Capital budget refers to the process through which firms decide on the long term investments to make. Projects of capital budgeting are supposed to generate cash flows for several years. The decision on whether to reject or accept capital budgeting project is dependent on analysis of cash flow that is generated by the project as well as its cost.
Capital budgeting makes it possible to determine which long term organization investments are worth funding through the capitalization structure like replacement machinery, new machinery, research development projects, new products and new plants.
In simple terms capital budgeting is the process of resources allocation for major investment and capital expenditures. The primary goal of this type of budgeting is to increase value of the firm to its shareholders. There are several techniques used in capital budgeting and some of these include:
- Net present value
- Payback period
- Accounting rate of return
- Profitability index
- Equivalent annuity
- Real options valuation
- Modified internal rate of return
- Internal rate of concern
The techniques mentioned above use incremental cash flows from each potential investment or project. There are times when techniques that are based in accounting rules and accounting earnings get used though economists might consider this as improper for instance ‘return in investment’ and accounting rate of return’. Hybrid and simplified methods can be used as well like discounted payback period and payback period.
There are several factors that determine capital budgeting such as the risk of the business, taxation policy, capital return, working capital, trend of earning, political unrest, geographical condition, lending policies of financing institutions, funds availability, structure of capital, exchange rate of currency, market forecast and immediate urgency of the project.
Capital budgeting projects can be classified as:
- Independent project-Which refers to a project whose cash flows cannot be affected by the reject/accept decision of other projects. As such, all independent projects that are able to meet capital budgeting criterion should be accepted
- Mutually exclusive projects-Which include a set of projects from which at the very least, one can get accepted. For instance, a set of projects that are designed to accomplish similar tasks. When choosing this type of project, there should be one that satisfied the criterion for Capital Budgeting and it is the only project that can get accepted.
Capital budgeting projects and investments must be funded with excess cash that is raised through debt capital, retained earnings or equity capital. Dent capital refers to borrowed cash which can be in the form of bonds or loans that are issued to creditors.
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