The Importance of Capital Budgeting

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The Importance of Capital Budgeting
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The blood of a business is 'capital'. Just like
human body functions on blood, a business also
functions on capital. When an organization has
capital, it can reach great heights. However, the
capital has to be planned and used well. If the
capital is not invested smartly it would lead to
huge disasters for the organization. A business
house thus invests smartly in different options
like venture capital, mutual funds, etc besides
investing in different projects. Investing in
mutual funds or shares, is only partially in
control of the entrepreneur. However, the
entrepreneur has complete control over one
decision - deciding the projects one wishes to
invest in.
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Every business organization works on different
projects. This diversifies the risk. Working with
only one client or only one project poses high
risk for the organization because the functioning
of the entire organization depends on this single
project. Thus, choosing different projects is
essential for the organization. Again choosing
the right projects that is budgeting the capital
the organization has is essential. This smart
investment of the capital of the organization is
known as Capital budgeting. In other words, the
analysis of the firm's decision of investment is
known as Capital budgeting. Investment of the
organization in big projects, is a very important
decision because these investments are usually
for long term and cannot be reversed easily. The
capital thus gets stuck in these projects for
long and might lead to a negative results for the
organization. Thus, the management of the
organization uses capital budgeting techniques to
determine and choose which of the projects is
more feasible and profitable for the organization.
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Why is this decision critical?The capital
available with an organization is limited. This
is true in case of capital raised through debt or
equity. There is a constraint of capital
rationing in the organizations. Thus, the
investments have to be planned and there are many
factors that help in taking this decision. These
factors are Capital to be invested Rate of
return Expected profit Duration of
investment, etcThus, the management has to be
very careful in deciding whether a particular
project would be actually beneficial for the
organization. Besides, deciding which of the two
given projects is important is also very
important.
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• There are a few techniques that help the
  management in capital budgeting and deciding on
  various venture cpital projects or other
  investments. These techniques are
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
• Payback Period (PP)
• The management usually analyzes every project
  using all these for techniques and the one which
  gets the maximum positive results from all these
  techniques is considered the best project.

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