The method by which a firm evaluates possible significant projects and investments is known as capital budgeting. Capital budgeting is necessary before such a project is approved or denied, such as constructing a new factory or a significant investment in an outside enterprise.
A firm might examine a potential project’s lifetime cash inflows and cash outflows as part of capital budgeting to see if the potential returns produced have reached a sufficient target benchmark. Investment appraisal is another name for capital budgeting.
In an idealistic situation, firms would seek all projects & opportunities that maximize shareholder value and profit. Since the amount of capital/money available for new projects in every firm is limited, managers apply capital budgeting strategies to assess which projects will provide the best return over a given period.
Capital budgeting is essential as it establishes responsibility and quantifiability. Any firm that invests in a project without fully comprehending the risks and rewards will be considered irresponsible by its shareholders. Additionally, if a firm does not have a method to assess the efficacy of its investment decisions, it stands little chance of surviving in competitive markets.
Importance of capital budgeting:
- Assists the company in making long-term decisions and setting long-term objectives.
- It indicates predicted future cash inflows and outflows
- Large sums of money invested by the firm are secured against future uncertainty.
- The company understands the current investment’s future total value and net profitability.
- The shareholders’ confidence grows, and they become more motivated in making investments in the company