Definition and Explanation of Capital Budgeting

Definition and Explanation of Capital Budgeting:

Learning Objective of this article:

  1. Define and explain the term “capital budgeting”.
  2. 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:

  1. Tri-Con Global Restaurants, Inc. makes an investment when it opens anew Pizza Hut restaurant.
  2. L. L. Bean makes an investment when it installs a new computer to handle customer billing.
  3. DiamlerChrysler makes an investment when it redesigns a product such as the Jeep Eagle and must retool its production lines.
  4. Merck & Co. invests in medical research.
  5. 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.

You may also be interested in other articles from “capital budgeting decisions” chapter:

  1. Capital Budgeting – Definition and Explanation
  2. Typical Capital Budgeting Decisions
  3. Time Value of Money
  4. Screening and Preference Decisions
  5. Present Value and Future Value – Explanation of the Concept
  6. Net Present Value (NPV) Method in Capital Budgeting Decisions
  7. Internal Rate of Return (IRR) Method – Definition and Explanation
  8. Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
  9. Net Present Value (NPV) Method – Comparing the Competing Investment Projects
  10. Least Cost Decisions
  11. Capital Budgeting Decisions With Uncertain Cash Flows
  12. Ranking Investment Projects
  13. Payback Period Method for Capital Budgeting Decisions
  14. Simple rate of Return Method
  15. Post Audit of Investment Projects

  16. Inflation and Capital Budgeting Analysis
  17. Income Taxes in Capital Budgeting Decisions
  18. Review Problem 1: Basic Present Value Computations
  19. Review Problem 2: Comparison of Capital Budgeting Methods
  20. Future Value and Present Value Tables

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