Getting capital budgeting for your business is an important decision that one needs to take. It involves lots of funds and the process is irreversible. Thus one should be careful and calculative when taking this decision.
The significance of doing capital budgeting
- Capital budgeting is an important tool in the field of financial management
- It helps the financial managers to evaluate the different projects and also the viability in taking on these huge investments
- It helps to expose the owner to the risks and if there is any uncertainty in the different projects.
- It helps to keep check if the expense is more or less than required
- The management is given with an effective control on what the cost involved in the capital investment project is
- The business fate is based on how the resources are utilized optimally
The decision of opting for capital budgeting
The main reasons why one needs to do capital budgeting is to maximize the profit. This can be done through two ways that are either by increasing the revenue or by reducing the cost. The increase in the revenue can be done by expanding the operations and this is done by adding a new product line. The method of reducing cost is to represent the obsolete return on the assets.
Accepting or rejecting a decision – If the proposal gets accepted then the business will invest in it. Alternatively, the proposal gets rejected then the firm stays away from that investment. The acceptance of a proposal is decided based on a rate of return that it yields. It should be greater than the required rate of return or the cost of capital. If it is lower, the proposal gets rejected. All the independent projects get accepted because the independent projects have no competition.
The projects that are mutually exclusive will compete with one another in a way such that the acceptance of one project will excel accepting the other project. Only one of the projects can be chosen. The mutually exclusive investment decision gain a lot of importance when one or more of the proposal gets accepted. When the best alternative is accepted then the other alternatives get eliminated.
In a case when the business has fewer funds then capital budgeting is straightforward. In this, the investment proposal that gives a return that is greater than some predetermined return gets accepted. But however, the actual business could have a different picture. The business could have some fixed capital budget and there could be many investment proposals that would be competing for the same. Capital rationing is when the firm has a number of acceptable investments that required greater finances than what is available in the firm. The investment is ranked based on the predetermined criteria which include the rate of return. The project that has a higher rate of return is given priority.