Definition: Capital budgeting is a method of analyzing and comparing substantial future investments and expenditures to determine which ones are most worthwhile. In other words, it’s a process that company management uses to identify what capital projects will create the biggest return compared with the funds invested in the project. Each project is ranked by its potential future return, so the company management can choose which one to invest in first.
What Does Capital Budgeting Mean?
Most business’ future goals include expanding their operations. This is difficult to do if the company doesn’t have enough capital or fixed assets. That is where capital budgeting comes into play.
Capital budgets or capital expenditure budgets are a way for a company’s management to plan fixed asset sales and purchases. Usually these budgets help management analyze different long-term strategies that the company can take to achieve its expansion goals. In other words, the management can decide what assets it might need to sell or buy in order to expand the company. To make this decision, management typically uses these three main analyzes in the budgeting process: throughput analysis, discounted cash flows analysis, and payback analysis.
Example
Obviously, capital budgeting involves difficult decisions. In most cases buying fixed assets is expensive and cannot be easily undone. The management has to decide to spend cash in the bank, take out a loan, or sell existing assets to pay for the new ones. Each one of these decisions comes with the eternal question: will they receive the proper return on investment? Because when you think about it, buying new fixed assets is no different than putting money any other investment. The company is buying equipment hoping that is will pay off in the future.
That is why many managers used the present value of future cash flows when deciding what to buy. Present value dollars will help them analyze the current and future cash inflows and outflows equally to come up with the best plan for the future.
