Capital budgeting can be defined as the way to allocate resources of the firm in a most efficient manner which increases the value of the firm by highest magnitude. It is used to asses whether mine a firm’s long term investments such as machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding through the firm’s capitalization structure. If they provide returns above required return then they shall be funded. Also capital budget determines how much to allocate between different expenses
Capital budgeting is not a scientific model, the methods adopted in capital budgeting have many limitations.
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- Inaccuracy of forecast cash flow : based on a set of assumptions of cash flow without consideration of business condition in detail
- Time horizon : The problem of forecasting increases with increase of time horizon
- Discounting rate : generally budgeting use a fixed discounting rate , consider as cost of capital of firm. The cost of capital may vary with change in interest rate or other factors in market.
- Expense allocations. Some time many cost are not consider in decision making , and mark as sunk cost , which may create problem in profit calculation.
To minimize such problem , firm should use following methods to improvement
- Interest rate should be different for different year in discount
Rather than using old discounting method , we should use probability method of decision making.