Capital Budgeting is the process of planning expenditures on assets whose cash flows are expected to extend beyond one year. It refers to the investment decision involving fixed asset of a firm. The term capital refers to the fixed assets used in production and budget is a plan that details projected inflows and outflows during some future periods. Thus capital budget in an outline of planned expenditures on fixed assets and capital budgeting is the process of analyzing projects and deciding which are acceptable projects.
Capital Budgeting involves:
(a) Determine the cost, or purchase price, of the asset.
(b) Estimate the cash flows expected from the asset.
(c) Evaluate the risking of the projected cash flows to determine the appropriate rate of return to use for the present value of the estimated cash flows.
(d) Compute the PV of the expected cash flows.
(e) Compare the present value of the expected cash inflows with initial investment, or cost, in regard to acquire the asset. If a firm invests in a project with a present value greater than its cost, the value of the firm will increase.
The more effective the firm’s capital budgeting procedures, the higher the price of its stock and it carries a better sign in Credit portfolio.
Capital Budgeting Techniques/Methods:
(a) Payback period (PBP)
(b) Discounted Payback period (DPBP)
(c) Net Present Value (NPV)
(d) Benefit Cost Ratio (BCR)
(e) Internal Rate of Return (IRR)