What is Capital Budgeting?
Capital budgeting is defined 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
· Existing product or market expansion
· New products and services
· Regulatory, safety and environmental
· Other, including pet projects or difficult to evaluate projects
Additionally, projects can also be classified as mutually exclusive or independent:
– Mutually exclusiveprojects indicate there is only one project among all possible projects that can be accepted.
– Independent projects are potential projects that are unrelated, and any combination of those projects can be accepted.
Capital budgeting is a step by step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company’s growth initiatives, involves determining the investment rate of return that such a project will generate. However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project. For example, a social or charitable project is often not approved based on rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplace.
Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project
