Importance Of Capital Budgeting

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Corporate organizations have strategic growth plans like attaining a particular market share , attaining a revenue figure or achieving geographical business coverage and even a strategic partnership like merger and acquisitions . All these goals or strategies are futuristic and have financial implications to the firm. Capital budgeting is the process of identifying and evaluating capital project in order to accept or reject the project. The process can be summarized into ; 1) Idea generation, 2) Project appraisal , 3) setting of project priorities and 4) monitoring and control CAPITAL BUDGET PROCESS For a number of reasons detailed below , Capital Budgeting is the most important function of financial manger as : 1. Most capital…show more content…
Firstly, most decision to do a project needs to align with organization corporate goal. Business owners /managers usually have a long term view (Corporate Strategy) or picture of what they want their business to attain in many years to come and at one point or the other over the years have taken informed decisions to attain the set objective. This implies that before taking such decisions, the manager’s or business owner needs to do a SWOT (Strength, Weakness, Opportunity & Threat) analysis of the project in line with the objective and strategy of the company. The implication of this is that some projects may not be executed regardless of the financial gains if it is not in line with business long term goal. EXTERNALITIES /CARNIBALIZATION Investment decisions sometimes are made to break business frontiers. It may also be with a view to enter a new market or new product line or attract new customers. If opportunities that abound in taken the investment decision may impacts business negatively or slows down other business line which the company is not willing to compromise, then such project may not see the light of the day . An example is when a soft drink company introduces a diet version of an existing beverage that may cause low sales of the existing product ENVIROMENTAL…show more content…
Reinvestment rate is determined by the prevailing market rates. • Payback period is a measure of liquidity , the shorter the pay back , the better . The major limitation of this technique is that it does not take into cognizance time value of the money and disregard period beyond the payback period. This means that once the revenue or cashflow is able to cover the initial cost every other revenue from the project is not important and that investment salvage value in future is not relevant. This method too i s not consistent with the goal of shareholder wealth maximization • The cash flows in capital budgeting are only projections and most painted as given meaning the cash flows as projected is certain . sometimes forecast cash flow may not be received and it may be higher than forecast . Market sentiments and economic reality may cause a wide gap between forecast and actual cash flows , though mitigated by discounting the cash flow to reflect fair valuation .

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