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Concept
Capital budgeting
Summary
Capital budgeting in corporate finance, corporate planning and accounting is area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structures (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures.
An underlying goal, consistent with the overall approach in corporate finance, is to increase the value of the firm to the shareholders.
Capital budgeting is typically considered a non-core business activity as it is not part of the revenue model or models of most types of firms, or even a part of daily operations. It holds a strategic financial function within a business. One example of a firm type where capital budgeting is plausibly a part of the core business activities is with investment banks, as their revenue model or models rely on financial strategy to a considerable degree.
For the budget allocated to ongoing expenses and revenue, see operating budget.
Many formal methods are used in capital budgeting, including the techniques such as
Accounting rate of return
Average accounting return
Payback period
Net present value
Profitability index
Internal rate of return
Modified internal rate of return
Equivalent annual cost
Real options valuation
These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.
Corporate finance#Investment and project valuation
Cash flows are discounted at the cost of capital to give the net present value (NPV) added to the firm.
Official source
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Related publications (3)
Related concepts (16)
Rate of return
In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment over a specified time period, such as interest payments, coupons, cash dividends and stock dividends. It may be measured either in absolute terms (e.g., dollars) or as a percentage of the amount invested. The latter is also called the holding period return.
Net present value
The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.
Corporate finance
Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Correspondingly, corporate finance comprises two main sub-disciplines.
Related lectures (79)
Capital Budgeting: Cash Flows and NPV
Explores the significance of incremental cash flows in capital budgeting decisions and how to calculate the net present value accurately.
Green Bonds: Sustainable Investment and Impact
Delves into the world of green bonds, exploring their history, rapid rise, certification process, and challenges in evaluating their environmental and financial performance.
Valuing Firms and Projects
Introduces the DCF method for valuing firms and projects, emphasizing the importance of using cash flows over earnings in finance.