Capital Budgeting may be defined as the decision making the process by which a firm evaluates the purchase of major fixed assets including – building, machinery and equipment. Capital budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of shareholder wealth maximization. It is the process of planning expenditures on assets whose cash flows are expected to intend beyond one year. It is a step by step process that businesses use to determine the merits of an investment project.
Steps of capital budgeting:
(a) The cost of the project must be determined.
(b) Management must estimate the expected cash flows from the projects including the salvage value of the asset.
(c) The riskiness of the projected cash flows must be estimated.
(d) Management determined the cost of capital at which to discount the project cash flows.
(e) The expected cash flows are put on a present value basis to estimate the value of the asset of the firm.
(f) The present value of the expected cash inflows is compared with the cost of the project. If the value of the assets exceeds its cost, the project should be accepted.
(g) Deciding on how to allocate the available capital among alternative investment proposals.
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible its owners or shareholders.