Capital budgeting is a financial management technique used by individuals and business organizations in determining the most appropriate investment decisions to make. In most cases, individuals, as well as profit-making organizations, have to choose from a variety of investments options available and select the most profitable or viable option. For business organizations, capital budgeting entails determining the most viable projects, in which organization may inject its financial resources. It entails financial evaluation and comparison of investment projects (Shapiro, 2010). Capital budgeting involves choosing the most profitable projects from a variety of projects due to limitation of financial and economic resources. Firms often invest their funds in projects that would yield reasonable returns over their lifetimes.
According to Shapiro, capital budgeting is usually used in making long-term investment decisions that involve outlay of large sums of money (2010). Capital budgeting involves forecasting or projecting the amount of initial investments or cash outflows as well as the total cash inflows that are expected in return. Projects that have good returns in long-run are usually preferred to those with poorer returns (Baker & English, 2011).
Various methods are used during capital budgeting. Some of the most common capital budgeting techniques include net present value (NPV), future value (FV), payback periods, internal rate of return (IRR), profitability index (PI) and accounting rate of return (ARR). Capital budgeting uses the concept of time value of money in making investments decisions.
A good example of a real world application of capital budgeting is when a firm wants to invest in two mutually independent projects. Using the net present value (NPV) method, the firm would select the project with positive NPV and reject the project with negative NPV. Similarly, it would select the project with an internal rate of return higher than the company’s cost of capital and reject the project with internal rate of return lower than the cost of capital or expected rate of return. Other examples of real life applications where capital budgeting techniques are applied include construction of manufacturing plants, replacement of equipment and machinery, development of new products and funding of research and development projects among others.
An experiential example of capital budgeting is saving money for college education. Using the concept of future value (FV) of annuities, I had to calculate the amount I had to save periodically over a fixed period of time, so that I would be able to obtain the total amount of money that my college education requires. Additionally, capital budgeting has been effectively used in retirement planning and purchase of financial securities such as share, bonds and debentures.