Definition and Explanation of Capital Budgeting:
Learning Objective of this article:
- Define and explain the term "capital
- What is meant by the term "investment
in capital budgeting decisions"? Explain with examples.
The term "capital budgeting" is used
to describe how managers plan significant outlays on projects that have
long-term implications such as the purchase of new equipment and the
introduction of new products.
Most companies have many more potential
projects than can actually be funded. Hence, managers must carefully select
those projects that promise the greatest future return. How well managers
make these capital budgeting decisions is a critical factor in the long run
profitability of the company.
Capital budgeting involves
investments. A company must commit funds now in
order to receive a return in the future. Investment is not
limited to stocks and bonds. Purchase of inventory or equipment
is also an investment.
Examples of Investments:
- Tri-Con Global Restaurants, Inc. makes
an investment when it opens anew Pizza Hut restaurant.
- L. L. Bean makes an investment when it
installs a new computer to handle customer billing.
- DiamlerChrysler makes an investment when
it redesigns a product such as the Jeep Eagle and must retool its
- Merck & Co. invests in medical research.
- Amazon.COM makes an investment when it
redesigns its website.
All of these investments are characterized by a commitment of funds today
in the expectation of receiving a return in future in the form of
additional cash inflows or reduced cash outflows.