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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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