What is capital budgeting in finance?

Capital budgeting is a process a business undertakes to evaluate potential major projects or investments. It is a planning process used to decide the company’s long term investments like new machinery, new plants, new products, research development projects etc. are worth the funding through firm capitalisation. Primary objective of investments is to increase the value of the firm to the shareholders.

Capital budgeting usually involves the following −

  • Computation of each projects future accounting profit by period.
  • The cash flow by period.
  • The present value of cash flow after considering time value of money.
  • The number of years it takes for a project cash flow to pay back the initial cash investment.
  • An assessment of risk etc.

Features of capital budgeting are as follows −

  • It involves high risk.
  • Large profits are estimated.
  • Time period between the initial investments and estimated returns is long.

Capital budgeting process includes −

  • Proposal for investments.
  • Project screening and evaluation.
  • Project selection.
  • Implementation.
  • Performance review.

Some of the factors affecting capital budgeting are −

  • Availability of funds.
  • Structure of capital.
  • Management decisions.
  • Need of the project.

Capital budgeting decisions includes −

  • Accept/reject decision.
  • Mutually exclusive project decision.
  • Capital rationing decision.

Techniques of capital budgeting are mentioned below −

  • Non- Discounted cash flow techniques
    • Accounting Rate of return method.
    • Payback period method.
  • Discounted cash flow techniques
    • Net present value method.
    • Internal rate of return method.
    • Probability index method.

Updated on: 11-Aug-2020


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