What Is Capital Budgeting?

Capital budgeting: Capital budgeting is a technique involved in the finances of a business or a firm. It allows businesses or firms to determine which fixed asset purchase should be accepted and which should be rejected. It helps the companies to create a quantitative view of its investment in the proposed fixed asset investment by making a decision. The capital budgeting is mostly based on forecasting and predictions. The goal of capital budgeting is to always maximize wealth. There are two types of project : Mutually exclusive: In this type of project, you must select only one project which means the project which gives the highest profit. Independent: In this type of project, one can accept all the projects which give the highest profit. You can choose more than one project. • Importance of Capital Budgeting: Capital budgeting is based on forecasting and predicting future expected cash flows. It prevents firms from being bankrupted if their investments are made incorrectly or result in failure. For large investments, capital budgeting is a mandatory process as it impacts the evolution of a business and ensures the long term prosperity of a business. Investing in an outside venture, or constructing a new plant, etc., are examples where the companies are required to evaluate their investments using capital budgeting to avoid its losses. There are various finance assignment writing services UK present that creates effective articles on such topics for better understanding. • Capital budgeting methods: There are various methods to evaluate fixed assets using capital budgeting. Some of the most important ones are: 1. Net present value analysis: Find the present value of the asset purchase and then compare all the proposed projects with their present values, and accept those who are the highest value in all even if the funds run out. How to choose which project to accept? Accept project which is greater than 0 and reject the one which is lesser than one. 2. Payback: Analyzing the period required to recover your initial investment. The payback which is acceptable is a maximum of 4 years and if it is more than 4 years so one should reject the project. In a nutshell, one should accept a project which offers the lesser payback. 3. Internal rate of return: The internal rate of return measures the rate of return that will make the present value of cash flow equal to the initial investment. The initial rate of return is similar to the concept of yield to maturity but the only difference is YTM is applicable for bonds. If the IRR is greater than the required return then one must accept the project and if it is lesser than one must reject the project. 4. Profitability index: The profitability index is very much similar to net present value. The profitability index is the ratio of initial investment to the present value of inflows. If the profitability index is greater than one then one must accept the project. And if it is lesser than one even if it is 0.9 the project should be rejected.