Question

What is capital budgeting? Discuss in details its financial importance and value.

Answer 1

Capital Budgeting is the process taken to determine whether the investment in proposed project to be made or not.

It is necessary for an entity to ensure that the amount is invested in very prudent manner. It requires the proper planning which is done through proper budgeting. Due to this, capital budgeting has significant importance while making investment decisions.

Capital Budgeting involves: -

1. Identification of investment projects that are strategic to overall business objectives of an entity;

2. Estimating and evaluating post-tax incremental cash flows from each of the investment proposals that are taken into consideration; and

3.Selection of an investment proposal that maximizes the return to the investors and provides aid in achieving overall objectives of an entity.

The financial Importance as well as Value of Capital Budgeting can be undertanding from below mentioned points:

(i) Substantial expenditure: Investment decisions are related with fulfillment of long term objectives and existence of an entity. To invest in a project or projects, a substantial capital investment is required. Based on size of capital and timing of cash flows, sources of finance that are use to finance the project are selected. Due to huge capital investments and associated costs, it becomes very necessary for an entity to make such decisions after a thorough study and planning, otherwise there is great possibility that investment made may not give desired results.

(ii) Long time period: The capital budgeting decision involves a long period. These decisions not only affect the future benefits and costs of the firm but also influence the rate and direction of growth of the firm that the business seeks to achieve from proposed project. Further due to the effect of time value of money, a project which may look promising is not commercially viable.

(iii) Irreversibility: Most of the investment decisions are irreversible. Once the decision implemented it is very difficult and as well as reasonably and economically not possible to reverse the decision. The reason may be upfront payment of amount, contractual obligations, technological impossibilities etc. Therefore, investment projects need to be taken into consideration wisely.

(iv) Maximization of Wealth: If the investment decisions are taken in a effective manner, then the possibility of success of proposed project increased. It helps in increasing the wealth of shareholders and helps to impart growth to the firm. Further shareholders are also keen to make investment in the entities which takes capital budgeting decisions in a proper manner

(v) Complex decisions: The capital investment decision involves an assessment of future events, which in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision. Further in current scneario, qualitative factors also gained importance while taking investment decisions.