Capital Budgeting

Capital Budgeting is the process by which a business evaluates and decides on long-term investments or projects. This involves analyzing potential expenditures on Assets such as buildings, machinery, or new technology to determine their expected return and impact on the company’s financial performance.

Methods of Capital Budgeting include:

• Net Present Value (NPV): Calculates the difference between the present value of cash inflows and outflows. A positive NPV indicates a profitable investment.
• Internal Rate of Return (IRR): The Discount Rate that makes the NPV of an investment zero. A project is considered favorable if the IRR exceeds the required rate of return.
• Payback Period: The time it takes for an investment to generate an amount of cash equal to the initial investment. Shorter payback periods are generally preferred.

Examples and cases:

• A manufacturing company considering the purchase of a new machine that costs $500,000 and is expected to generate additional Cash Flows of $150,000 per year for 5 years. The NPV and IRR will help determine if this investment is worthwhile.
• A retail chain evaluating the expansion of its store locations. They will assess the costs of construction against projected sales increases and Operating Expenses.