Capital Budgeting is used for decision making of the long term investment that whether the projects are fruitful for the business and will provide the required returns in the future years and it is important because capital expenditure requires huge amount of funds so before doing such expenditure in capital asset management do capital budgeting to assure themselves that the capital spending will bring profits in the business.
Importance of Capital Budgeting
Capital Budgeting is the formal process of investments or expenditure that is huge in amount. It involves the company’s major decision where to invest the current fund in the development of the organization, such as for addition, disposition, modification, or replacement of fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.. Capital budgeting becomes vital due to the vast amount of investment that is involved and the risk associated with the same.
Here is the top 10 importance of capital budgeting –
- #1 – Long Term Effect on Profitability
- #2 – Huge Investments
- #3 – Decision cannot be Undone
- #4 – Expenditure Control
- #5 – Information Flow
- #6 – Helps in Investment Decision
- #7 – Wealth MaximizationWealth MaximizationWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits.
- #8 – Risk and Uncertainty
- #9 – Complicacies of Investment Decisions
- #10 – National Importance
Let us discuss each one of them in detail –
Importance of Capital Budgeting – Top 10
The following are a list of top 10 Importance of Capital Budgeting
#1 – Long Term Effect on Profitability
For the growth & prosperity of any organization, a long term vision is necessary, because a wrong decision may severely impact the survival of the firm, which may influence the capital budgetingThe Capital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds. in the long run. Not only this, but it also impacts the companies future cost & growth. In the long run, capital spending has a significant impact on business profitability. If the expenditures occurred after preparing a budget appropriately, there are certain chances of increasing the profitability of an organization.
#2 – Huge Investments
Any organization needs considerable investment to grow as the company has limited resources to grow while taking the investment decision; it has to make a wise decision. Because the wrong decision may blow up the sustainability of the business, it may profoundly impact the purchase of an asset, rebuilding or replacing existing equipment.
#3 – Decision cannot be Undone
Most of the time, the capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc. decision are irreversible in nature; it caters to vast investment, and it is difficult to find the market for it. The only way to remains with the company is to scrap the asset and bear the losses.
#4 – Expenditure Control
Capital budgeting requires more attention to the expenditure and do R&D for an investment project if needed. A good project turns into bad if the expenses were not done in a controlled manner and not monitored carefully, While this step is quite crucial in the capital budgeting process.
#5 – Information Flow
The initialization of the project is merely an idea, whether it is accepted or rejected, depends upon the various level of authority and circumstances. The capital budgeting processCapital Budgeting ProcessThe capital budgeting process is planning to evaluate the potential investments or expenditures whose amount is significant. It helps determine the company’s investment in the long term fixed assets such as investment in the addition or replacement of the plant & machinery, new equipment, Research & development. facilitates the transfer of information to appropriate decision-makers so they can make a better decision in the growth of the organization.
#6 – Helps in Investment Decision
The long-term investment decisions are time-consuming as it takes several years for accomplishment beyond the current period. Uncertainty defines the involvement of the risk in it. Management loses his flexibility and liquidity of funds when making an investment decision. It must be considered while accepting the proposal.
#7 – Wealth MaximizationWealth MaximizationWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits.
Motivate the organization to invest in long term investment to safeguard the interest of the shareholder in the organizationShareholder In The OrganizationA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.. If the organization invests in certain projects in a planned manner, the shareholder will show their interest in the organization. It will help them to maximize the growth of the organization. Any expansion of the organization is further related to the growth, sales, and future profitability of the firm and assets based on capital budgeting.
#8 – Risk and Uncertainty
When we invest in certain project expects a certain return in the permanent commitment of funds. More risk is involved because of the permanent commitment of funds. Capital budgeting decision is surrounded by a great number of uncertainties whether the investment is in present or in future. Longer the period of the project, more the risk and uncertainty involved. The estimates about the cost, revenues, and profits may vary depending upon the time.
#9 – Complicacies of Investment Decisions
The investment in long term proposals is quite tedious and involves a lot of complicacy in nature. While the purchase of fixed assets is a continuous process, so the management needs to understand the complicacy of connected projects.
#10 – National Importance
Initiation of any project offers new job opportunities, helps in economic growth, which increases per capita incomePer Capita IncomeThe per capita income formula depicts the average income of a region computed by dividing the total income of that area by the total population of the region. It is used to figure out the average income of a city, provision, state, country, etc.. These are the contribution made by the company during the selection of a new project.
Few Other Important Aspect of Capital Budgeting
Capital Budgeting decision involves two more important decisions, such as:
- Financial Decision
- Investment Decision
At the time of taking the project, the business has confirmed to give the commitment to a project and associated risk involved in it. Project delay, cost overrunsCost OverrunsCost overrun, also known as budget overrun, is a scenario in which the cost of a project or business tends to rise above what was budgeted for. This can be due to improper budgeting or underestimating of the actual cost owing to unforeseen scenarios that were not factored into the budgeting process. & regulatory restriction that impact a lot in the project execution, ultimately increases the cost of the project.
Apart from it, the company also makes an investment in its future direction and its growth, which influences much more on the future projects that business considers a lot and evaluate it accordingly. So whenever capital investment decision is taken into account, it considers both perspective financial & investment.
It is also a fact that running a business is required less effort rather than a constant exercise in capital budgeting decisions. For that, it becomes necessary to make a successful capital investment decision while taking financial and investment decisions.
This has been a guide to Capital Budgeting Importance. Here we provide a detailed explanation of the top 10 reasons why capital budgeting is important along with its features. You may learn more about accounting from the following articles –