Role Of Capital Budgeting In Financial Decision-Making

(role of capital budgeting in financial management, cost of capital in financial management)

The very definition of capital budgeting emphasizes its importance in every financial decision-making process. Capital budgeting is a systematic process used to critically analyze and evaluate the merits and demerits of an investment plan. Hence, any decision, whether to accept or reject any part of the proposed investment plan is important, as it will affect the growth of the business.

Capital budgeting can be and should be applied to all businesses, irrespective of whether it is a private limited, public limited, voluntary, profit organization, not-for-profit organization, franchise, or others. This is because it not only gives a quantitative measure of the business’ future successes but it also gives an estimate of the value earned from the intangible assets that a business will need to accomplish in order to sustain.

How does Capital Budgeting help?

  1. It gives an exact idea of the rate of return that a particular investment plan will generate. In cases of not-for-profit organizations or other charitable activities, the rate of return will be measured against its intangible values such as public satisfaction, people’s goodwill, and others.

  2. It is the best way to track, measure, and account for any activity that involves the flow of money.

  3. It gives a better understanding of the different areas of risk that an investment plan will encounter in its due course.

  4. It also calculates the feasibility of a project before its launch, thus it is best to carry out capital budgeting at the start to estimate the profitability of any investment project.

  5. It is a good way to assess the effectiveness of all the decisions made during the investment plan and evaluate its effectiveness for future decisions.

  6. It helps in deciding the financial profitability and in preparing strategic goals for the investment option both in short and in long-term.

  7. It helps with decisions regarding new investment options, its evaluation, and preparation of the business model.

  8. Capital budgeting can be considered as an excellent tool to predict future cash flows and this, in turn, helps in deciding whether to accept an investment project or not.

  9. Based on the estimates and outcomes from a capital budget, decisions are made at different hierarchical and authoritative levels, thus enables the flow of information within an organization.

  10. Organisations are in a better position to make decisions regarding project approvals when the capital budget is in order.

Thus, it is evident that capital budgeting helps with both financial decisions and investment decisions.