Capital budgeting is a method of analyzing the possible risks and rewards of an investment decision. Business managers utilize capital budgeting to assess the potential costs of an investment over time. It helps managers determine how investment costs correlate with business earnings. Capital budgeting has many advantages. It serves as a financial-planning tool that, when used correctly, can save a business from making poor and costly investment decisions.
Multiple Budgeting Methods
An advantage of capital budgeting is that several budgeting techniques are available to suit the varying needs of businesses. For example, the "net present value" capital-budgeting technique measures an investment's profitability. This method considers cash flows and analyzes the risk of future cash flows. The "internal rate of return" capital-budgeting method helps a firm analyze which investments or projects will yield the highest internal rate of return. A firm is free to choose from the capital-budgeting techniques that will provide the most complete and accurate information about a particular investment.
Capital budgeting is a unique decision-making and risk-assessment tool. It gives businesses the opportunity to review potential investments and projects individually and objectively. Capital budgeting allows businesses to compare the value of a particular investment to the company's business plan and goals. It also offers the opportunity to determine if the investment or project makes sense financially for the firm. Capital budgeting helps businesses understand the anatomy of an investment, which in turn helps the firm understand the risks involved.
Predict Potential Return
Many capital-budgeting methods allow a firm to predict the future value of an investment by considering its current value. Capital budgeting also allows a firm to determine how long it will take an investment to mature. Some investment dollars could earn more in interest in a bank rather than in a particular investment vehicle. Through capital budgeting, a firm is better equipped to predict which investment tool will provide the best return.
Capital budgeting is advantageous because it allows a firm to make long-term investment decisions. Investment projects vary in size. Projects also have different benefits to the business such as in increase in cash flow or a decrease in risk. A firm typically cannot utilize current expenditures to evaluate a capital-investment project because the project is often too large and requires a significant amount of time to realize a return. Capital budgeting helps a firm create long-term goals, analyze several investment opportunities and forecast the results of the long-term project.
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