Meaning and Nature of Capital Budgeting

Meaning and Nature of Capital Budgeting

 *Dr.P.Shanmukha Rao  **Dr.N.V.S.Suryanarayana

The term Capital Budgeting refers to long term planning for proposed capital outlay and their financing. It includes raising long-term funds and their utilization. It may be defined as a firm’s formal process of acquisition and investment of capital. Capital Budgeting may also be defined as “The decision making process by which a firm evaluates the purchase of major fixed assets. It involves firm’s decision to invest its current funds for addition, disposition, modification and replacement of fixed assets.

It deals exclusively with investment proposals, which an essentially long term projects and is concerned with the allocation of firm’s scarce financial resources among the available market opportunities. Some of the examples of Capital Expenditure are

    (i) Cost of acquisition of permanent assets like land and buildings.

    (ii)           Cost of addition, expansion, improvement or alteration in the fixed assets.

   (iii)           Research and Development cost of projects.


  “Capital budgeting is long term planning for making and financing proposed capital outlays”.

T.Horngreen “Capital budgeting is concerned with allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with immediate and subsequent streams of expenditure for it”.

In any growing concern, capital budgeting is more or less a continuous process and it is carried out by different functional areas of management such as production, marketing, engineering, financial management etc. All the relevant functional departments play a crucial role in the capital budgeting decision process of any organization, yet for the time being, only the financial aspects of capital budgeting decision are considered to discuss.

The role of a finance manager in the capital budgeting basically lies in the process of critically and in-depth analysis and evaluation of various alternative proposals and then to select one out of these. As already stated, the basic objectives of financial management is to maximize the wealth of the share holders, therefore the objectives of capital budgeting is to select those long term investment projects that are expected to make maximum contribution to the wealth of the shareholders in the long run.

According to Lynch ” Capital budgeting consists of in planning development of available  capital for the purpose of maximizing the long term profitability of the concern”.      

           In the words of Charles T. Horngren  “Capital budgeting is a long term planning for making and financing proposed capital outlays”.

Significance of capital budgeting:

The financial management is essentially concerned with the planning and   controlling of the financial resources of a firm. It expresses the procurement of funds along with their efficient use in order to maximize the firm’s benefit. The assets have two broad classification viz.,

          a) Short term or current assets and

          b) Long term or fixed assets.

Features of Capital Budgeting

The important features, which distinguish capital budgeting decisions in other Day-to-day decisions, are:

  • Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future.
  • The future benefits are expected and are to be realized over a series of years.
  • The funds are invested in non-flexible long-term funds.
  • They have a long terms and significant effect on the profitability of the concern.
  • They involve huge funds.
  • They are irreversible decisions.  They are strategic decisions associated with high degree of risk.

Importance of capital budgeting:

The importance of capital budgeting can be understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the organization. The importance of capital budgeting arises mainly due to the following:

Large Investment

Capital budgeting decision, generally involves large investment of funds.  But the funds available with the firm are scarce and the demand for funds are exceeds resources.  Hence, it is very important for a firm to plan and control its capital expenditure.

Long Term Commitment of Funds

Capital expenditure involves not only large amount of funds but also funds for long-term or an permanent basis.  The long-term commitment of funds increases the financial risk involved in the investment decision.

Irreversible Nature

The Capital expenditure decisions are of irreversible nature.  Once, the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.

Long Terms Effect on Profitability

Capital budgeting decision has a long term and significant effect on the profitability of a concern.  Not only the present earnings of the firm are affected by the investments in capital assets but also the future growth and profitability of the firm depends up to the investment decision taken today. Capital budgeting decision has utmost importance to avoid over or under investment in fixed assets.

Difficulties of Investment Decision

The long terms investment decisions are difficult to be taken because uncertainties of future and higher degree of risk.

Notional Importance

Investment decision though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.


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