What is capital budgeting?
What is capital budgeting? Capital budgeting, also known as investment appraisal, is the process that companies use to help decide which of their long-term, large-scale projects deserve investment and how to do it. This could include investing in new software or developing a new product. These large-scale projects are called capital expenditures.
Key takeaways:
- Capital budgeting is the process of evaluating long-term investment projects that involve significant financial commitments and expected returns.
- Effective capital budgeting can help companies prioritize investments and maximize financial returns.
- Capital budgeting involves various techniques and methods, such as net present value (NPV), internal rate of return (IRR), and payback period analysis.
- Capital budgeting decisions involve trade-offs and risks, and companies need to consider these factors while making investment decisions.
Where have you heard about capital budgeting?
You may have heard about capital budgeting if you're looking to invest in a company and want to know what long-term investments they have planned.
What you need to know about capital budgeting
Capital budgeting aims to maximise a firm's future profits, by helping it to see which large projects will be the best for the business. This is because most companies can only afford a limited number of capital expenditures at a time.
When deciding on whether to invest in a capital expenditure, a company may look at the project's projected return on investment (or ROI). They may also look at the payback period. The payback period is calculated by taking the total cost of a given project and dividing it by the amount of cash it is expected to generate each year.
Balancing this all up helps to estimate if a project would ultimately increase the overall value of the company.
Find out more about capital budgeting
The minimum return on investment that a company expects to earn when investing in a project is called the hurdle rate. The hurdle rate is also known as the required rate of return or target rate.
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