Capital Budgeting

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CAPITAL BUDGETING

The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark.  Also known as "investment appraisal."

Generating investment project proposals consistent with the firm’s strategic objectives; Estimating after-tax incremental operating cash flows for the investment projects; Evaluating project incremental cash flows;

Selecting projects based on a value-maximizing acceptance criterion; and Continually reevaluating implemented investment projects.

* Since CASH is central to all decisions of the firm, the expected benefits to be received from the project is expressed in terms of Cash Flows and not income flows. Cash flows should be measured on an incremental, after-tax basis.

* a) include all cash flows that occur during the life of the project * b) consider the time value of money
* c) incorporate the required rate of return on the project

* The minimum rate of return needed to induce investors or companies to invest. * The minimum acceptable rate of return at a given level of risk. Different investors have different reasons for choosing their required returns. Normally, it is determined by a person's or institution's cost of capital. * For example, an investor may also carry a debt with a high interest rate; if an investment does not meet a required rate of return, it would make more sense for the investor to pay down his/her debt. The required return is also related to the amount of risk an investor is willing to accept. One with a portfolio consisting largely of bonds will generally have a lower required return than one whose portfolio contains mainly stocks.

* A Capital Budgeting Decision may be defined as the firm’s decision to invest its current...
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