Capital budgeting is the process of determining if a long-term investment or project is worth the capital. Business owners use such factors as cash flow when making important decisions.
Capital budgeting is usually applied when a business has limited capital to spend. This principle is used to maximize the most return within the parameters of a budget. An investment or project must yield some form of value to the company. This can come in the form of mergers, acquisitions or expanding the organization in other ways.
Various techniques are used in capital budgeting, such as accounting rate of return and payback period. For example, the payback period refers to the amount of time necessary to recover the funds invested in the project. The accounting rate of return is the profit that arises from the venture. This is accomplished by dividing the profit by the investment. However, inflation must be taken into consideration when calculating expenses because the monetary value lowers as inflation increases, affecting the projected rate of return.
Managers also apply a principle known as minimum rate of return when deciding to embark on an investment endeavor. This is the minimum amount of return that the investors need to approve new operations. Minimum rate of return also accounts for other factors, such as the level of risk and cash flow influx.