Capital Budgeting

Published Feb 3, 2023

Definition of Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investments that are expected to generate value for a company. That means it is used to determine which projects a company should invest in and which ones it should avoid. To do this, companies use a variety of methods and techniques, such as net present value (NPV), internal rate of return (IRR), and payback period.

Example

To illustrate this, let’s look at a hypothetical example. Imagine a company is considering investing in a new factory. To evaluate this project, the company’s management team has to consider a variety of factors, such as the cost of the project, the expected return on investment, the risk involved, and the expected cash flows. After careful consideration, the team decides that the project is worth investing in and gives it the green light.

Why Capital Budgeting Matters

Capital budgeting is an important tool for companies to make informed decisions about their investments. It helps them to evaluate the potential risks and rewards of a project and decide whether it is worth investing in or not. This allows companies to make better decisions and maximize their returns on investment. In addition, capital budgeting also helps companies to allocate their resources more efficiently and make sure that their investments are in line with their long-term goals.