Capital Budgeting in Financial Management
What is Capital Budgeting?
Capital budgeting is the process which enables the management to decide which, when and where to make long-term investments. Businesses always look for opportunities that increase shareholder wealth. In capital budgeting, the managers try to figure out investment opportunities that are worth more to the business than they cost to acquire.
Ideally, firms should peruse all such projects that have good potential to increase the business worth. Since the available amount of capital at any given time is limited; therefore, it restricts the management to pick out only certain projects by using capital budgeting techniques in order to determine which project has potential to yield the most return over an applicable period of time.
With the help of Capital Budgeting Techniques, management decides whether to accept or reject a particular project by making the analysis of the cash flows generated by the project over a period of time and its cost. Management decides in favor of project if the value of cash flows generated by the project exceeds the cost of undertaking that project.
Capital Budgeting Decision Rules
A Capital Budgeting Decision rules likely to satisfy the following criteria:
- Must give consideration to all cash flows generated by the project.
- Must take into account Time Value of Money concept.
- Must always lead to the correct decision when choosing among mutually exclusive projects.
Regardless of the specific nature of an investment opportunity under consideration, management must be concerned not only with how much cash they are expecting to receive, but also when they expect to receive it and how likely they are to receive it.
Evaluating the size of the investment, timing; when to take that investment, and the risk involved in taking particular investment is the essence of capital budgeting.
What are Five Methods of Capital Budgeting?
The most commonly used capital budgeting techniques are:
- Internal Rate of Return
- Net Present Value
- Profitability Index
- Accounting Rate of Return
- Payback Period
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