Capital Budgeting: It’s Concept & Significance

An organization undertakes multiple projects with different capital requirements, rates of return, and time duration.

For example, some projects may need investment over a longer period of time, whereas others need investments only in the initial years.

 

“Capital Budgeting is a kind of thinking that is necessary to design and carry through the systematic programme for investing stockholders’ money”-Joel Dean.

Since every project requires investment; therefore, an organization should take project selection decisions very prudently to ensure the optimum utilization of funds invested.

Any wrong selection of a project may incur heavy losses for the organization. In addition, the reputation and goodwill of the organization may also get affected.

An organization needs to evaluate the capital requirements of a project and the returns generated from it, before selecting a project. This can be done with the help of capital budgeting, which is a process of determining the actual profitability of a project. In other words, capital budgeting is a process that helps in planning the investment projects of an organization in the long run. The long- term investments of an organization can be purchase and replacement of fixed assets, new product launching or expansion of existing products, and research and development.

The capital budgeting process can be effective if an organization determines the total capital expenditure for a project that is expected to generate returns over a particular period of time. An organization uses various techniques to determine the total expenditure for a project and rate of return yielded from it. Some of the popular techniques are net present value, internal rate of return, payback period, sensitivity analysis, and decision tree analysis.

Concept of Capital Budgeting:

Capital budgeting is a planning process that is used to determine the worth of long-term investments of an organization. The long- term investments of the organization can be made in purchasing a new machinery, plant, and technology.

In other words, capital budgeting is a method of identifying, evaluating, and selecting long-term investments. The concept of capital budgeting has a great importance in project selection as it helps in planning capital required for completing long-term projects. Selection of a project is a major investment decision for an organization.

Therefore, capital budgeting decisions are included in the selection of a project. In addition, capital budgeting helps in estimating costs and benefits involved in a particular project. A project is not worth investing, if it does not yield adequate return on invested capital.

Some of the management experts have defined capital budgeting in the following ways:

According to Charles T. Homgreen, “Capital Budgeting is long-term planning for making and financing proposed capital outlays.”

As per Richards and Greenlaw, “The capital budgeting generally refers to acquiring inputs and long-run returns.”

In the words of G. C. Philipattos, “Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project; with the immediate and subsequent stream of expenditures for it.”

According to Joel Dean, “Capital Budgeting is a kind of thinking that is necessary to design and carry through the systematic programme for investing stockholders’ money.”

From the aforementioned definitions, it can be concluded that capital budgeting is an important process for any organization.

The significance of capital budgeting is explained in the following points:

(a) Long-term Applications:

Implies that capital budgeting decisions are helpful for an organization in the long run as these decisions have a direct impact on the cost structure and future prospects of the organization. In addition, these decisions affect the organization’s growth rate.

Therefore, an organization needs to be careful while making capital decisions as any wrong decision can prove to be fatal for the organization. For example, over-investment in various assets can cause shortage of capital to the organization, whereas insufficient investments may hamper the growth of the organization.

(b) Competitive Position of an Organization:

Refers to the fact that an organization can plan its investment in various fixed assets through capital budgeting. In addition, capital investment decisions help the organization to determine its profits in future. All these decisions of the organization have a major impact on the competitive position of an organization.

(c) Cash Forecasting:

Implies that an organization needs a large amount of funds for its investment decisions. With the help of capital budgeting, an organization is aware of the required amount of cash, thus, ensures the availability of cash at the right time. This further helps the organization to achieve its long-term goals without any difficulty.

(d) Maximization of Wealth:

Refers to the fact that the long-term investment decisions of an organization helps in safeguarding the interest of shareholders in the organization. If an organization has invested in a planned manner, shareholders would also be keen to invest in the organization. This helps in maximizing the wealth of the organization. Capital budgeting helps an organization in many ways. Thus, an organization needs to take into consideration various aspects.