Capital Budgeting – Definition, Process & Importance

What is Capital Budgeting?

Capital Budgeting is the process by which companies make investment decision on long term assets in capital expenditure. Oftentimes, it involves evaluating investment by estimating cash flows & expected rate of return. Further, with proper planning & control firm’s investment decisions on projects are taken to invest its current funds efficiently in anticipation of expected future benefits.

In simple words, it is the process of deciding whether to accept or reject capital budgeting projects on the basis of the benefits it will provide to the company in future.

Definition of Capital Budgeting

According To Charles T Horngreen: “Capital Budgeting is the long term planning for making and financing proposed capital outlays”.

According To Lynch “Capital Budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern.”

From the above definition, capital budgeting is the process by which companies allocate funds to various investment projects for capital budgeting decision.

Capital Budgeting Process & Features

Capital Budgeting process involves decisions of investment on long term assets using current funds for future benefits.

Evaluation criteria for capital budgeting projects is based on different capital budgeting techniques comprising mainly discounted cashflow techniques (DCF Techniques) and non-discounted cashflow techniques. Popular capital budgeting methods for evaluation in DCF comprises of Net Present Value(NPV)Internal Rate of Return (IRR) and Profitability Index.

In non-discounted cashflow, most common method for evaluating capital budgeting projects is Accounting Rate of Return (ARR) and Payback Period.

capital budgeting process

In order to understand capital budgeting, let’s check out the some of the features of capital budgeting –

  1. Exchange of funds for future benefits.
  2. The future benefits are expected to be realized over a period of time.
  3. Company invest funds in long term activities.
  4. They have a long term and significant effect on the profitability of the concern,
  5. They involve huge funds.
  6. It considers time value of money when one uses NPV method as project evaluation criteria.

Capital Budgeting Importance

1. Large Investment

Capital budgeting decision involves large investment of funds. But the funds available with the firm are always limited and the demand for funds far exceeds the resources. Hence it is very important for a firm to plan and control its capital expenditure.

2. Long Term Commitment of Funds

Capital expenditures involves not only large amount of funds but also funds for long term or permanent basis. The long tern commitments of funds increases, the financial risk involved in the investment decision. Greater the risk in budgeting decisions involved, greater is need for careful planning of capital expenditure i.e. Capital Budgeting.

3. Irreversible Nature

The Capital expenditure decision is of irreversible nature. Once the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.

4. Long term Effect on profitability

Capital budgeting decisions have a long term and significant effect on the profitability of a concern. Not only the present earnings of the firm are effected by the investments in capital asserts but also the future growth and profitability of the firm depends upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern.

5. Difficulties of investment Decisions

The long term investment decision are difficult to take. These decision extends to a series of years beyond the current accounting period, uncertainties of future, higher degree of risk.

6. National Importance

Investment decision are of national importance because it determines employment, economic activities and growth.

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