Monday, 8 July 2013

Importance of capital budgeting

Importance of capital budgeting


Capital budgeting decisions are of paramount importance in financial decision. So it needs special care on account of the following reasons:

1. Long-term Implications: 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: 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: 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: 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: 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.

Kinds of capital budgeting decisions:

Generally the business firms are confronted with three types of capital budgeting decisions. (i) The accept-reject decisions; (ii) mutually exclusive decisions; and (iii) capital rationing decisions.

1. Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those investment proposals which yield a rate of return greater than cost of capital are accepted and the others are rejected. Under this criterion, all the independent proposals are accepted.

2. Mutually exclusive decisions: It includes all those projects which compete with each other in a way that acceptance of one precludes the acceptance of other or others. Thus, some technique has to be used for selecting the best among all and eliminates other alternatives.

3. Capital rationing decisions: Capital budgeting decision is a simple process in those firms where fund is not the constraint, but in majority of the cases, firms have fixed capital budget. So large amount of projects compete for these limited budgets. So the firm rations them in a manner so as to maximize the long run returns. Thus, capital rationing refers to the situations where the firm has more acceptable investment requiring greater amount of finance than is available with the firm. It is concerned with the selection of a group of investment out of many investment proposals ranked in the descending order of the rate or return.

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