Importance of Capital Budgeting

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  • Involves commitment of huge financial resources

The capital investment involved is usually very large. It will have several far-reaching implications on the activities of business and may even seriously affect the very financial or flexibility of the business. It is these implications which make capital budgeting so important.

  • Wrong sale forecast may lead to over-or under-investment of resources

It shows the possibility of expanding the production facilities to cover additional sales shown in the sales forecast. In fact the economic life of the asset acquired represents an indirect sales forecast for the duration of its economic life. Any error in this record may result in over-or under-investment in fixed assets, i.e., excess production capacity or inadequate capacity. It also enables the cash forecast to be completed.

  • Leads to better timing of assets

Capital budgeting may allow alternative forms of assets to be considered as replacement for assets which are wearing out or are in danger of becoming obsolete in other words, it would lead to better timing of asset purchases and improvement in quality of assets purchased. It helps to match efficiently the need for capital goods with their availability. It also assists in formulating a sound depreciation and asset replacement policy.

  • It ensures the selection of the right source of finance at the right time.

Capital expenditure decisions involve substantial funds which may not be immediately, and automatically available. A well – established capital budget would enable the management to decide in advance the source of finance and ensure their availability at the right time.

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