Capital budgeting is the process of making investment decisions in capital expenditures. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year.
The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. In simple language we may say that a capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future.
Need and Importance of Capital Budgeting:
(a) Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.
(b) Analyze the proposal for expansion or creating additional capacities.
(c) To decide the replacement of permanent assets such as building and equipment’s.
(d) To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.
Limitations of Capital Budgeting:
(1) All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances.
(2) The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obliviously the results based upon wrong data may not be good.
(3) There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.
(4) Urgency is another limitation in the evaluation of capital investment decisions.
(5) Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.