Planning the expenses and revenues and balancing the finances is important for households and business alike. Financial planning is a key factor to the success of any enterprise.
What is Capital Budgeting?
Capital budgeting or investment appraisal is a financial planning process that businesses use to analyze if an investment project is worth pursuing. The decision to implement an investment project or not is based on the merits of the project and involves evaluating the return rate of the investment. Determining the level at which the return rate is acceptable for the business depends on factors specific to the project and company. For instance, in a nongovernmental organization that works on a non-profit basis, a charitable or social project would not be approved based on the investment return rate, but on other specific criteria.
There are more methods used in the investment appraisal process, including Internal rate of return, Net present value, Profitability index, Payback period, Real options analysis, and Equivalent annuity. In a constrained business environment, the decision to select between mutually exclusive projects with the same high internal rate of return may result in selecting a project with a lower Net present value. Another method of analysis for an investment project is the Modified Internal Rate of Return.
Why Is It Important?
Investment appraisal is important because it creates measurability and accountability for the enterprise. Any company that is planning to invest its resources in a project without fully understand the risks and have a prognosis for the expected returns, would be considered irresponsible by its shareholders and owners. If a company cannot measure the results of an investment decision, it might not have chances to survive in the marketplace, which is a highly competitive environment. Aside from nonprofit organizations, companies need to earn profits. The investing appraisal process helps measuring the long-term financial and economic profitability of company’s investment projects. This financial planning is also creating a step-by-step process, enabling the enterprises to achieve several benefits:
1. Investment appraisal helps to set long-term strategic goals, which is essential to the prosperity and growth of any enterprise.
By knowing how to evaluate the investments, businesses have the ability to start new investment projects, which is important for their ability to compete and make profits. Financial planning enables companies to forecast their future cash flows. It helps the transfer of information between different management levels within a company. The budget helps monitoring of expenses required for a project. The financial analysis process helps in taking management decisions that make the company more efficient.
2. Investing appraisal decisions involve not only a singular aspect of a business, but two key decisions at once: an investment decision and a financial decision. The investment decision guides the future growth and direction of the company. The financial decision sets a financial commitment to a certain project and acceptance of the risk involved. This dual decision process with profound significance for businesses involves a great responsibility. There are executives who lost their jobs over bad investment decisions. In a certain way, running a business is nothing more than a constant flow of budgeting decisions.