Capital Budgeting – by Shatakshi Bhargava

Organizations (except Not-For-Profit-Organizations) work with the sole purpose of maximizing their profits. Though investment projects (long run generally) are the major source of profits, firms do not invest in all the projects available to them. They evaluate the opportunities in the market and then decisions are taken. This process of deciding whether a firm’s long run investment is worth pursuing or not is called ‘capital budgeting’. Since these investments are financed by firm’s capital, the firm would be willing to take up only those projects that are expected to increase market value of firm’s shares in the long run. Capital budgeting is popularly referred to as investment appraisal.

Evaluating and analyzing any investment project deals with cost of the project and cash flows regarding the same. Such projects are funded through equity capital, debt capital, bank loans and firm’s retained earnings. But the firm must ensure that the quantum of interest on borrowings should be relatively less than the expected (forecasted) rate of return. The firm must also give weights to the projects, the firm might pursue and should implement the one that has the highest weight (the one which is  financially rewarding). The firm is also expected to select the project that involves minimum cost. This would help the firm to select the most optimal investment strategy.

Factors like cash liquidity, rate of return, risk involved, size of the firm, economic value of the project and its need, taxation policy, government policy, economic and political situation within the country, etc  affect the decision making process the most. Since investment projects involve huge cash outflow (initially) and high risk, a firm must be careful while undertaking any such project and must consider all the relevant factors that influence it. Firm’s future is at a stake before any kind of return is guaranteed. There is uncertainty, affecting the profitability of the firm, and most importantly, long term investment decisions are irreversible. Hence, there is a need for capital budgeting.

Click here for government certification in Accounting, Banking & Finance