What is capital budgeting?
– Capital budgeting is the process a company uses to decide which long-lived, high-cost projects to accept or reject. Examples include building a factory, buying major equipment, or acquiring another business. The goal is to pick projects that are expected to create more value than they consume.
Why it matters (primary purpose)
– Firms have limited funds. Capital budgeting ranks candidate projects so management can allocate capital to investments that most likely increase shareholder value, subject to risk and financing constraints.
Core concepts and jargon (brief definitions)
– Cash flows: actual expected future receipts and payments attributable to the project (revenues, operating costs, maintenance, taxes, salvage value).
– Discounting: converting future cash flows to today’s dollars because money today is worth more than the same amount later.
– Net present value (NPV): the sum of discounted cash flows minus the initial investment. NPV > 0 suggests the project adds value.
– Cost of capital: the company’s required return on investment (often measured as a weighted average cost of capital, WACC). It is used as the discount rate.
– Opportunity cost: the return foregone by committing capital to this project instead of the next best use.
– Payback period: how long until cumulative cash inflows equal the initial outlay (simple, ignores time value of money unless you use discounted payback).
– Throughput: the rate at which revenue-generating product or service flows through the business system; throughput analysis focuses on bottlenecks that limit total throughput.
Main capital budgeting methods (what they are and when to use them)
1. Discounted Cash Flow (DCF) / NPV
– What it does: forecasts project cash flows and discounts them back at the cost of capital to compute NPV.
– When to use: preferred for most decisions because it accounts for timing, scale, and financing cost.
– Formula: NPV = Σ (CFt / (1 + r)^t ) − InitialInvestment, where CFt = cash flow at time t, r = discount rate.
– Decision