Basics of capital budgeting
Capital investments are long-term investments in which the assets involved have useful lives of multiple years. Construction of a new manufacturing facility and purchases of machinery and equipment are examples of capital investments. Capital budgeting is a method of estimating the financial viability of a capital investment over its lifetime and focuses on cash flows rather than profits. It involves identifying cash inflows and cash outflows rather than accounting revenues and expenses flowing from the investment. Items like debt principal payments are included in capital budgeting because they are cash flow transactions. Non-cash expenses like depreciation are not included in capital budgeting because they are not cash transactions. Capital investments create cash flows that often spread several years into the future so capital budgeting methods include adjustments for the time value of money. To assess the value of a capital investment, the timing of the future cash flows are taken into account and converted to the current time period (present value). There are seven steps involved in capital budgeting:
- Identify long-term goals of the individual or business.
- Identify potential investment proposals for meeting identified long-term goals
- Estimate and analyze the relevant cash flows of potential investment proposals
- Determine financial feasibility of each of the investment proposals using capital budgeting methods
- Choose the projects to implement
- Implement the projects
- Monitor the projects implemented as to how they meet the capital budgeting projections and make adjustments where needed.
There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the payback period, discounted payment period, net present value, profitability index, internal rate of return, and modified internal rate of return.
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