Capital Budgeting - Research Paper Example

Capital budgeting is a resource allocation process that requires a balance between three factors, which include amount of resources that are to be expended, rate of utilization of those resources, and the time within which the investment starts showing some return in the form of profit. The basic aim of this report is to provide an in-depth understanding of important issues related to capital budgeting. The report also demonstrates the role of capital budgeting in the process of business development.

Importance of Capital Budgeting Morgan (2006) states, “The success of a business depends on the capital budgeting decisions taken by the management”. Capital budgeting is basically a tool to evaluate, analyze, compare, and select the most appropriate project from a list of projects available for investment. Capital budgeting is one of the most important managerial tools, which helps the managers choose among different projects based on cash flows and rates of return. The managers choose those projects for investment, which are likely to generate considerable profits for their companies.

In an interview with Mr. Darren Sammy, assistant manager finance department of Covrick Business Solutions, Sammy said that capital budgeting, if done properly, not only strengthens the financial position of the investing companies but also plays its role in strengthening the economy of a country as a whole (D. Sammy, personal communication, February 25, 2011). One can know the importance of capital budgeting by the fact that it increases a company’s credibility and profits by assisting the managers in the selection of most suitable investment opportunity for the company.

Capital budgeting also helps the companies get considerable benefits from an investment over time, reduce the risks related to capital shortage, and increase the revenues. Three Important Factors There are some factors, which the companies need to consider while creating a capital budget for any specific project. Tatum (2011) asserts, “In order for the capital budgeting for a project to be attractive, the projections have to indicate several factors that will make up the outcome of the project”.

Those factors include time needed to recoup the allocated resources, expected generation of revenues from the project, and amount of resources required to sustain the project’s momentum. It is a fact that a company, which recoups all allocated resources within a reasonable amount of time, enjoys more profits from the venture as compared to those companies which are not able to recover their investments in a short time. Capital budgeting for a project is successful if the project continues to generate profits for a long time.

The graph of profitability generated from a selected project should continue to rise before leveling out, and this can only happen when the amount of resources required to sustain the project’s momentum are less than the amount of resources allocated to the project at the point of launch. Capital Budgeting Process Having discussed the importance of capital budgeting in the businesses and the considerable factors for budgeting, let us have a look at the capital budgeting process. The capital budgeting process helps managers select the most profitable projects from a pool of projects, time the projects’ expenditures, and include the selected projects into a