Capital budgeting is a step by step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company's growth initiatives, involves determining the investment rate of return that such a project will generate. However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project. For example, a social or charitable project is often not approved based on rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplace.
Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project. Capital budgeting is also vital to a business because it creates a structured step by step process that enables a company to:
Develop and formulate long-term strategic goals – the ability to set long-term goals is essential to the growth and prosperity of any business. The ability to appraise/value investment projects via capital budgeting creates a framework for businesses to plan out future long-term direction.
Seek out new investment projects – knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry....
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