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.