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 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, the involvement of a large amount of money, and the 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:
- Identify available project which may have future prospects.
- Calculate the amount of fund required to be invested (Outflow) for different projects
- Calculate all expected benefit will receive within the project tenure
- Conducting cost-benefit analysis
- Compile all the results of the analysis
- Evaluate each of the alternatives
- For single project selection, select the best one from the alternatives, and for multiple projects, select the most beneficial project.
- 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 the 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 in Corporate Finance
- Investment of a Large Amount of Money
- Long-Term Investment
- The probability of Incurring Enormous Loss
- Evaluation of Available Investment Alternatives
- Selection of Right Investment
- 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 on the wrong investment. Capital budgeting is one of the popular tools to evaluate investment alternatives to a large amount of money.
In the case of long-term investment, precautions must be taken because from the long-term investment we expect long-term benefits and money will be stuck for a longer period. There is less flexibility in the 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 in the right amount in the 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 the right investment for his firm, which has a good potentiality of bringing benefits 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 investments. 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.