Financial Management

Introduction of Capital Budgeting : Importance and

Limitations

What is Capital Budgeting?

Capital budgeting is a process of evaluating investments and huge expenses in
order to obtain the best returns on investment.
An organization is often faced with the challenges of selecting between two
projects/investments or the buy vs replace decision. Ideally, an organization
would like to invest in all profitable projects but due to the limitation on the
availability of capital an organization has to choose between different
projects/investments.
Capital budgeting as a concept affects our daily lives. Let’s look at an example-
Your mobile phone has stopped working! Now, you have two choices: Either
buy a new one or get the same mobile repaired. Here, you may conclude that the
costs of repairing the mobile increases the life of the phone. However, there
could be a possibility that the cost to buy a new cell phone would be lesser
than its repair costs. So, you decide to replace your cell phone and you proceed
to look at different phones that fit your budget!
IMPORTANCE OF CAPITAL BUDGETING

LONG-TERM GOALS

For the growth & prosperity of the business, long-term goals are very important
for any organization. A wrong decision can be disastrous for the long-term
survival of the firm. Capital budgeting has its effect in a long time span. It also
affects companies future cost & growth.

INVOLVEMENT OF A LARGE NUMBER OF FUNDS

Capital Investment requires a large number of funds. As the companies have

limited resources, the company has to make a wise & correct investment decision.
The wrong decision would harm the sustainability of the business. The large
investment includes the purchase of an asset, rebuilding or replacing existing
equipment.

IRREVERSIBLE DECISION

The capital Investment decisions are generally irreversible as it requires large

amounts of funds. It is difficult to find the market for that asset. The only way
remains with the company is to scrap the asset & incur heavy losses.

MONITORING & CONTROLLING THE EXPENDITURE

Capital budget carefully identifies the necessary expenditure and R&D required
for an investment project. Since a good project can turn bad if expenditures aren’t
carefully controlled or monitored, this step is a crucial benefit of the capital
budgeting process.

TRANSFER OF INFORMATION

The time that project starts off as an idea, it is accepted or rejected; numerous
decisions have to be made at a various level of authority. The capital budgeting
process facilitates the transfer of information to appropriate decision makers
within a company.

DIFFICULTIES OF INVESTMENT DECISION

The long-term investment decisions are difficult because it extends several years
beyond the current period. Uncertainty indicates a higher degree of risk.
Management loses his flexibility and liquidity of funds in making investment
decisions so it must consider each proposal very thoroughly.

MAXIMIZATION OF WEALTH

Long-term investment decision of the organization helps in safeguarding the

interest of the shareholder in the organization. If the organization has invested in
a planned manner, the shareholder would also be keen to invest in that
organization. This helps in the maximization of wealth of the organization. Any
expansion is fundamentally related to further sales and future profitability of the
firm and asset acquisition decisions are based on capital budgeting.

Limitations of Capital Budgeting :

Time Value
One of the most common capital budgeting methods, particularly among small
businesses, is the payback period method. It simply requires that a project's
forecast cash flows repay its investment within a set amount of time. Say you
require payback within five years. If a project has $45,000 in up-front costs and
estimates cash flows of $10,000 a year for five years, this project meets your
criteria. The problem is that this method doesn't account for the time value of
money -- the fact that equal sums of money at different points in time have
different values based on a number of factors. If you had to borrow the money
for the project at 4 percent annual interest, for example, you actually would lose
money, and inflation would add losses on top of that. Other capital budgeting
methods consider these issues, but they, too, have limitations.

Discount Rates
Capital budgeting methods that attempt to account for the time value of money
do so by figuring your cost of capital -- the annual rate it will cost you to
finance a project, either by borrowing the money and paying interest or using
your own money and not earning a return on it somewhere else. Figuring the
proper discount rate, as it's called, is yet another challenge. Even if you peg it
fairly accurately, there's always a chance that interest rates will rise or
something else will happen to increase your cost of capital down the road,
reducing the real value of those future cash flows. If you get the discount rate
wrong to start with, your yes-or-no decision on pursuing a project will be based
on a flawed assumption.

Cash Flow
The single most important step in capital budgeting is also the most difficult to
get right: forecasting the cash flows a project will produce. Capital budgeting is
simply the process of determining whether the increased revenue from a project
justifies the investment required, but that future revenue is only your best
estimate. Even up-front costs, which are more immediate and therefore easier to
forecast, are still only estimates at this stage. Overestimate revenue or
underestimate costs, and a project that looks profitable could become a money-
loser. Underestimate revenue or overestimate costs, and you might end up
rejecting a project that would have proved profitable.

Time Horizon
Forecasting cash flows gets increasingly difficult the farther into the future you
go. You can make predictions based only on what you know right now. As you
expand the time horizon for a capital project, the likelihood rises that between
the time you get started and the time you expect to be reaping the benefits, some
disruptive event will change your operating environment. Unforeseen
competition, legal and regulatory changes or technological innovations can
affect the ultimate success of your project, yet they may be impossible to
consider in your capital budgeting process. At the same time the most ambitious
projects -- the ones that truly can take your company to the next level -- may
take years to develop. As is often the case in finance, getting the reward requires
taking the risk.