Sunday, October 16, 2011

Capital Budgeting Basics

CFA Level 1 - Corporate Finance

What is Capital Budgeting?
Capital budgeting is defined as the process of planning for projects on assets with cash flows of a period greater than one year. 

These projects can be classified as:
·         Replacement decisions to maintain the business
·         Existing product or market expansion
·         New products and services
·         Regulatory, safety and environmental
·         Other, including pet projects or difficult to evaluate projects

 Additionally, projects can also be classified as mutually exclusive or independent:

- Mutually exclusive projects are potential projects that are unrelated, and any combination of those projects can be accepted.
- Independent projects indicate there is only one project among all possible projects that can be accepted.

 The Importance of Capital Budgeting
Capital budgeting is important for many reasons:
- Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period.
- When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset.
- Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan of the company.

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