Wednesday, February 13, 2013

Limitations of capital budgeting

Capital budgeting refers to budgeting of capital expenditure. Long term planning and control of capital expenditure is called capital budgeting. According to R. M Lynch, ‘Capital budgeting consists in employment of available capital for the purpose of maximizing the long term profitability of the firm.” Capital budgeting is the process of analyzing alternative proposals and deciding whether not to commit fund to a particular investment proposal (long term project) whose benefits are to be realized over a period of time longer than one year. It is the total of generating, evaluating, selecting, and following up of capital expenditure alternative. Capital budgeting is concerned with heavy expenditure decisions. The benefits or returns from such expenditure are expected to be derived over many years in future. Success or failure of any business depends upon the quality capital budgeting. The limitations of capital budgeting are discussed under.

    The estimate of profitability of investment proposals is not accurate because they relate to future uncertainties. A sudden loss in any area of business will influence the return. This results in the profitability of the firm.  Capital budgeting is very complicated process because it is difficult  to estimate the cost of capital and to estimate the rate of return. Once the return is estimated a finance manager can find out within what time the investment can be reimbursed. So this is very difficult to calculate the return on investment. The cost incurred and benefits received occur at different time periods. Here arises the problem of time value of money. So the cost and benefits cannot be logically comparable. An investment made today is having a time value less than that of in future. So the return in the future period cannot be compared the investment made today. A man invests 10000 today in a business and he earns 2500 yearly. The time value of 2500 rupees may reduce to 2400 in the coming year. When we calculate the payback period, we find it difficult find an accurate period for reimbursing the initial investment.

  There are immeasurable considerations such as employee welfare, reputation of the firm etc. This is the area where the financial managers cannot forecast and foresee. This is a hidden cost which arises when the business starts functioning. This is a must for the business to run. Sometimes there will be huge cost may arise.  Capital budgeting is an irreversible decision. Once taken is taken, it cannot revert. If it is reverted, there occurs a huge loss. A business proposal starts with huge initial investment is a crucial decision for Enterprise. Once it is taken nobody can come back to the past. Whatever the consequence on the investment done has to be faced. Coming back to the past or in initial stage arises a huge loss. 

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