Capital Budgeting Importance

Publication Date :

12 May, 2019

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Table Of Contents

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 assets. 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 Maximization
#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 budgeting 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 investment 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 process 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 Maximization

Motivate the organization to invest in long term investment to safeguard the interest of the shareholder in the organization. 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 income. 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 overruns & 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.