The Importance of Capital Budgeting

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The importance of capital budgeting cannot be exaggerated. Some of the reasons for this importance are mentioned below:

• Capital budgeting involves a greater amount of risk on account of unforeseen situations. Capital is generally invested with the expectation of future benefits which are likely to accrue over a long period of time. Therefore, a right decision has to be taken to ensure a favorable impact on the profitability and competitive position of the firm.

• Capital budgeting decisions are not easily reversible within a short period. Therefore, if a wrong decision is taken, it can lead to a heavy capital loss. In other words, if the firm allows the project to be completed, it will have to pay the penalty for a wrong decision for a longer period of time. But in case of areas like inventory control and credit control, even if an adopted policy is found to be wrong and undesirable, the same can be rectified within a short period. If a firm takes a number of wrong decisions, it would have a damaging impact on the viability of the firm. So, investment proposals should be properly taken.

• Investment decisions usually involve large amounts that remain blocked throughout the lifetime of the project. Apart from the long term capital investment, the necessary working capital support must also be ensured. In most of the cases, the supply of capital is not in abundance and, therefore, restraint has to be exercised in selecting investment proposals. It should be emphasized that whatever may be the source, it is not cost free. Therefore, during the selection of the investment proposals, the risks in terms of the supply of capital should be reduced as far as possible. This implies ensuring a regular return from the project, which should be reduced as far as possible. This implies ensuring a regular return from the project, which should be equal to or higher than its cost and, secondly, the recovery of capital invested during the lifetime of the project.

• It...
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