This is the most important topic in financial management. By Capital budgeting we mean the long term decisions for investment. Should we invest money into the long term project or not, this all decision making, analysis and conclusion is well covered under the umbrella of capital budgeting.
Whenever you invest money into the capital budget, it starts to give inflow from the coming years and this inflows remain continue up to the life of the project. Once that capital asset has been used fully, it might be sold at a scrap value.
When taking decisions to make investments into fixed assets or projects, you may face several options in front of you. Obviously, you cannot choose all the options because you have the scarce resources available. Keeping in view your scarce resources, you will have to choose the best possible option that gives you sufficient return.
You cannot make decision over the basis of one or two factors. Financial management is a multi dimensional analysis which helps greatly in evaluating the long term project from multiple facets. You have to see the investment amount required for the project, the cost of capital, the time period involved for the analysis and the possibilities of the cash inflows and outflows. We denote possibility of cash flows using probabilities in the business mathematics and it plays a vital role in developing the worst, bad, good and excellent scenarios.
Though, it is a multi facet analysis and seems very difficult, but if proper attention is given, then in my opinion, this is the most interesting and simple topic. It is simple because of its implications in our daily life and how we do decisions on a regular basis without knowing that we are making decisions by some form of financial management techniques.
Techniques for Capital Budgeting
There are various techniques which are used to evaluate the fixed asset investment. These are:
- Net present value – NPV
- Internal rate of return – IRR
- Pay-back period – PBP
- Profitability index – PI