What is Capital Budgeting?
Capital budgeting is the process of budgeting for the acquisition of "capital assets." In accounting, capital assets are assets that are depreciable (i.e. have a useful life beyond one accounting period). Four capital budgeting models that can be used to determine whether or not a capital investment is a viable investment: payback period, accounting rate of return, net present value and internal reate of return.
When a business is deciding on an investment, the business must consider and incorporate the concept of time-value-of-money (TVM). Time-value-of-money is simply the concept that money earns money over time.
The payback period and the accounting rate of return are used when making short-term investment decisions. These two models do not incorporate the time-value-of-money as these are short-term decisions and the time-value-of-money would not be relevant.
The money that will be used to purchase an investment can be earning money (i.e. interest). Therefore, businesses, when considering long-term investment decisions, must incorporate the time-value-of-money concept in long-term business decision making.
The net present value and internal rate of return models incorporate the time-value-of-money concepts.
When a business is considering a capital investment, the business must take into consideration any cash inflows and cash outflows.
- future cash revenue generated from investment
- future savings in ongoing cash operating costs resulting from investment
- future residual value of asset
- investments ongoing cash operating costs and refurbishment, repairs, and maintenance costs
- new investment cost
Accounting lecture notes: http://tiny.cc/nw1enw
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