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Why are Capital Budgeting Decisions considered important for a firm?
Capital Budgeting Decisions are critical in nature, and they are complex too. Capital budgeting decisions are not taken frequently and since large funds are involved, the decisions must consider the long-term impact on the profitability and cost structure of the firm.
Another important note about capital budgeting decisions is that they are irreversible in nature. Therefore, capital budgeting decisions have to be taken after thorough analysis and research.
The significance of capital budgeting decisions can be categorized into the following five subjects −
Growth
Capital budgeting decisions are important because they extend the growth of a company. The decisions are taken to make the company profitable and they often affect the growth patterns of the company. If the decisions are not meant for growth, then there is no use of capital budgeting.
While a good decision can extend the firm’s future growth, an incorrect capital budgeting decision can have an adverse impact on the growth of a company. So, capital budgeting decisions are significant in terms of the growth of a company.
Risk
Capital budgeting decisions also increase the future risk of a firm. If the decisions increase average earnings but create frequent fluctuations in earnings, it will be riskier in terms of long-term profitability. The firms, therefore, need to consider the risk associated with capital budgeting decisions.
Another reason why risks become a significant point is that capital budgeting decisions involve large funds and since the decisions are taken for the future, it brings enough uncertainty to the table. Therefore, the risk associated with the decisions makes capital budgeting decisions significant for the firm.
Irreversibility
Capital budgeting decisions are taken for the future, and they are irreversible in nature. Even if they are irreversible, they will be enough loss-making. Once taken, the capital budgeting decisions cannot be taken back. That is why, the managers must consider all aspects with respect to the firm’s profitability and growth when they take a capital budgeting decision.
Irreversibility makes capital budgeting decisions less flexible in nature and hence makes them more significant for the firm to consider the long-term effect on the firm’s existence.
Complexity
Capital budgeting decisions are complex in nature as they involve large funds and are made for the uncertain future. Managers need to take many aspects into consideration while making capital budgeting decisions for this reason.
However, whatever the extent of analysis and research done, the decisions are never completely free from flaws. That is why, capital budgeting decisions are also significant for a firm due to their complex nature.
Funding
Capital budgeting involves large funds and hence is costly in nature. Capital budgeting decisions hence are not taken frequently. Moreover, enough research and analysis are needed before committing to the involvement of the funds. As wrong decisions can lead to large losses, capital budgeting decisions are significant for the firm in terms of funding as well.
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