What Are the Basics of Capital Budgeting?

Capital budgeting is a company’s process for generating, finding, and evaluating projects as sources of long-term funding. Basics of capital budgeting include knowledge of cash flow calculations, the cost of capital, and risk. New projects to build in this area could include an entirely new product or ideas to improve existing ones. Many of these new ideas typically originate from the employees in the company’s research and development department.

Research and development may generate new project ideas, but the basics of capital budgeting involve evaluating the profitability of each of these new endeavors. Ideally, a company only chooses new ventures that generate the most revenue. The evaluation process generally involves measuring the potential cash flows of a project and determining any financial risk involved in the venture. Keeping costs under control while appealing to a high number of consumers is a common primary goal of many capital undertakings.

Calculations for the cost of capital budget projects are factored as cash flows instead of as accounting profits, even though accounting profits are the traditional calculation method for American businesses. Cash inflows include money from sales, and cash outflows include initial investment and product launch expenses. For the basics of capital budgeting, financial managers use actual cash flows instead of accounting profits because it is easier to tie cash to the project than to its profits, which can flow from a variety of sources. Accounting profits also have a time lag, because accountants present the actual totals at the end of the accounting time period.

Cash flow totals have the advantage of real time calculation. This ability also comes in handy when accounting for the potential financial risk of a new project. Determining risk is a large part of the basics of capital budgeting. Risk in capital budgeting means estimating what is expected to happen with the funds dedicated to, and returning from, a new project. Financial managers may use different methods to calculate risk, but most methods include predicting cash flows.

Financial managers are primarily concerned with the systematic risk of a new project. Systematic risk means the project’s financial impact on corporate shareholders. The calculation of systematic risk is likely to involve predictions of the company’s future ability to pay stock dividends and the new project’s expected influence on the business’s overall financial health. Risk may be measured using several approaches, including the certainty equivalent and the risk-adjusted discount rate methods.