The finance function has to deal with one of the most important decisions regarding the amount to be invested in fixed assets and the decision is technically in the form of “Capital budgeting”. Thus, the capital budgeting decisions are decisions as to whether or not capital should be invested in long-term projects. It includes study of different proposals concerning capital expenses to assess their impact on the financial condition of the business and to select the best out of the different options. The function of finance in this area is to enable the management to take a proper capital budgeting decision.

Capital budgeting decisions are the most crucial and critical decisions for a business to take. This is the fact due to the various reasons.

1.    Capital budgeting decisions have long-term implications on the operations of the business. A wrong decision may affect the long-term survival of the company. The investment in fixed assets more than required, may increase the operating costs of the company. The inadequate investment in fixed assets may make it difficult for the company to compete and may affect its market share.

2.    Capital budgeting decisions involve large amount of the funds. As such, it is necessary to take the decision very carefully and to make the arrangement of the funds for the procurement of these assets.

3.    The capital budgeting decisions are unalterable because it is hard to locate the market for such capital goods. The only alternative is to scrap these assets, which involve huge losses.

4.    Capital budgeting decisions are difficult to make because it involves the assessment of future events, which are difficult to ascertain. The investments are required to be made immediately but the returns are expected over a number of years.

The process of Capital budgeting generally involves project generation, project evaluation, project selection, and project execution.

Limitations of Capital Budgeting

The basic drawback of the capital budgeting process lies in this verity that it entails a variety of estimations. These estimations are specifically in respect of –

a)    Cash outflow.
b)    Revenues/ saving and costs attached with projects.
c)    Life of the projects.