01.10.2019 What Is Cap tal Budget ng?

Is Cap tal Budget ng? - Techn ques, Analys s & Examples - V deo & Lesson Transcr pt | Study.com

What Is Capital Budgeting? - Techniques, Analysis & Examples

Lesson Transcript

Capital budgeting is important to the growth and development of a business. In this lesson, you will learn
what capital budgeting is, why it is important, and how it is used.

What Is Capital Budgeting?

In a perfect world, Versace would be a great place to live. Unfortunately, it's not in the budget.
Corporations, like people, are limited by their budgets. What do you do when you have a limited
budget? You gure out the best ways to spend what you have to get what you need or want. For
a business, that may be new equipment. When corporations gure out ways to get what they
need or want, it's called capital budgeting. So, corporations conduct nancial analysis to
determine whether an investment or project is a good idea to pursue.

Capital Budgeting Decisions

Since the main purpose of a corporation is to make money, it's important to wisely choose
which opportunities to pursue. There are several factors that a corporation needs to
understand in order to make a capital budgeting decision. They need to understand their cash
ow. That is, the amount of money that goes into and out of a business. How much money do
we have?

Corporations also need to understand the nancial implications of an investment. How will this
capital expenditure, money spent on projects and investments, a ect us now and in the
future? Once they understand the nancial implications of an investment, they need to
understand whether it's a good investment for them. So they need to understand their criteria
for making an investment. What do they hope to gain? How much do they want to spend? What
outcome would make this a good or bad investment for them?

Payback Period
There are several common techniques that corporations use to determine how money is spent.
This lesson will discuss three techniques: payback period, net present value, and internal rate of
return. The payback period is the easiest to calculate.

A business that wanted to buy a new piece of equipment might use this technique to make a
capital budgeting decision. The payback period is the amount of time that it takes for an
investment or project to pay for itself. For instance, the equipment costs $5,000 to purchase and
will potentially earn $1,000 in pro ts a month. The equipment will pay for itself in ve months.
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01.10.2019 What Is Cap tal Budget ng? - Techn ques, Analys s & Examples - V deo & Lesson Transcr pt | Study.com

How easy was that? You just need key pieces of information, such as the cost of the machine
and how much pro t it could produce over a speci c period of time.

Time Value of Money

The downside of using the payback period technique is that it does not account for the time
value of money. That means that money is worth more today then it will be in the future.
Money has a time value for three reasons.

The rst reason that money has a time value is that in the future you'll need more money to buy
the things that you buy now. This is called in ation. Money also has a time value due to
uncertainty. The longer it takes you to recoup the money you have spent, the more uncertain it
becomes that you will get it back. The nal reason that money has a time value is due to
opportunity cost. More than likely, there will be alternative opportunities for you to invest in.
Having cash in hand today to invest in another opportunity is more valuable than the cash you
will receive in the future.

Net Present Value

Unlike the payback period technique, the net present value and internal rate of return do factor
in the time value of money. They're a little bit more complicated than the payback period to
calculate, but they are more accurate.

The net present value compares the outgoing cash associated with a project or investment
with the the discounted cash ows expected to be generated by the project or investment. For
instance, assume a business owner is looking into a project requiring a $243,000 initial cash
outlay. She expects the project to general $50,000 cash every month for 12 months. Using a
discount rate of 12%, based on her cost of capital, the discounted total of returns on the project
is $562,754. Using net present value, the project will earn $562,754 - $243,000 = $319,754 in
pro ts.

Related to the net present value is the internal rate of return, which is the discount rate at
which the net present value is zero. Once the discount rate is calculated, they can be compared
to a hurdle rate, like 12% in the previous example, to see if the project has a greater percentage
return than what it will cost.

Lesson Summary
Lets review the main points of this lesson. There are several vocabulary words that you should
remember. Capital budgeting is the nancial analysis that corporations conduct to determine if
they should pursue a potential investment or project. Cash ow is the money that goes into
and out of a business. Capital budgeting decisions should be based on three things:

1. How much money do we have?

2. What is the nancial impact of the opportunity?

3. What are my criteria for investing in this opportunity?

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01.10.2019 What Is Cap tal Budget ng? - Techn ques, Analys s & Examples - V deo & Lesson Transcr pt | Study.com

Three capital budgeting techniques are:

1. Payback period

2. Net present value

3. Internal rate of return

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