What is Capital Budgeting? Key Principles in Capital Bugdeting

Capital Budgeting is relatively known as an investment appraisal, a significant process in planning that is used in order to determine if the investment made by an organization is worth pursuing.

These investments may include replacement machinery, new products, new plants, new machinery and development projects. Capital budgeting simply includes a budget for expenditure, major capital and investment.

Additionally, there are formal methods basically used in capital budgeting that include many techniques. These techniques include the “net present value”, payback period, “accounting rate of return”, profitability index, equivalent annuity and “internal rate of return”.

All these methods make use of cash flows from a potential project or investment. Techniques primarily based on accounting rules and accounting earnings are used. However, economists consider some of these techniques as improper. Hybrid and simplified methods are sometimes used such as “discounted payback period” or “payback period”.

Capital budgeting merely attempts to determine the future. Its process should first be utilized before starting a large project. Without an efficient capital budgeting, your own company may make its fatal mistake. Here are some of the aspects of capital budgeting, as each one has to play its critical role to your success.

Identifying Opportunities
As an entrepreneur or a business owner, you are surely always presented with various potential opportunities. Try to turn to a number of various directions as a company. Remember that the first crucial step in the process of capital budgeting is merely identifying the opportunity available at this moment. Before you make a decision, you must first know the opportunity that is available.

Assessing Opportunities
After you have already identified the opportunities for your company, the next step in the process is to assess them. Assess each opportunity in an individual basis to compare it with the company’s statement of mission and vision.

Carefully look at the value of each opportunity in order to see if it matches with your own value. Other potential opportunities can possibly be eliminated before you come across the financial information. Of course, you would want to pursue the opportunities that match your business plan.

Assessment of Cash Flow
Another significant part of the process in capital budgeting include the assessment of cash flow. Once you look at a new project, you can certainly come up with a plan for cash flow.

Estimate the amount of cash required to finally complete your project. Consult one from different experts that can help you right away. For instance, if you likely consider starting a new business, you must consult a builder or an architect in order to determine the cost.

The second part in the assessment of cash flow can help you determine the money that the project could possibly bring in. Never make use of the case scenario when you try to calculate this number. Instead, use a more realistic number in the assessment of your cash flow. This process will help you in order to determine if the project is practical or not.

Making Decisions
Finally, the main objective of capital budgeting is to assist you in making smart decisions for your own business. Take the important steps in order for every opportunity to be evaluated properly. Doing so can help your business avoid any disastrous consequence.

If these steps aren’t clearly followed, expect a project that does not add value on your company. It might be the last mistake that your company remakes. Therefore, the process in capital budgeting should be crucially considered before aptly making big decisions for any kind of project.

Other Importance of Capital Budgeting
Additionally, capital budgeting is of paramount importance to any financial decision. It importantly functions in the senior management of an organization especially those that merely involve in replacement of acquisition of assets. In general, the major purpose why these assets are acquired by an organization is to enjoy its benefits in the future. Basically, these assets can either be considered as physical or financial in form.

On the other hand, a certain organization that is reviewing, deciding or analyzing on whether an asset will be acquired or not is said to be involved in the capital budgeting process.

Therefore, the process of selecting, making and identifying investment decision on assets is called capital budgeting. It is now when the company can generate benefits in the next coming years to come.

Capital budgeting is obviously considered as a vital activity in a business or company. A huge amount of money will be wasted once the investment has turned out to be uneconomic or wrong.

It can be difficult to understand the subject because of the mathematical content or the topic nature covered. Still, it aims to build a concept about the value of money in the future that might be spent now. This is basically done in order for the techniques of “internal rate of return”, annuities and “net present value” to be examined.