7.4 : Advantages and Limitations of Capital Budgeting

Capital budgeting is essential for companies as it enables them to plan and invest in projects aligned with their long-term goals. For instance, a company like Tesla might use capital budgeting to decide whether to build a new manufacturing plant. This process helps ensure the new facility will enhance production efficiency and profitability while managing risks such as fluctuations in demand or raw material costs.

Capital budgeting has several limitations that businesses must consider. One key challenge is the reliance on estimates for future cash flows and discount rates, which can be inaccurate and lead to misguided investment decisions. Additionally, it often overlooks qualitative factors such as environmental impact, social responsibility, or employee well-being, focusing mainly on financial data. The complexity of capital budgeting techniques, especially for large-scale projects, can make the process time-consuming and difficult to navigate.

Moreover, capital budgeting struggles to account for non-financial benefits, such as improved employee morale or customer satisfaction, since these are hard to quantify in monetary terms. The process is designed for long-term projects, making it less suitable for short-term decision-making.

In summary, while capital budgeting is vital for strategic planning, companies must navigate these challenges to ensure success.