Introduction to Capital Budgeting
Concepts
Capital budgeting is the process that
companies use for decision making on capital
projects with a life of a year or more.
An efficient allocation of capital is the most
important finance function in the modern
times. It involves decisions to commit the
firm’s funds to the long-term assets. Capital
budgeting or investment decisions are of
considerable importance to the firm, since
they tend to determine its value by
influencing its growth, profitability and risk.
,Existing firms invest to continue to exist and
to grow.
When a firm is investing to grow, it is also
investing to maximize the owners' wealth. To
maximize the wealth of a firm's owners, its
managers must regularly evaluate investment
opportunities and determine which ones
provide a return commensurate with their
risk.
Illustration I
Consider firms A, B and C, each having
identical assets and investment opportunities.
In addition, the following information
specifically relates to an individual firm:
, Firm A's management does not take advantage
of its investment opportunities and simply pays
all of its earnings to its owners.
Firm B's management only makes those
investments necessary to replace any
deteriorating plant and equipment, paying out
any left-over earnings to its owners.
Firm C's management invests in all those
opportunities that provide a return better than
what the owners could have earned had they
had the same amount of invested funds to
invest themselves.
Concepts
Capital budgeting is the process that
companies use for decision making on capital
projects with a life of a year or more.
An efficient allocation of capital is the most
important finance function in the modern
times. It involves decisions to commit the
firm’s funds to the long-term assets. Capital
budgeting or investment decisions are of
considerable importance to the firm, since
they tend to determine its value by
influencing its growth, profitability and risk.
,Existing firms invest to continue to exist and
to grow.
When a firm is investing to grow, it is also
investing to maximize the owners' wealth. To
maximize the wealth of a firm's owners, its
managers must regularly evaluate investment
opportunities and determine which ones
provide a return commensurate with their
risk.
Illustration I
Consider firms A, B and C, each having
identical assets and investment opportunities.
In addition, the following information
specifically relates to an individual firm:
, Firm A's management does not take advantage
of its investment opportunities and simply pays
all of its earnings to its owners.
Firm B's management only makes those
investments necessary to replace any
deteriorating plant and equipment, paying out
any left-over earnings to its owners.
Firm C's management invests in all those
opportunities that provide a return better than
what the owners could have earned had they
had the same amount of invested funds to
invest themselves.
