What is capital budgeting?

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The method by which a firm evaluates possible significant projects and investments is known as capital budgeting. Capital budgeting is necessary before such a project is approved or denied, such as constructing a new factory or a significant investment in an outside enterprise.

A firm might examine a potential project’s lifetime cash inflows and cash outflows as part of capital budgeting to see if the potential returns produced have reached a sufficient target benchmark. Investment appraisal is another name for capital budgeting.

In an idealistic situation, firms would seek all projects & opportunities that maximize shareholder value and profit. Since the amount of capital/money available for new projects in every firm is limited, managers apply capital budgeting strategies to assess which projects will provide the best return over a given period.

Capital budgeting is essential as it establishes responsibility and quantifiability. Any firm that invests in a project without fully comprehending the risks and rewards will be considered irresponsible by its shareholders. Additionally, if a firm does not have a method to assess the efficacy of its investment decisions, it stands little chance of surviving in competitive markets.

Importance of capital budgeting:

  1. Assists the company in making long-term decisions and setting long-term objectives.
  2. It indicates predicted future cash inflows and outflows
  3. Large sums of money invested by the firm are secured against future uncertainty.
  4. The company understands the current investment’s future total value and net profitability.
  5. The shareholders’ confidence grows, and they become more motivated in making investments in the company

About the author

Pieter Borremans

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