Efficient allocation of the financial resources of a firm is an imperative necessity for the efficient functioning of a firm. The firm’s investment decisions involve decisions regarding long-term capital assets such as land, buildings, equipment and more. The investment on these assets is considered very important because it enables an organization to make profits. It, therefore, follows that the future development of a firm could, to a large extent, depend on effective selection of capital investment projects.
Capital budgeting is the process of making investments in capital expenditure. Capital expenditure refers to that expenditure the benefits of which are expected to be received over a period of time, especially exceeding one year. The chief characteristic of capital expenditure is that expenses are incurred all at one point in time, whereas the benefits are realized in the future. Capital expenditure decisions are also called long-term investment decisions.
Some of the examples of capital expenditure are cost of acquiring permanent and long-term assets like plants and machinery, cost of additions, expansions, improvement or alterations in fixed assets, and research and development costs. Capital budgeting implies the firm’s decision to invest its current funds most efficiently in the long-term activities, in anticipation of an expected flow of benefits over a long period of time. The long-term activities include: searching for new and more profitable investment proposals, investigating engineering/ marketing considerations and making economic analyses to determine the profit potential of investment proposals.
The decisions concerning capital budgeting are crucial because they are long-term oriented and irreversible in nature. The efficient running of a firm is reflected by the way decisions are made for the effective utilization of the firm’s financial resources. Such capital budgeting decisions are considered to be of paramount importance, because they can affect the working of a firm.