Importance Of Capital Budgeting

Capital Budgeting

Before making a long-term investment, a company has to plan and analyse its long-term investments which called Capital budget. Capital budget may be defined as the process of evaluating and selecting the long-term investment that are consistent with the company goal which is maximize the shareholders’ wealth. Capital budget also known as investment appraisal need to be consider before making any investment decision because the capital of the company is limited. Due to invest in the long-term investment consume a long period of time, the company should deliberate it business operation cash inflows and outflows in order to determine whether the potential returns generated meet a sufficient target within the fewer project.

Importance

Large Amount of fund in Capital Budgeting: Funds are limited and opportunities are abundant. Capital investment involve commitment of large amount of money, if funds are committed into one project, the company may forgone other project. Thus, prepare a great planning before invest is necessary. ii. Irreversible decisions in Capital Budgeting: Capital budgeting decisions in most of the situations are irreversible because it is difficult to find these assets due to these are no a ready market. The only way out will be scrap the capital assets so acquired and incur heavy losses. iii. Risk and uncertainty in Capital budgeting: Capital budgeting decision is surrounded by great number of uncertainties. Investment is present and return is future. The future is uncertain and full of risks. Longer the period of project, greater the risk and uncertainty. As the future is uncertain, company can’t guarantee the amount of return still remain the same.

Type of investment

This is suitable for the company to measure their cash flows if invest in certain project whether won’t affect their daily business operation or cause shortage of cash in business operation. And it also can truly measure the total cash flows arising during the life of project and calculate accurate profitability of the project. But, in the reality, it is difficulty obtain the accurate cash flows due to the uncertainty of future. Thus, alternative the project’ NPV is very high, but the firm has limit funds, frim would not select this project due to higher commitment to undertaking the project.

Last but not least, Internal rate of return (IRR) is another discounted cash flow technique which is discount rate that cash inflows of a project, produces a zero net present value. The criteria of accept and reject is if the IRR is greater than the cost of capital, the project would accept and the excess amount will give to the shareholders as a return.

The advantages using IRR are it recognize the time value of money. And it based on cash flows basis, no accounting profits. This will help the company evaluation the approximate or nearest rate of return. The drawback of IRR are it too complicated to calculate. This method may produce different rates of return that cause confusing for taking