Capital budgeting is the process of analyzing the benefits of an investment, including buying equipment or launching a new product line. The decisions underlying capital budgeting are largely financial. They revolve around the concept of future value of money, which states that money has a value that will change over time. Thus, net present value, which translates future value to present value, is a common decision-making tool. The return over time from the new investment needs to be greater than the return that could be earned if the money were invested in stocks or bank accounts. Making decisions about capital budgets involves considering the cash flow from the new investment as well as the time that the investment needs to generate revenue before it becomes profitable.
At A Glance
- The future value of current money, a factor in deciding whether to invest in a new capital project, can be calculated using a formula; the rate of return will be linked to the risks associated with the endeavor.
- The net present value of an investment can be calculated by analyzing the projected future cash inflows, rolled back to the present value, and cash outflows of the investment.
Capital decisions are made based on net present value.
- There is no simple formula to calculate internal rate of return (IRR), but it can be calculated with spreadsheets by using a trial and error approach.
- Capital decisions can be made based on the internal rate of return.
- The formula for the discounted cash flow of an investment involves estimating its value based on the sum of future cash flows.
- In capital decision-making, earnings before interest and taxes ratios may be used to verify that the discounted cash flow assumptions are correct; discounted cash flow decisions are also part of the dividend payout ratio.
- The break-even point is a factor in deciding whether to invest in a new capital project.
- The break-even point of an investment is calculated by dividing fixed costs by the sales price per unit minus the variable costs.