Capital Budgeting Meaning, Features, Significance and Limimations | Investment Decisions Meaning, Features, Significance and Limimations

[Meaning of Capital Budgeting or Investment Decision, Nature of Capital Budgeting or Investment Decision, Importance and Limitations of Capital Budgeting or Investment Decision, Financial Management Notes for NEP and CBCS Pattern]

Meaning of Capital Budgeting or Investment Decision

The term capital budgeting or investment decision means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives.

According to Milton “Capital budgeting involves planning of expenditure for assets and return from them which will be realized in future time period”.

According to I.M Pandey “Capital budgeting refers to the total process of generating, evaluating, selecting, and follow up of capital expenditure alternative”

Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate.

Nature / Features of Capital budgeting decisions

a)      Long term effect: Such decisions have long term effect on future profitability and influence pace of firms growth. A good decision may bring amazing returns and wrong decision may endanger very survival of firm. Hence capital budgeting decisions determine future destiny of firm.

b)      High degree of risk: Decision is based on estimated return. Changes in taste, fashion, research and technological advancement leads to greater risk in such decisions.

c)       Huge funds: Large funds are required and sparing huge funds is problem and hence decision to be taken after proper care .

d)      Irreversible decision: Reverting back from a decision is very difficult as sale of high value asset would be a problem.

e)      Most difficult decision: Decision is based on future estimates/uncertainty. Future events are affected by economic, political and technological changes taking place.

f)       Impact on firm’s future competitive strengths: These decisions determine future profit or cost and hence affect the competitive strengths of firm.

g)      Impact on cost structure – Due to this vital decision, firm commits itself to fixed costs such as supervision, insurance, rent, interest etc. If investment does not generate anticipated profit, future profitability would be affected.

Need and Importance of Capital Budgeting

Capital budgeting means planning for capital assets. Capital budgeting decisions are vital to any organization as they include the decisions as to:

a)      Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.

b)      Analyze the proposal for expansion or creating additional capacities.

c)       To decide the replacement of permanent assets such as building and equipments.

d)      To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.

The importance of capital budgeting can be well understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern. The need, significance or importance of capital budgeting arises mainly due to the following:

1)      Large Investments: Capital budgeting decisions, generally, involve large investment of funds. But the funds available with the firm are always limited and the demand for funds far exceeds the resources. Hence it is very important for a firm to plan and control its capital expenditure.

2)      Long-term Commitment of Funds: Capital expenditure involves not only large amount of funds but also funds for long-term or more or less on permanent basis. The long-term commitment of funds increases the financial risk involved in the investment decision. Greater the risk involved, greater is the need for careful planning of capital expenditure, i.e. Capital budgeting.

3)      Irreversible Nature: The capital expenditure decisions are on irreversible nature. Once the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.

4)      Long-term Effect on Profitability: Capital budgeting decisions have a long-term and significant effect on the profitability of a concern. Not only the present earnings of the firm are affected by the investments in capital assets but also the future growth and profitability of the firm depends upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost importance to avoid over investment or under investment in fixed assets.

5)      Difficulties of Investment Decisions: The long term investment decisions are difficult to be taken because (i) decision extends to a series of years beyond the current accounting period, (ii) uncertainties of future and (iii) higher degree of risk.

6)      National Importance: Investment decisions though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.

This, we may say that without using capital budgeting techniques a firm may involve itself in a losing project. Proper timing of purchase, replacement, expansion and alternation of assets is essential.

Limitations of Capital Budgeting

Capital budgeting techniques suffer from the following limitations:

1) The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obliviously the results based upon wrong data may not be good.

2) The economic life of the project and annual cash inflows are only estimation. The actual economic life of the project is either increased or decreased. Likewise, the actual annual cash inflows may be either more or less than the estimation. Hence, control over capital expenditure cannot be exercised.

3) Capital budgeting process does not take into consideration of various non-financial aspects of the projects while they play an important role in successful and profitable implementation of them. Hence, true profitability of the project cannot be highlighted.

4) All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not be practically true in some particular circumstances.

5) There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.

6) It is also not correct to assume that mathematically exact techniques always produce highly accurate results.

7) In case of urgency, the capital budgeting technique cannot be applied.

8) Only known factors are considered while applying capital budgeting decisions. There are so many unknown factors which are also affecting capital budgeting decisions. The unknown factors cannot be avoided or controlled.