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Friday, August 26, 2011

Capital Budgeting in Finance

When a company invests in a new asset, the asset usually appears on the balance sheet rather than being immediately charged against income as an expense. The asset is then charged against income through depreciation expense over its estimated useful life. This expense is supposed to match the timing of the income generated by the asset because there are often differences between depreciation for tax and accounting purposes, it may be necessary to create a liability account for deferred taxes if the tax depreciation is greater than the financial accounting depreciation.

Although the income statement provides some indication of the profitability of the business, it provides little indication of the true return on invested capital or whether a particular capital investment is worthwhile. A project may provide a positive return but the return may be too small to justify the investment. The return on capital invested must be measured on a cash-flow basis and take time into account. That is the purpose of capital investment analysis, also called capital budgeting.

Capital Budgeting in Finance involves the analysis of project proposals and the ranking and selection of those projects suitable for investment. It is an integral part of a company’s strategic-planning process. Capital Budgeting is a process of analyzing expected cash flows and expected risks in a disciplined, quantitative way against a backdrop of overall corporate strategy.

For a company of any size, an overriding concern of management is to increase the owners’ value. To do so requires investing in projects that return more than the cost of capital. Capital budgeting deals with the asset side of the balance sheet. It is concerned with what investments should be made, not how the projects are financed. Inevitably, those two decisions overlap in the minds of a company’s CFO and treasurer. A simple comparison of the next project to the next financing can be misleading, however, particularly if that financing includes debt with tax-deductible interest payments. The CFO should take a broad look at all the company’s investment opportunities and all of its capital sources, including both debt and equity, when making capital investment decisions.

Capital budgeting in Finance requires assumptions about the future. To decide how a proposed project compares with other investment opportunities and to identify risks and pitfalls, one should ask for the insights of thoughtful individuals from different departments and different professional experience. In addition to sharing their views on whether a project should be a strategic priority, these individuals may review items in the project proposal, such as raw material costs, labor costs, the market for the product to be produced, when the product will become obsolete, price points, competition and terminal value of the capital assets.

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Our other articles on Finance include Present Value, Net Present Value, Internal Rate of Return, Present Value Annuity, Private Equity & Venture Capital

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