What is Capital Budgeting?
Capital budgeting is a fiscally responsible process that is designed to manage available resources to select the long term projects that demonstrate the highest degree of potential to yield a high return on the investment of those resources. Capital budgeting requires understanding the balance between the amount of resources that will be expended, the rate at which those resources will be utilized, and how quickly the investment will begin to show a return, reach the break even point, and eventually begin to show a profit. The basic formula for capital budgeting is a very simple one. Essentially, capital budgeting involves comparing the discounted cash flow with the internal rate of return. Discounted cash flows have to do with the value of resources that are involved in the initial launch of the project, allowing for gradual reductions or discounts for each year of the project. Rates of return, in particular the internal rate of return, are the average rates that are earned by each re
Capital budgeting can be defined simply as the process of planning for projects on assets with cash flows of a period greater than one year. These projects can be classified as: Replacement decisions to maintain the business Replacement decisions for cost reduction Existing product or market expansion New products, markets or mandatory investments Additionally, projects can also be classified as mutually exclusive or independent: – Mutually exclusive projects are potential projects that are unrelated, and any combination of those projects can be accepted. – Independent projects indicate there is only one project among all possible projects that can be accepted. The Importance of Capital Budgeting Capital budgeting is important for many reasons: – Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period. – When making the decision to purchase an asset, managers need to forecast the revenue over
