Capital Budgeting

According to W. Kenton (2020), the mechanism by which a company evaluates

future major ventures or investments is known as capital budgeting. Capital budgeting is
needed before a project is accepted or refused, such as the construction of a new plant
or a large investment in an outside venture. A business would evaluate a prospective
project's lifetime cash inflows and outflows as part of capital budgeting to see whether
the potential returns produced reach a suitable target benchmark. Investment
assessment is another name for capital budgeting .
In an ideal world, companies will follow all ventures and opportunities that
increase shareholder value and benefit. Since the amount of capital or resources
available for new projects in any sector is small, management uses capital budgeting
techniques to assess which projects can provide the best return over a given period.
Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a
project, the mix of cash inflows in the form of revenue, and other future outflows in the
form of maintenance and other costs.
Present Value
These cash flows, except for the initial outflow, are discounted back to the
present date. The resulting number from the DCF analysis is the net present value
(NPV). The cash flows are discounted since present value states that an amount of
money today is worth more than the same amount in the future. With any project
decision, there is an opportunity cost, meaning the return that is foregone as a result of
pursuing the project. In other words, the cash inflows or revenue from the project needs
to be enough to account for the costs, both initial and ongoing, but also needs to exceed
any opportunity costs. With present value, the future cash flows are discounted by the
risk-free rate such as the rate on a U.S. Treasury bond, which is guaranteed by the U.S.
government. The future cash flows are discounted by the risk-free rate (or discount rate)
because the project needs to at least earn that amount; otherwise, it wouldn't be worth
pursuing.
Cost of Capital
Also, a company might borrow money to finance a project and as a result, must
at least earn enough revenue to cover the cost of financing it or the cost of capital.
Publicly-traded companies might use a combination of debt–such as bonds or a bank
credit facility–and equity–or stock shares. The cost of capital is usually a weighted
average of both equity and debt. The goal is to calculate the hurdle rate or the minimum
amount that the project needs to earn from its cash inflows to cover the costs. A rate of
return above the hurdle rate creates value for the company while a project that has a
return that's less than the hurdle rate would not be chosen.
Source: https://www.investopedia.com/terms/c/capitalbudgeting.asp