Capital budgeting is the process of evaluating the viability of long-term investments with a view of allocating financial resources to profitable investments. The appraisal techniques used in capital budgeting mainly focus on the costs of investments relative to the benefits they generate during their economic life. Indeed, capital budgeting is one of the most important decisions company management can make, because it facilitates the appraisal and selection of the most viable investments. It actually provides the absolute decision criteria for accepting or rejecting investment proposals.
You can use either discounted or non-discounted cash flow methods to estimate the cash flows of a planned capital investment. Discounted cash flow methods account for time value of money using techniques such as net present value, called NPV, and internal rate of return, often referred to as IRR. NPV shows the difference between an investment's present value of costs and its present value of benefits, and is calculated using a market-based discount rate. IRR shows the returns an investment is expected to generate during its useful life. Non-discounted cash flow methods -- payback period and average rate of return -- do not factor the time value of money. Payback period is the duration it takes to recover the initial capital of an investment, while average rate of return is the profit an investment is expected to generate.
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Capital budgeting provides the framework for evaluating, classifying and ranking both mutually exclusive and independent long-term investments. It enables you to determine the most appropriate investment when dealing with mutually exclusive investments -- that is, picking a choice from various competing investments. This way, you can allocate your scarce financial resources according to the priority of different investment proposals.
Long-term investment decisions are primarily premised on cost-benefit analysis, which compares the initial capital costs against profits generated. This facilitates the performance of due diligence and determination of the opportunity costs of an investment. Opportunity cost is the consequence of forgoing alternative investments. Cost-benefit analysis is an important tool for aligning your investment decisions to the long-term goals of your organization.
The payback period and average rate of return methods are easy to compute and understand in all levels of management. This simplifies the decision-making process for the management team, especially when seeking investments with short repayment periods due to liquidity constraints or unpredictable cash flows. The straightforward nature of these methods makes them helpful in decisions involving risky investments in uncertain market environments.
Management uses capital budgeting to determine the scope of cash flow risks associated with different investments. This makes it possible to consider the costs of risk mitigation measures when evaluating investments. In case of high risks, a company is capable of ensuring that there are sufficient compensating factors prior to undertaking a capital investment.