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The Importance of Capital Budgeting

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                <p>The blood of a business is ‘capital'. Just like
human body functions on blood, a business also functions on capital. When
an organization has capital, it can reach great heights. However, the
capital has to be planned and used well. If the capital is not invested
smartly it would lead to huge disasters for the organization. A business
house thus invests smartly in different options like venture capital,
mutual funds, etc besides investing in different projects. Investing in
mutual funds or shares, is only partially in control of the entrepreneur.
However, the entrepreneur has complete control over one decision –
deciding the projects one wishes to invest in.</p>
<p>Every business organization works on different projects. This
diversifies the risk. Working with only one client or only one project
poses high risk for the organization because the functioning of the
entire organization depends on this single project. Thus, choosing
different projects is essential for the organization. Again choosing the
right projects that is budgeting the capital the organization has is
essential. This smart investment of the capital of the organization is
known as Capital budgeting. In other words, the analysis of the firm's
decision of investment is known as Capital budgeting.</p>
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<p><strong>Investment of the organization in big projects, is a very
important decision because these investments are usually for long term
and cannot be reversed easily. The capital thus gets stuck in these
projects for long and might lead to a negative results for the
organization. Thus, the management of the organization uses capital
budgeting techniques to determine and choose which of the projects is
more feasible and profitable for the organization. </strong></p>
<p><strong>Â </strong></p>
<p><strong>Why is this decision critical?</strong></p>
<p><strong>The capital available with an organization is limited. This is
true in case of capital raised through debt or equity. There is a
constraint of capital rationing in the organizations. Thus, the
investments have to be planned and there are many factors that help in
taking this decision. These factors are:</strong></p>
<ul>
<li><strong>·        </strong><strong>Capital to be
invested</strong></li>
<li><strong>·        </strong><strong>Rate of
return</strong></li>
<li><strong>·        </strong><strong>Expected
profit</strong></li>
<li><strong>·        </strong><strong>Duration of investment,
etc</strong></li>
</ul>
<p><strong>Thus, the management has to be very careful in deciding
whether a particular project would be actually beneficial for the
organization. Besides, deciding which of the two given projects is
important is also very important. </strong></p>
<p><strong>There are a few techniques that help the management in capital
budgeting and deciding on various venture cpital projects or other
investments. These techniques are:</strong></p>
<ol>
<li><strong>1.       </strong><strong>Net Present Value
(NPV)</strong></li>
<li><strong>2.       </strong><strong>Internal Rate of Return
(IRR)</strong></li>
<li><strong>3.       </strong><strong>Profitability Index
(PI)</strong></li>
<li><strong>4.       </strong><strong>Payback Period
(PP)</strong></li>
</ol>
<p><strong>The management usually analyzes every project using all these
for techniques and the one which gets the maximum positive results from
all these techniques is considered the best project. </strong></p>
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posted:11/17/2011
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