What is Capital Budgeting?
Capital Budgeting Process is a business decision-making process that determines which capital-intensive initiatives should be undertaken. Capital-intensive initiatives include opening the new factory, expanding the workforce, entering a new market and developing new products.
The company’s strategy for evaluating such expenditures determines whether they are considered worthwhile. However, it is the process by which a company analyses potential of large projects or investments.
Above all, it is required before a project is approved or rejected, such as the construction of a new plant or a large investment in an external venture.Moreover, it is used to make long-term investment decisions about whether specific projects will result in sustainable growth and the potential return.
Features of Capital Budgeting
The Capital budgeting features are as follows:
1) The time lag between initial investments and expected returns is considerable.
2) Organizations typically estimate large profits.
3) The procedure is fraught with danger.
4) It is a long-term fixed investment.
5) Investments in a project determine an organization’s future financial position.
6) All projects require a significant amount of funding.
7) The amount of money invested in a project determines a company’s profitability.
Objectives of Capital Budgeting
The following points summarizes its objectives:
Capital Expenditure Management:
Firstly, organizations must estimate the cost of investment in order to control and manage the necessary capital expenditures.
Choosing Profitable Projects:
Secondly, the company must choose the most appropriate project from the many options available to it.
Identification of Source Of funds:
Finally, businesses must identify and select the most viable and appropriate funding source for long-term capital investment. It must compare various costs, such as borrowing costs and expected profit costs.
Factors affecting Capital Budgeting Decisions
Each project will involve a different amount of investment. Certain initiatives are expensive and have a high profit margin. However, such initiatives may be neglected if the corporation lacks sufficient funds.
2. Minimum rate of return on investment is required:
On capital investments, each management team expects a minimum rate of return or break-even point. Moreover, it denotes the point at which a project is considered unachievable.
3. Cash Inflows:
Earnings after taxes but before depreciation are referred to as cash inflows. This is because depreciation is recorded as a book item with no associated cash outflow. As a result, depreciation is included in into the cash inflow.
4. Legal Commitments:
Management should keep legal obligations in mind when selecting a project. Several legislative restrictions have been imposed in the leather and chemical industries to protect the environment from pollution. Above all, Legal provisions are now considered more important by management than cost and profit.
5. Research and Development Projects:
Research and Development projects are vital for technology-based businesses. This is due to the rapid development of technology in a short period of time. In addition, in Long term, the Development and Research effort generates greater benefits. Thus, in the case of Research and Development projects, profitability is put second to corporate survival.
In Conclusion, Capital Budgeting Financial Management: a planning process used for long-term investment decision making, such as whether the projects are productive for the business and will provide the required rate of return in the future years or not. In addition, it is important because capital expenditure requires a large amount of funds. Thus, companies must ensure themselves that the spending will bring profits to the business prior to actually making such capital expenditure.
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