Capital budgeting is the process of planning expenditures that are incurred on assets whose cash flow is expected to range beyond one year. In other words, it needs a lot of planning for setting up budgets on projects expected to have long term implications. This is usually used for processes such as purchasing new equipment or launching a new product in the market. Most of the business enterprises will want to do a thorough research on a project before taking it on because it has a great impact on the company’s financial performance.
Capital budgeting is mostly used in the projects like investments in property, plants and equipment, large advertising campaign, research and development works.
Decisions on capital budgeting are mostly taken by the management and these decisions usually decide the success of a business. The management of the company will analyze different factors about the project before finally taking it. Capital expenditures require large outlay of funds. Firms should find modes to ascertain the best way to raise and repay the funds. Capital budgeting is a long term commitment.
Due to the requirement of thorough information and analysis in capital budgeting, it has paved the way for series of models to assist firms in amassing the best of the allocated resources. Payback model is the oldest method and it determines the length of time required for a business to recover its cash outlay. There is another model called return on investment and it evaluates the project based on standard historical cost accounting estimates.
Popular methods of capital budgeting include net present value (NPV), discounted cash flow (DCF), internal rate of return (IRR), and payback period.
When a capital budgeting of a business is done, a firm is involved to do the valuation of the business. This helps in identifying the cash flow of the business and discounts at the present market value. In capital budgeting, valuation techniques are undertaken to analyze the impact of assets instead of financial assets.
The importance of capital budgeting is not the mechanics used, such as NPV and IRR, but is the varying key involved in forecasting cash flow. The importance of capital budgeting is not only its mechanics, but also the parameters of forecasting the incurrence of cash in the business.