Q2. What is meant by capital budgeting? Explain the importance of capital budgeting.
Capital budgeting is the process by which the financial manager decides whether to invest inspecific capital projects or assets. In some situations, the process may entail in acquiring assetsthat are completely new to the firm. In other situations, it may mean replacing an existingobsolete asset to maintain efficiency.According to Larence J Gitman (Principles of Managerial Finance), Capital budgeting is theprocess of evaluating and selecting long-term investments that are consistent with the firms goalof maximizing owner wealth.
Importance of Capital Budgeting
Capital budgeting decisions are the most important decisions in corporatefinancial management.These decisions make or mar a business organization. These decisions commit a firm to invest itscurrent funds in the operating assets (i.e. long-term assets) with the hope of employing themmost efficiently to generate a series of cash flows in future. These decisions could be groupedinto:
• Decision to replace the equipments for maintenance of current level of business or decisions
aiming at cost reductions, known as replacement decisions
• Decisions on expenditure for increasing the present operating level or expansion through
improved network of distribution
• Decisions for production of new goods or rendering of new services
• Decisions on penetrating into new
• Decisions to comply with the regulatory structure affecting the operations of the company, like
investments in assets to comply with the conditions imposed byEnvironmental ProtectionAct
• Decisions on investment to build township for provi
ding residentialaccommodation to employees working in a manufacturing plant The reasons that make the capital budgetingdecisions most crucial forfinance managersare:
• These decisions involve large outlay of funds in anticipation of cash flows in futur
e Forexample, investment in plant and machinery. The economic life of such assets has long periods.The projections of cash flows anticipated involve forecasts of many financial variables. The mostcrucial variable is thesales forecast.