Question

What do you mean by capital budgeting? Explain the process of capital budgeting.

Answer 1

Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return

Average accounting return

Payback period

Net present value

Profitability index

Internal rate of return

Modified internal rate of return

Equivalent annual cost

Real options valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.