Question

1. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over a period exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible.

Capital budgeting is hardly an exact science. If it were, companies would never make bad decisions about expansions, product development, equipment upgrades and other capital projects. The fact that companies do make these kinds of mistakes points to the limitations of capital budgeting. In your view, what are the limitations to capital budgeting?

Answer 1

Limitations of Capital Budgeting can be listed as below.

1) Assumptions Based - While doing Capital budgeting there are many assumptions to arrive at the decision. For eg rate of discount, growth rate, cash imnflows, outflows etc. But in actual this may changein real work scenario and would make the decision useless. It is said that the results are as good as asumptions.

2) Duration of the Capital Budgeting - Generally the capital budeting decisions are long term in nature which may nto be valid in short term. Hence proper adjustments afre required to make it work for short term.

3) Non Consideration of Non Financial Factors - Capital budgeting decisions will not consider the factors which do not impact financially. Hence it is difficult to take decisions sometimes regarding the acceptance of the capital projects.

4) Incorrect Estimation of the Risk - It may be difficult to factor the risk component involved in the project, project cashflows and the profitability which in turn will not lead to appropraite decision making.