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An investment decision made by a firm is generally known as the Capital budgeting or the capital expenditure. A Capital budgeting is defined as the firm’s decision to invest its current funds in a most efficient way in the long term assets in anticipation of an expected flow of benefits over a series of years. Capital budgeting is a planning process of a business in which the business determines whether projects likes building of a new plant, new machinery, new products or investing in a long term venture are worth pursuing. It is a budget made for major investments or expenditures and capitals. A prospective project’s lifetime cash inflows and outflows are being assessed in order to determine whether the returns generated meet a sufficient target benchmark.
The main purpose of the capital budgeting is the expansion, improvement, replacement of the equipments if needed and the research and development of products if required for the firm. Businesses should pursue all the possible projects and opportunities that enhance the shareholder value. As the amount of the capital available at any given time for the new projects is being limited the management needs to use the capital budgeting techniques to determine which project will yield the most return over a period of time.
Some of the following are the reasons which help to understand the importance of the capital budgeting:
a) It influences the growth of the company in long run.
b) It affects the risk of the firm.
c) It is irreversible or reversible at substantial loss
d) It involves the commitment of a large amount of funds
e) Investments decisions are the most difficult decisions to be made.
There are various evaluation methods used for capital budgeting which are as follows:
a) Net Present Value (NPV)
b) Payback Time
c) Internal rate of return (IRR)
d) Discounted cash flow (DCF)
The capital budgeting projects are being classified as an Independent projects or Mutually Exclusive Projects. The former is a project whose cash flows are not affected by the accept/reject decisions for other projects, whereas the latter is a set of projects from which at most one will be accepted.
In end, capital budgeting is the process of determining a big expenditure is in a company’s best interest.
Topics in Capital Budgeting
Capital Investment Decisions