Importance of Capital Budgeting | What is capital budgeting and what is its goal?| Capital Budgeting Process | Why capital budgeting is needed?
What is the concept of capital budgeting?
Capital Budgeting is the long term investment planning, analyzing, and decoding process used to evaluate and select capital expenditures consistent with the firm’s goal of owner wealth maximization. Capital expenditures are the long term investments made to expand, replace, or renew fixed assets or to obtain some other less tangible benefit.
Capital Budgeting Process
The capital budgeting process contains five distinct but interrelated steps beginning with proposal generation, followed by review and analysis, decision making, implementation and follow up.
Capital Budgeting or investment decision requires special attention because the following reason can be explained in the following manner:
Why capital budgeting is needed?
A firm’s decision to invest in long term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm. On the other hand, inadequate investment in the asset would make it difficult for the firm to compete successfully and maintain its market share.
A long term commitment to investment may also change the risk complexity of the firm. If the adoption of an investment increases average gain but curser frequent fluctuations in its earning, the firm will become riskier.
Investment decisions generally involve a large number of funds which make it imperative for the firm to plan its investment very carefully and make an advance arrangement for procuring finances internally or externally.
Capital budgeting is not reversible. This means that once we made capital budgeting decisions they are not easily reversible. This is because there may neither any market for such second-hand capital goods nor there is any possibility of conversion of such capital assets into other usable assets.
Investment decisions are an assessment of future event which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of investment. External Environment causes uncertainty in cash flow estimation.