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The Importance of Capital Budgeting

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The Importance of Capital Budgeting

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  • July 2008
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Capital budgeting (or investment appraisal) is the planning process used to determine a firm’s expenditures on assets whose cash flows are expected to extend beyond one year such as new machinery, equipments, etc. It is also the process of identifying, analyzing and selecting investment projects whose cash flows are expected to extend beyond one year such as research and development project.

Capital expenditures can be very large and have a significant impact on the firm’s financial performance. Besides, the investments take time to mature and capital assets are long-term, therefore, if a mistake were done in the capital budgeting process, it will affect the firm for a long period of time. Basically, the importance of capital budgeting are as follow:

1) Avoid forecast error

The future success of a business largely depends on the investment decisions that corporate managers make today. Investment decisions may result in a major departure from what the company has been doing in the past. Through making capital investments, firm acquires the long-lived fixed assets that generate the firm’s future cash flows and determine its level of profitability. Thus, this decision greatly influences a firm’s ability to achieve its financial objectives.

For example, if the firm invests too much it will cause higher depreciation and expenses. On the other hand, if the firm does not invest enough, the firm will face a problem of inadequate capacity and thus, lose its market share to its competitors.

2) Helps firm to plan its financing

Proper capital budgeting analysis is critical to a firm’s successful performance because capital investment decisions can improve cash flows and lead to higher stock prices. Yet, poor decisions can lead to financial distress and even to bankruptcy. Although a tactical investment decision generally involves a relatively small amount of funds, strategic investment decisions may require large...

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