Why Capital Budgeting? Reasons and Importance

The capital budgeting decisions is crucial, important and critical business decision due to the following reasons-

1)     Substantial expenditure – Capital budgeting decision requires large amount of

Funds, hence decision is to be taken with due diligence and care to ensure that it       does not prove to be too costly or financially unfeasible to the Company.
2) Long term perspective – Capital budgeting projects are generally long lived projects with their benefits or cash flow spreading over many years. Hence the decision not only affects the future benefits and the cost but also the growth of the company. Hence a thoughtful decision should be taken for selecting the project.
3) Irreversibility – Most of the investment decisions are irreversible. Once the investment is made then withdrawing from the project becomes difficult. The firm incurs substantial losses from discontinuing the project. This is because it’s difficult to find a buyer for a second hand project.
4) Complex Decision making – Capital budgeting decisions are generally dependent on future events and future events are very difficult to predict. Because the economic environment is so unpredictable so the cash flows from the project cannot be static.
e.g. A firm deciding to make investment in a gold mine will face the difficulty of determining the exact returns from the project as the gold rates keep changing every minute.

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