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Capital Budgeting

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The Basics of Capital Budgeting
  • What is Capital Budgeting?

Capital budgeting is the process of analyzing potential investments for the firm. Capital budgeting decisions are probably the most important ones financial managers must make. Capital budgeting decisions usually involves substantial expenditures on new assets.  These decisions are particularly important because the firm loses much of its flexibility by locking into projects and because capital budgeting decisions define the firm's strategic direction.

Capital budgeting is the process of comparing the

costs and benefits of a long term asset in order to

evaluate its value.

 

Capital budgeting is in many senses no different than

the valuation of any asset. It deals with the

comparison of cash flows at different points in time.

 

When valuing financial assets we were concerned with

their value, that is the present value of all their future

cash flows. Capital budgeting is the same, it is simply

the present valuing of all future cash flows and the

comparison of those flows against the costs

associated with them.

 

Do people actually use capital budgeting?

 

Capital Budgeting is perhaps the most useful skill that

you will gain in this course. Most of the major

purchasing decisions you will make in your life can be

evaluated as a capital budgeting problem. In fact

your very attendance at this fine educational

institution probable occurred as the result of a capital

budgeting decision. This is a process that most

individuals carry out unconsciously, and when dealing

with small purchases this is alright. In the corporate

world, the purchases are rarely small.

 

The establishment of a set of rules has made is

possible for the process of making purchasing

decisions to be simplified

--> The process of determining whether or not projects such as building a new plant or investing in a long-term venture are worthwhile.

Notes:

Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF), and payback period.

Also known as investment appraisal.

Capital Budgeting as Management Process

  • Development of a strategic plan
  • Generation of potential investment

opportunities

  • Estimation of a project’s cash flows
  • Acceptance or rejection
  • Project post-audit