Definition and Explanation of Capital Budgeting:

Learning Objectives:

1. Define and explain the term "capital budgeting".
2. What is meant by the term "investment in capital budgeting decisions"? Explain with examples.

The term "capital budgeting" is used to describe how managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and the introduction of new products.

Most companies have many more potential projects than can actually be funded. Hence, managers must carefully select those projects that promise the greatest future return. How well managers make these capital budgeting decisions is a critical factor in the long run profitability of the company.

Capital budgeting involves  investments. A company must commit funds now in order to receive a return in the future. Investment is not limited to stocks and bonds. Purchase of inventory or equipment is also an investment.

Examples of Investments:

1. Tri-Con Global Restaurants, Inc. makes an investment when it opens anew Pizza Hut restaurant.
2. L. L. Bean makes an investment when it installs a new computer to handle customer billing.
3. DiamlerChrysler makes an investment when it redesigns a product such as the Jeep Eagle and must retool its production lines.
4. Merck & Co. invests in medical research.
5. Amazon.COM makes an investment when it redesigns its website.
   
   All of these investments are characterized by a commitment of funds today in the expectation of receiving a return in future in the form of additional cash inflows or reduced cash outflows.

 

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