Capital Budgeting

Capital budgeting is a process of planning that is used to ascertain the long-term investments of the firm. The long-term investment of a firm may be for new machinery, new plants, replacement machinery, new products and the research and development projects.

Judging the capital requirement of a business is the most important step while raising the fund or capital for a business. A part of the collected capital is generally used for capital investment by the business while a substantial part is kept as working capital. The major purpose of capital budgeting is to recognize and also prioritize the capital investments on the basis of maximum returns to the business.

Capital budgeting can also be considered as a managerial tool required for managing the collected capital of the business. The core responsibility of the financial managers is to choose the investments in a way so as to generate good rates of return. Hence, this is the job of the financial manager to decide whether a particular investment should be included in the portfolio or not.

This entire task is called capital budgeting. The financial manager needs to have a sound knowledge on evaluating, selecting and comparing projects.

The concept of capital budgeting gives immense importance on the project selection of a business. This is because the business is experiencing capital expenditure on every project that is generating cash flow in the future. If the capital expenditure is large, proper capital budgeting should be used to ensure future earning of the business.

Some of the major techniques of capital budgeting are

  • Net Present Value
  • Internal Rate of Return
  • Profitability Index
  • Equivalent Annuity
  • Modified Internal Rate of Return

The capital budgeting process faces some constraints also. The capital that is collected by the business may be limited and hence limits the choice of capital budgeting. The concept of project ranking should be used in capital budgeting. This is a process of allocating the capital in projects in a way that makes sure that the maximum possible returns can be generated.

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