IMPORTANCE OF CAPITAL BUDGETING

IMPORTANCE OF CAPITAL BUDGETING

1. Long-term Implications of Capital Budgeting

A capital budgeting decision has its effect over a long time span and inevitably affects the company’s future cost structure and growth. A wrong decision can prove disastrous for the long-term survival of firm. On the other hand, lack of investment in asset would influence the competitive position of the firm. So the capital budgeting decisions determine the future destiny of the company.

2. Involvement of large amount of funds in Capital Budgeting

Capital budgeting decisions need substantial amount of capital outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrect decision would not only result in losses but also prevent the firm from earning profit from other investments which could not be undertaken.

3. Irreversible decisions in Capital Budgeting

Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a market for such assets. The only way out will be scrap the capital assets so acquired and incur heavy losses.

4. Risk and uncertainty in Capital budgeting

Capital budgeting decision is surrounded by great number of uncertainties. Investment is present and investment is future. The future is uncertain and full of risks. Longer the period of project, greater may be the risk and uncertainty. The estimates about cost, revenues and profits may not come true.

5. Difficult to make decision in Capital budgeting

Capital budgeting decision making is a difficult and complicated exercise for the management. These decisions require an over all assessment of future events which are uncertain. It is really a marathon job to estimate the future benefits and cost correctly in quantitative terms subject to the uncertainties caused by economic-political social and technological factors.

6. Large and Heavy Investment

The proper planning of investments is necessary since all the proposals are requiring large and heavy investment. Most of the companies are taking decisions with great care because of finance as key factor.

7. Permanent Commitments of Funds

The investment made in the project results in the permanent commitment of funds. The greater risk is also involved because of permanent commitment of funds.

8. Long term Effect on Profitability

Capital expenditures have great impact on business profitability in the long run. If the expenditures are incurred only after preparing capital budget properly, there is a possibility of increasing profitability of the firm.

9. Complicacies of Investment Decisions

Generally, the long term investment proposals have more complicated in nature. Moreover, purchase of fixed assets is a continuous process. Hence, the management should understand the complexities connected with each projects.

10. Maximize the worth of Equity Shareholders

The value of equity shareholders is increased by the acquisition of fixed assets through capital budgeting. A proper capital budget results in the optimum investment instead of over investment and under investment in fixed assets. The management chooses only most profitable capital project which can have much value. In this way, the capital budgeting maximize the worth of equity shareholders.

11. Difficulties of Investment Decisions

The long term investments are difficult to be taken because decision extends several years beyond the current account period, uncertainties of future and higher degree of risk.

12. Irreversible Nature

Whenever a project is selected and made investments as in the form of fixed assets, such investments is irreversible in nature. If the management wants to dispose of these assets, there is a heavy monetary loss.

13. National Importance

The selection of any project results in the employment opportunity, economic growth and increase per capita income. These are the ordinary positive impact of any project selection made by any company.