growth of the country
along with boosting up the morale of personals.
10.Understanding the Complications of the projects: With the help of the Capital
budgeting process, the management of the company can have the idea of
different types of complications or Complexities that can be faced or arise
during the development of the project. Hence, the management can have
ready and advance strategies for dealing with such future complexities arising
from the project.

L - 2 Capital Budgeting

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Capital Budgeting

What is Capital Budgeting?

Importance of Capital Budgeting

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