Are you struggling with searching what is capital budgeting, and definition, importance of capital budgeting, now you are in right place. Lets stray – You will gain a thorough knowledge of the application of the concept of financing for investment decision-making in the case of fixed assets or capital budgeting. Capital is defined here as a fixed asset used in production and a budget is defined as a plan for the expected inflows and outflows for some time to come.
Definition of Capital Budgeting:
Definition of Capital Budgeting – it can be said that a capital budget is the outline of planned expenditure for fixed assets. In that sense, capital budgeting is all about the long-term investment decisions of the organization. The term capital budgeting is used primarily to describe how a manager will outline action plans for projects that will have an impact on the firm in the long run.
Such as the purchase of new equipment and the production of new products. Most companies have multiple projects and they can also invest in each. The manager who promises to give the most profit to the project must accept it. Making the best capital budgeting decisions considering the long-term profitability of a company as an important factor; Proves the manager efficiency. In defining capital budgeting, different authors have defined almost identical content.
What is Capital Budgeting by various author:
Besley and Brigham said, “Capital budgeting is the process of planning and evaluating the amount of money spent on an asset in the hope of receiving the expected cash flow for more than a year. ”
Garrison and Noreen said, “Capital budgeting involves investment & the company must commit funds now in order to receive a return in the future,”
According to JC Van Horne, “Capital budgeting is the process of identifying, analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year,”
According to LJ Gitman – “Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth”.
According to Horngren, Foster, and Datar, ”(Capital budgeting is the making of long-run planning.”
Types of Capital Budgeting / Features of Capital Budgeting:
Capital Budgeting – Types of Capital Budgeting One of the tasks of a financial manager is to make investment decisions. That is why he takes the help of capital budgeting. Analyzing the given definitions of capital budgeting reveals some of its own unique features. Which is in harmony with its nature.
Features of capital budgeting:
A. Long-term investment: By investing now, you can get results for a long time. Although the investment may be one-time. Which is mainly used for acquiring fixed assets. Such as – the restoration of property, expansion, modernization, selection of alternative equipment, etc.
B. Huge Investment: An investment is made to acquire a property on a long-term basis. So it requires enough money; Which is plenty.
C. Advantages of long-term investment: Since the investment is made for a long period of time, it also provides long-term benefits.
D. Cash flows: Cash inflows occur throughout the life of the project. Of course, there can also be outflows.
E. Risk or Uncertainty: Generally, the more money and time, the greater the risk. Therefore capital budgeting is riskier.
F. Time value of money: Time value of money is one of the features of capital budgeting. Which makes it possible to select relatively profitable projects.
G. Capital Rationing: Capital rationing is one of the strategies for effective use of limited capital. Which has given special distinction to capital budgeting.
H. Adjustment of Liquidity and Profitability: One of the features of capital budgeting is to achieve the desired balance between liquidity and profitability of the organization. Failure to make the right balance between liquidity and profit can lead to increased capital expenditure.
In general, the above issues are one of the features of capital budgeting. There are also minor features like time intervals, long-term projects, alternative investment opportunities, etc.
Importance of Capital Budgeting:
The Importance of Capital Budgeting When a financial manager makes the most important financial decision out of many options, there are many things to consider collectively. For example, when a project is undertaken, the firm has to make some concessions for decision-making flexibility, because the effect of capital budgeting falls on the firm on a long-term basis.
For example, if a firm invests in an asset with a tenure of 10 years, its operations will be affected for 10 years. The firm is “locked-in” by a capital budgeting decision.
A property purchase decision that will last 10 years with a 10-year sales forecast is an asset augmentation fundamentally related to that sales forecast. Undoubtedly, the future development of the firm depends on the correct and efficient decision of investing funds. The importance of capital budgeting is discussed below.
1.To achieve long-term goals: Capital budgeting is closely associated with achieving long-term goals. If it is possible to make investment decisions efficiently, then the returns will be satisfactory. But if the decision is wrong, a terrible situation can arise. Even the question of the existence of the firm comes up. That being said, capital budgeting has a direct impact on the growth or decline of a firm.
2. Profit earning capacity: Investing in the right and effective project through capital budgeting increases the profit earning capacity of the firm. However, if the opposite happens, the ability to make a profit also decreases. As a result, it is a very sensitive decision.
3. Long-term investment: Long-term investment is made for the purpose of making a profit for many years to come. The decision in this regard is very sensitive as the capital is submerged for a long time. It is not easy to change the decision if a mistake arises. As a result, capital budgeting is very important in this case.
4. Reducing risk: Investment projects are expected to generate cash flows at an average or average rate per account year, but in reality, investment decisions are made with this in mind. This reduces the risk.
5. Large capital investment: Large capital investment is required to meet long-term objectives. As a result, in case of errors, large losses have to be borne. So capital budgeting is a proper consideration.
6. Balancing between liquidity: profitability and value of the firm: The firm’s expenditure structure is largely dependent on the national capital expenditure decision. And the nature of the firm’s future liquidity, profit, share price, growth, and development, etc. depends on this cost decision. Capital budgeting is very important for making decisions in this regard.
7. Competitions: Competing in the current business world of extreme global competition to survive in the market, efficient and timely investment decisions need to be taken by competing companies to make a mistake.
7. Selecting alternative projects: The role of capital budgeting is very effective in selecting the most profitable projects from certain options.
9. Uncertainty For example socio-political, natural, and technological elements, so capital budgeting is very effective in ensuring uninterrupted future cash flow.
10. Present plan for fund collection: As a result, the firm can easily adopt other plans with future cash flows. In conclusion, capital budgeting is an undeniable task for any firm. Its importance is immense.