Definition and Importance of Capital Budgeting in Financial Management

Investment decision making is also known as capital budgeting. Capital budgeting is the process of deciding whether or not to commit resources to projects whose costs and benefits will be spread over several time periods. Thus, the term ‘capital budgeting’ is actually the process of making investment decisions in capital expenditures of fixed assets. The word investment refers to the decision to invest and the capital invested. It involved the sacrifice of a present and certain satisfaction in exchange of a future return.

Thus, the investment decision is an arbitrage over time that involves a degree of risk. One of the tasks of the financial manager is to plan for a properly balanced group of investment in assets on the one hand, and a properly balanced capital structure on the other. Capital budgeting is the matching of funds uses and sources in line with overall objectives of the firm.

Definition of Capital Budgeting

The term ‘capital budgeting’ has been formally defined as follows :-

(1) “Capital budgeting is long-term planning for making and financing proposed capital outlay.” —Charles T. Horngren

(2) “The capital budgeting generally refers to acquiring inputs with long-run returns.” –Richards & Greenlaw

(3) “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 streams of expenditures for it.” G.C. Philippatos

(4) “Capital budgeting consists in planning for development of available capital for the purpose of maximizing the long-term profitability (return on investment) of the firm.” —R.M . Lynch

(5) “Capital budgeting involves the planning of expenditures for assets, the returns from which will be realized in future time periods.” —Milton H. Spencer

Importance of Capital Budgeting in Financial Management

The selection of the most profitable assortment of capital investment can be considered a key function of financial management. In addition, it is the most important area of decision-making for the financial manager. Actions taken by management in this area affect the operations of the firm for many years to come.

The Importance of Capital Budgeting can be illustrated well on the following grounds :-

(1) Heavy Investment – Almost all the capital expenditure projects involve heavy investment of fund. And these funds are accumulated by the firm from various external and Internal sources. So their proper planning is becomes inevitable.

(2) Permanent Commitment of Funds – The funds involved in capital expenditure are not only large but more or less permanently blocked also. Therefore, these are long-term investment decisions. The longer the time, the greater the risks involved. Hence, a careful planning is essential.

(3) Long-term Impact on Profitability – Capital expenditure projects exercise a great impact on the profitability of the firm for a very long time. If properly planned they can increase not only the size, scale and volume and sales but its growth potentiality also.

(4) Complications of Investment Decisions – The long-term investment decisions are more complicated in nature. They entail more risk and uncertainty. Further, the acquisition of capital assets is a continuous process. So the management must be gifted ample prophetic skill to keep into future.

(5) Worth Maximization of Shareholders – Capital budgeting decisions are very important as their impact on the well-being and economic health of the enterprise is far reaching. The main aim of this process is to avoid over investment and under investment in fixed assets. By selecting the most profitable capital project, the management can maximize the worth of equity shareholders investment.

Thus, the significance of- capital budgeting decisions becomes obvious. The other facts for its significance can be enumerated as follows :

Other Importance of Capital Budgeting

(1) Management loses his flexibility and liquidity of funds in making investment decisions so it must consider each proposal very thoroughly.

(2) Asset expansion is fundamentally related to further sales and future profitability of the firm and assets acquisition decisions are based on capital budgeting.

(3) The funds available of a firm are always in scarcity so they must be properly planned. Modern industrial organizations are characterized by large scale production and intensive mechanization. This all requires balanced and properly planned allocation of scarce capital resources to the most profitable investment proposal Hence, the process of capital budgeting has become very significant nowadays. The financial executive must plan capital budgets often years in advance. Some of the large companies in the U.S.A., for example, have ten year capital budgeting programmes.

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