What Is Capital Budgeting? - Techniques, Analysis & Examples

What Is Capital Budgeting? - Techniques, Analysis & Examples
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  • 0:04 What Is Capital Budgeting?
  • 0:38 Capital Budgeting Decisions
  • 1:30 Payback Period
  • 2:17 Time Value of Money
  • 3:03 Net Present Value
  • 4:24 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Capital budgeting is important to the growth and development of a business. In this lesson, you will learn what capital budgeting is, why it is important, and how it is used.

What Is Capital Budgeting?

In a perfect world, Versace would be a great place to live. Unfortunately, it's not in the budget. Corporations, like people, are limited by their budgets. What do you do when you have a limited budget? You figure out the best ways to spend what you have to get what you need or want. For a business, that may be new equipment. When corporations figure out ways to get what they need or want, it's called capital budgeting. So, corporations conduct financial analysis to determine whether an investment or project is a good idea to pursue.

Capital Budgeting Decisions

Since the main purpose of a corporation is to make money, it's important to wisely choose which opportunities to pursue. There are several factors that a corporation needs to understand in order to make a capital budgeting decision. They need to understand their cash flow. That is, the amount of money that goes into and out of a business. How much money do we have?

Corporations also need to understand the financial implications of an investment. How will this capital expenditure, money spent on projects and investments, affect us now and in the future? Once they understand the financial implications of an investment, they need to understand whether it's a good investment for them. So they need to understand their criteria for making an investment. What do they hope to gain? How much do they want to spend? What outcome would make this a good or bad investment for them?

Payback Period

There are several common techniques that corporations use to determine how money is spent. This lesson will discuss three techniques: payback period, net present value, and internal rate of return. The payback period is the easiest to calculate.

A business that wanted to buy a new piece of equipment might use this technique to make a capital budgeting decision. The payback period is the amount of time that it takes for an investment or project to pay for itself. For instance, the equipment costs $5,000 to purchase and will potentially earn $1,000 in profits a month. The equipment will pay for itself in five months.

How easy was that? You just need key pieces of information, such as the cost of the machine and how much profit it could produce over a specific period of time.

Time Value of Money

The downside of using the payback period technique is that it does not account for the time value of money. That means that money is worth more today then it will be in the future. Money has a time value for three reasons.

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