Importance of Capital Budgeting

First of all, let’s have some discussion about capital budgeting so that you can understand what capital budgeting is and why there is the importance of capital budgeting for financial decision making.

Capital Budgeting

Capital budgeting is the process of evaluating investment alternatives. Here investment alternatives are the long-term investment opportunities available to invest. Caution must be taken when capital budgeting because it is long-term in nature, an involvement of a large amount of money, and use of monetary resources.

The process of Capital Budgeting

At the time of Capital Budgeting, a simple decision-making process is followed by the finance manager. The process is as follows:

  1. Identify available project which may have future prospects.
  2. Calculate the amount of fund required to be invested (Outflow) for different projects
  3. Calculate all expected benefit will receive within the project tenure
  4. Conducting cost-benefit analysis
  5. Compile all the results of the analysis
  6. Evaluate each of the alternatives
  7. For single project selection, select best one from the alternatives and for multiple projects, select the most beneficial project.
  8. Finally, start with the selected project/ projects to implement.

Importance of Capital Budgeting

Now come to the point why managers give too much emphasis on capital budgeting, actually managers concern about capital budgeting because capital investment can bring both profit and loss. Managers actually want to see whether the project will be beneficial for the company or not. If it is beneficial then the project can be implemented by investing a large amount of money, otherwise not. And the tools help to identify the right project is capital budgeting tools.

Importance of Capital Budgeting

Importance of Capital Budgeting in Corporate Finance

  1. Investment of a Large Amount of Money
  2. Long-Term Investment
  3. The probability of Incurring Enormous Loss
  4. Evaluation of Available Investment Alternatives
  5. Selection of Right Investment
  6. Proper Utilization of Funds

Investment of a Large Amount of Money

A proper analysis must be done before investing a large amount of money because our valuable money may be spent out for wrong investment. Capital budgeting is one of the popular tools to evaluate investment alternatives of a large amount of money.

Long-Term Investment

In case of long-term investment, precautions must be taken because from the long-term investment we expect long-term benefit and money will be stuck for a longer period. There is less flexibility of movement of money form long-term investment. That’s why the importance of capital budgeting is increasing day by day.

The probability of Incurring Enormous Loss

You know the future is always uncertain and for a large amount of investment, there is a probability of incurring an enormous amount of loss if you chose a wrong investment opportunity. So, you must do capital budgeting first then chose an investment opportunity where you will get an optimal amount of return.

Evaluation of Available Investment Alternatives

Basically, we do capital budgeting for the purpose of evaluating all available investment alternatives so that we can invest for right amount in right place. Remember that before evaluation you must take valid data otherwise you would not get a proper result of the analysis.

Selection of Right Investment

After analyzing all the things related to investment using capital budgeting techniques a corporate finance manager can select a right investment for his firm, which has a good potentiality of bringing benefit for the organization.

Proper Utilization of Fund

As because you choose the right investment for your company, you may assume that you are utilizing the valuable fund of your organization.

The success of Business Depends on Capital Budgeting

We use different tools of Capital budgeting to make the financial choice for large investment. The process of capital budgeting not only helps us to evaluate but also to choose the right investment. That’s why I personally consider capital budgeting as one of the success factors of the business. An effective analysis will give you proper guidelines for the right investment. And the right investment will generate the best possible revenue for your business, which is the key considerations of the success of your business. That’s why we give importance to capital budgeting for investment decision making.

Tasks of Corporate Finance

Corporate finance is a branch of finance where financing decision about choosing a least-cost source of fund and optimal capital structure. The main tasks of corporate finance are to ensure the maximization of the value of the firm so that equity holders get the benefit. Remember one thing that corporate finance is not like public finance, both are different from each other.

The Main Tasks of Corporate Finance are

  • Capital Budgeting for the Corporation
  • Forming Optimal Capital Structure and
  • Management of Working Capital

Many people consider these tasks as a function of corporate finance. In addition to these tasks of corporate finance deals with many other financial activities according to the requirement of the corporation.

The main tasks of corporate finance

Capital Budgeting

Capital budgeting involves the long-term investment decision making by analyzing the investment alternatives. For long-term investment, a large amount of money is involved and the project manager has to spend lots of time and effort to execute the project. So before taking any long-term investment decision, it is required to make a capital budgeting. Popular forms of capital budgeting techniques are Net Present value (NPV), Internal Rate of Return (IRR), Pay Back Period (PBP), Profitability Index (PI) and Modified Internal Rate of Return (MIRR).

It is corporate managers responsibility to ensure the right amount of investment in a project by evaluating investment alternatives by using capital budgeting.

Developing Optimal Capital Structure

Another important task is followed in corporate finance is to develop an optimal capital structure for the corporation, that is choosing the right proportion of debt and equity capital. How much capital is to be raised by the debt and how much by equity fund is depends on the company’s financial strength and capability of using its resources. A company may choose fifty percent debt and fifty percent equity capital; 50:50, remember that it is not necessarily that every company use 50:50 debt and equity, a company can choose 30:70 or 40:60, or 60:40, or 45:65 ratio of capital.

Management of Working Capital

Management of working capital is the process of managing the current asset and current liabilities for the company. A corporate finance manager will decide how will he/she ensure the right amount of current asset to pay off the current liabilities. Different option available to pay off current liabilities, it can be paid off from the current asset or from the long-term asset. Whether it is to be from the long term or short term is not a matter but the thing is the cost of pay off the current liabilities. Normal practice by the corporate financial manager is to pay off current liabilities by using a current asset. To ensure a good financial position it is required to have a good working capital management system.