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What Is the Importance of Capital Budgeting?

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  • Written By: Osmand Vitez
  • Edited By: PJP Schroeder
  • Last Modified Date: 05 September 2016
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In business, a capital expenditure is a large use of cash for an item or project that a company expects will add value to the business in the future. In most cases, the capital expenditure falls under the company’s capital budgeting process. The importance of capital budgeting is to ensure a company has the ability to pay for the new item or project without cutting off funds for other current business activities. A corporate finance department or managerial accountants are the sources a company can use to calculate costs and potential revenues under capital budgeting procedures. Three activities fall under the importance of capital budgeting: identifying the cost for new opportunities, creating a capital budget, and finding sources of external sources, if necessary.

The cost of new items, projects, or opportunities is generally the focus of corporate finance departments and managerial accountants, among other things. The importance of capital budgeting in identifying costs for new opportunities is to ensure a company will not sacrifice successful business operations for potentially unprofitable ones. Costs can vary widely from project to project and include items such as direct materials, labor, and new fixed assets for completing the activities associated with a new opportunity. Once a company has all the associated costs with a project, it can review the potential income that may come from the new business opportunity. A review of costs versus income is the next phase in the role of capital budgeting.

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Creating a capital budget for each new project or opportunity is the crux of capital budgeting. The importance of capital budgeting here is to look at the bottom line for each project rather than the intangibles for each. The budget usually includes a line for each cost to start the project, with a total of all costs at the bottom. Next, the company may list any current funds the business has on hand to devote to starting the new projects. In some cases, a company may not fund the project entirely through internal funds, leaving some funds necessary from outside sources.

External funds are almost always necessary in capital budgeting. The difference between expected starting costs and internal funds appropriated for the project represent the amount of funds needed from debt or equity. The importance of capital budgeting here is to find the sources of external funds that have the lowest cost of capital. Low interest rates on debt and equity make capital expenditures more profitable. This is important for companies starting new projects.

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