5 Helpful Facts About Capital Budgeting – Master of Accounting Degrees

Capital budgeting refers to financial processes and decisions about long-term investments. Capital budgeting involves long-term funds that are raised by companies to invest in assets. The goal of capital budgeting is to generate future revenues. The funds raised to invest in long-term assets are usually limited, so companies must carefully analyze and budget how the funds are invested. Keep in mind that there are similarities between capital budgeting and asset valuation because both involve project costs being compared with the projected value that the company will receive.

Capital Budgeting Matters

Capital budgeting will financially impact the company in the future and poor decisions may negatively impact operations, so management must carefully plan and mitigate risks. The timing of investment decisions is important because most capital budgeting projects take years to execute. This means that if management procrastinates, the investment timing of the capital budgeting may be too late. Quick and efficient decision making will help companies stay ahead of their competition and dominate their industry.

Capital Budgeting Decisions

Capital budgeting decisions are usually very large investments, so fast decisions can also create problems and generate unnecessary costs for the company. When properly executed, capital budgeting projects are an excellent way to increase overall ROI and financial performance. Keep in mind that failure to properly predict cash flows and potential risks may result in serious problems. Cash flows for projects associated with assets with a documented history, such as property or buildings, are easier to predict.

Capital Budgeting Brainstorming

The ideas for capital budgeting projects usually come from management, but employees, customers, suppliers and professional partners are excellent sources. As long as they have credible experience and knowledge, investment ideas can come from anyone. For instance, a sales rep may always hear from a customer that there is a growing need for a product that doesn’t exist yet. The sales rep can conduct a little research and then present the idea to management.

Capital Budgeting Project Development

Based on the previous example, this will result in an evaluation of product viability through consultations with marketers, engineers, manufacturers and suppliers. Management my even order a formal feasibility study through a third-party expert. After the product idea is analyzed and approved, finance professionals will conduct a capital budgeting analysis to ensure the project will be financially beneficial. Based on this information, the company can conduct planning for research and development for new products, or operation expansions for existing products.

Capital Budgeting Project Classifications

There are independent projects that do not affect the acceptance or performance of other projects. To illustrate, a company that has $200,000 to spend on capital projects every year may decide to conduct one project for $30,000 and another for $50,000. Both projects will enjoy independent decision making. On the other hand, mutually exclusive projects involve sequentially separate projects. Management may first decide to complete the $30,000 project to analyze the success before they commit to a similar, more expensive project of $50,000.

Capital budgeting projects also involve various decisions, such as replacement decisions. These concern whether an existing asset should be replaced by a newer version, or if an entirely different version is required. Expansion decisions concern whether the company should increase operations by adding new products, services and locations.