What Is Capital Budgeting

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Capital budgeting, also known as financial budgeting, capital budgeting tools, and budget analysis, is a planning method utilized to identify if an enterprise’s long-term investments including new facilities, replacement of fixed assets, expansion of facilities, and new products, are worth the additional funding of funds through the firm’s capital structure. This involves first determining the value of the company’s assets to be financed, then determining the value of the company’s liabilities in terms of current accounts receivable and inventory, the potential of obtaining new credit, as well as the cost of operations and maintenance. The purpose of this exercise is to find the difference between the net worth of a firm and its current assets and liabilities. These valuations are also used to forecast short-term liquidity needs and help managers ensure that financing arrangements can be made for necessary operational and acquisition expenses.

The three basic capital budgeting methods are: balancing the books, operating by increasing assets and decreasing liabilities, or, operating by decreasing assets while increasing liabilities. Of these methods, only the third method is truly flexible since it allows managers to adjust investments according to fluctuations in the stock market. For instance, they could increase share values for a given period or reduce share values during the beginning of a profitable year in order to let the stock price fall somewhat before increasing it again later. It is called a flexible option because, although the manager may not always control all variables, he or she can effectively adjust investment portfolios on a moment-to-moment basis.

The balanced scorecard results of what is capital budgeting methods use the present value of all cash and accounts receivable to estimate the effect of expected cash flows. That is, the effect of a particular transaction is estimated by measuring what is currently being spent (the net effect of an outgoing transaction minus what is currently coming in). Then, the difference between actual expenses and anticipated expenses is subtracted to measure the net effect. The resulting figure, net present value, can then be used as the initial value of capital for budgeting purposes.

One of the advantages of what is capital budgeting is that it enables financial decision makers to make accurately focused decisions about investment portfolios. When managers make financial decisions, they must consider not only what is currently happening in the business, but also what will happen in the future. This means that they must use estimates of future cash flows. Unfortunately, most managers do not fully understand the potential pitfalls or obstacles that can be identified in this process. Thus, they underestimate the profitability of investment projects and their own ability to manage those projects.

To avoid these problems, financial decision makers should use capital budgeting techniques in order to estimate future cash flows using accurate and well-established statistical methods. One of the easiest ways to do this is to build a model using historical data. The model should include all of the variable that are known to affect investment projects. By closely modeling the physical and human factors that have been known to influence investment projects, financial decision makers can make more informed decisions about what is worth pursuing and what is not.

An example of how financial decision makers should use what is capital budgeting techniques is to compare the net present value of their portfolio with their estimated returns. In general, financial decision makers should choose investments that yield a higher annual return. The method by which they identify those projects is called the internal rate of return (IRR). The internal rate of return will vary greatly from one investor to another, but there are a number of good quantitative methods by which investors can measure IRR.

For example, the internal rate of return measures the amount of interest earned on any given cash balance, versus the amount of interest paid on the total debt balance. This calculation can be complicated, but it is a crucial part of the decision making process for most investors. If the internal rate of return is high, then an investor can anticipate that he or she will be able to earn a high return on their invested cash balances. However, if the internal rate of return is low, then an investor may not be able to maximize his or her return on investment because of the relatively lower amount of interest that is paid on the debt balance. In the latter case, a financial decision maker would probably prefer to have lower debt balances, but if the amount of interest is high enough on the debt balances, then a high IRR makes little or no difference.

Another example of what is capital budgeting is to compare current operating costs with projected short and long-term capital budgeting costs. Many financial decision makers make assumptions about their own operating costs and about how long they plan to stay in business. If the assumption turns out to be inaccurate, a company must adjust its budgeting process to reflect the new capital budgeting assumptions. The process of what is capital budgeting can be a daunting task for those who are not trained as financial managers. However, good managers know that it is an essential part of the financial management process.