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Capital Budgeting: Definition & Process

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  • 0:02 What Is Capital Budgeting?
  • 0:45 Using Capital Budgeting
  • 2:51 Cash Flows
  • 5:06 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

From time to time, businesses must purchase large pieces of equipment to replace older equipment or expand product lines. In this lesson, you'll learn how businesses budget for these purchases.

What Is Capital Budgeting?

Businesses make capital expenditures when they replace older equipment or expand a product line. Capital expenditures represent money spent by a business to buy or sell equipment, land, or machinery that is used to produce its product or offer services to its customers. Since these expenditures usually require large amounts of money, the business must create a budget to ensure it has enough money to pay for them. This is capital budgeting.

Let's meet Ms. Chip, who owns the Magnificent Cookie Company. Ms. Chip is expanding her product line to offer vegan cookies, and she is contemplating the purchase of a new machine. She is not sure how to evaluate if her company should go ahead with the purchase. Let's see if we can help Ms. Chip make this decision.

Using Capital Budgeting

A new machine represents the purchase of a new capital asset. A capital asset is something that a company owns that is used by the business to generate revenue over a long period of time. It is not something that is sold directly to consumers. Examples of capital assets include land, buildings, and equipment.

Since the purchase of capital assets require large amounts of money, a company must budget for these purchases. While a business usually prepares budgets for a 12-month period, the purchase of capital assets requires the business to plan for a longer time horizon because the asset will be used for longer than one year.

A capital budget provides information about the money that will be spent on capital assets and money that will be received from the sale of capital assets. It is a process that Magnificent Cookies can use to assess if it worthwhile to invest in a particular project or purchase a new asset.

Deciding whether or not to go ahead with the investment involves calculating the rate of return that the project will generate over its life. The rate of return represents the gain or loss on an investment, which is determined by taking the cost of the original investment into consideration. Deciding whether or not to go ahead with a project involves assessing the risks of the project as well as the returns.

Let's assume that the rate of return for the potential investment by Magnificent Cookies is 12%. How would Ms. Chip determine whether to proceed with the investment? Ms. Chip would want to consider her minimum return on this particular investment. For example, if she wanted to achieve at least a 10% return, then this would be a good investment. Even if the calculated rate of return were below her target of 10%, she may still decide to proceed with the investment because she may view the chance to enter the vegan market as a great opportunity since none of her competitors are currently in it.

Capital budgeting is important because it allows a business to measure the effectiveness of its investment decisions. Ms. Chip's shareholders would be pleased that she is looking at the risks and returns associated with this new investment before actually making it. Also, given that businesses only have so much money to work with, they need to ensure that each and every investment is worthwhile, which means that it will be a good use of company resources and result in higher company profits.

Cash Flows

Like all of us, a business only has so much money to work with at any point in time, and it needs to evaluate whether an investment or project is good for the business. When determining whether or not to proceed with a project or an investment, a company needs to quantify the additional amount of money that the project or investment will generate over time, which is known as its incremental cash flow. If the incremental cash flow is positive, the company's overall cash flow will improve if the project or investment is accepted.

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