Meaning of Capital Budgeting
Capital Budgeting is a process used for evaluating the long term investments that are of capital nature. It helps in finding out potential investments and expenditures that will provide a better return to business. Capital budgeting is also known as the investment appraisal process as it aims at increasing the return of business by choosing the most profitable project.
It analyses and finds out whether it is worth to fund through the firm capitalization structure the long term investments like purchase or replacement of machinery, new plants and products and project related to research development. It is an important process which helps managers in deciding out the most profitable capital projects by comparing all cash inflows and cash outflows of the project. It makes the choice clear that which project should be accepted and which should be declined.
Capital budgeting process involves: Identification of investment opportunities, then evaluating and choosing the most profitable investment, now capital budgeting and apportionment and at last review of the performance. The different techniques of capital budgeting used by business are Net present value, Payback period method, Internal rate of return, accounting rate of return and Profitability index. Capital budgeting is termed as a predominant function of management. Features Features of Capital Budgeting of Capital Budgeting is described below:
Features or Characteristics of Capital Budgeting
Capital Budgeting is related to taking decisions requiring large funds. It is a process used for selecting the high-value capital projects by the management. Managers use capital budgeting for properly analysing different investment opportunities and take decision with proper care.
The decisions taken through the capital budgeting process are irreversible in nature. This process requires making choices for large fund investment in different capital projects available. A decision once taken becomes difficult to be amended as it involves the allocation of large funds and affects company growth. High-value asset once purchased can’t be sold at the same prices and at the same time.
There is a high degree of risk involved in the capital budgeting process. Decisions taken in this process are concerned with future return and the future is uncertain. Future unforeseen like change in fashion and taste, technological and research advancement may lead to higher risk. It, therefore, involves critical analysis before taking any decision as there are a large amount of funds allocated by business through this process.
Long Term Effect on Profitability
Capital Budgeting decisions have long term effects on the profit-earning capacity of the business. It involves decisions regarding large investments providing return to business. Decisions taken through capital budgeting affects both current and future earning potential of the company. Any unwise decision may affect business growth adversely and may be fatal. Therefore capital budget is termed us utmost function for every business which has great influence over its profitability.
Impacts Cost Structure
The decisions taken through the capital budgeting process have a direct impact on the cost structure of the business. Through decision taken in this process, business commits themselves to costs like interest, insurance, rent, supervision etc. If the investment taken does not generate the anticipated income for the business, then it would increase the cost expenses and lead business to losses.
Decisions taken through the capital budgeting process are difficult in nature. Decisions taken here are regarding the future which is uncertain and may have many unforeseen. It, therefore, becomes difficult for managers to choose the most profitable investment providing better return in future.
Affects Competitive Strengths
Capital budgeting process directly influences the future competitive strength of the business. Decisions taken in this process are regarding the profit generating investments and affects the company growth. A right decision taken can lead the company to great heights whereas a wrong decision may become fatal for the business. Therefore capital budgeting directly influences the strengths and weaknesses of a business.