The Importance of Capital Budgeting
                     THE IMPORTANCE 
OF CAPITAL 
BUDGETING
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.
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. 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.
Why is this decision critical?
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:
· Capital to be invested
· Rate of return
· Expected profit
· Duration of investment, etc
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.
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:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Payback Period (PP)
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.
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