How should a company decide whether to invest in a project or not? Various techniques are available to do this, jointly known as Capital Budgeting. Some commonly known techniques are Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, etc.

Tere are certain long term projects that a company undertakes, usually involving a term period of more than a year, such as setting up a new plant, investing in R&D, launching a new product line, expenditure on an advertisement, construction of a new building, purchase of new plant and machinery, etc.

These projects involve a huge outlay of expenditure and fetch returns for several years down the line. As such, before deciding whether to invest in these projects and further, where to source the funds from, the firm needs to undertake due diligence about the profitability of the investment. This is where capital budgeting techniques help.

Now, every coin has two sides, and thus, capital budgeting techniques have both advantages and disadvantages. Let us first discuss the benefits of capital budgeting. Since the investments to be made are long-term and with huge expenditure, they involve a lot of risks, and in case of failure, the loss will be huge. Capital budgeting techniques help in understanding the costs and benefits, the risks and effects of the investment. The firm will consider all possible factors, such as costs, the risk involved, probability of success, discount value for future gains, the situation of the economy today and in the future, to construct forecasts about the profitability of the project. As such, the firm will make an informed and wise decision, and choose the project that is optimal for the firm.

In a competitive economy, it is necessary for a firm to choose its investments wisely, or it risks being overtaken by smarter and more efficient firms. The use of capital budgeting techniques allows the firm to control over-expenditure, as well as avoid under-expenditure. Thus, it maximizes shareholder value and gives the company an edge in the market.

Let us also look at the various limitations of capital budgeting. First off, the techniques used in capital budgeting are constructed based on certain assumptions, in the presence of uncertainty in the market. As such, they may not lead to accurate forecasts and may even give us the wrong results. If this is the case, then long-term and irreversible decisions based on wrong forecasts can lead to huge losses. For instance, the discounting factor used in the NPV method is assumed, and based on the firm’s subjective assessment, so it may differ from company to company. Another practical difficulty associated with capital budgeting is that it requires skilled professionals to undertake these techniques, and it may be costly to hire such professionals. These costs must also be taken into account.

However, once we have undertaken this qualified analysis, it is important to point out that despite its disadvantages, a firm cannot do away with capital budgeting, as a decision based on no information at all will definitely yield worse results than a decision based on incomplete information. What we can do is to try to improve the techniques by making more realistic assumptions and taking more market factors into account. These days, the new techniques of machine learning available can also help us make better forecasts. To sum up, capital budgeting may not be sufficient but is definitely a necessity in today’s competitive world.