What is Capital Budgeting?

It is a process that companies use for decision making on capital projects (projects with a life of a
year or more).
OR
It is a process that a business uses to determine which proposed fixed asset purchases it should
accept, and which should be declined.
This process is used to create a quantitative view of each proposed fixed asset investment,
thereby giving a rational basis for making a judgment.
The process involves analyzing a project’s cash inflows and outflows to determine whether the
expected return meets a set benchmark.

Importance of Capital Budgeting

The amount of cash involved in a fixed asset investment may be so large that it could lead to the
bankruptcy of a firm if the investment fails.
A wrong decision can be disastrous for the long-term survival of the firm.
Capital budgeting has its effect in a long time span.
It also affects companies future cost & growth.

Basic Principles of Capital Budgeting

Capital budgeting required sophisticated procedures and uses the following basic assumptions:
Decisions are based on cash flows
Timing of cash flows is crucial
Cash flows are based on opportunity costs
Cash flows are analyzed on an after tax basis
Financing costs are ignored
Cash flows are not accounting net income
Important Capital Budgeting Concepts
1. Sunk Cost
It is a cost which is already incurred and which need not be reflected in the incremental cash
flows used for estimation of net present value and internal rate of return. Sunk costs are named
so because they can't be recovered and changed.
2. Opportunity Cost
It is define as the loss of potential gain from other alternatives when one alternative is chosen.
Important Capital Budgeting Concepts
3. Incremental Cash flow
It is the cash flow that is realized because of a decision i.e. cash flow with decision – cash flow
without decision. If Opportunity cost are correctly assessed, the incremental cash flows provide
better results for capital budgeting.
4. Externality