What is Capital Budgeting?

What is Capital Budgeting?

Most of the companies will need to purchase fixed assets (Also see What Are Assets and How to Classify Them?) for the operations of the business. However, not all business owners will apply capital budgeting when they buy fixed assets for their companies. Capital budgeting is something that business owners can use to identify whether they can accept or decline a fixed asset purchase that the employees have proposed. By doing so, business owners will be able to view the proposed investments on the fixed assets and hence, this gives them a rational basis when they make any judgement.

Capital budgeting is essential as companies would spend a substantial amount of cash when they invest in fixed assets (Also see Introduction to Asset Accounts). Hence, a failure in the investment may result in the bankruptcy of a company. To prevent this from happening, if business owners are unable to do the accounting tasks on their own,  they should seek help from an accounting firm in Johor Bahru as they need clear accounting records for them to know the financial position of the company. Having an in-depth understanding of the financial position would help in the process of capital budgeting.

Capital budgeting is essential when the business owners are considering proposed fixed asset purchases that involve a large amount of money. However, if the investment is small, the priority should be on making the process of capital budgeting more efficient. Thus, business owners may focus more on making the investment as earlier as possible. This is to prevent the analysis of fixed asset proposals from obstructing the functioning of the departments that generate profits for the company.

Business owners may use a lot of ways to assess the fixed assets by using the capital budgeting system. Some of the notable examples are listed below:

Avoidance analysis

Business owners may identify whether they can increase the maintenance of existing assets to lengthen their useful life, instead of making investments on new assets to replace the old ones. The avoidance analysis helps in reducing the total investment that the company makes in its fixed assets.

Net present value analysis

Business owners need to determine the net change in cash flow (Also see How to Manage Your Business Cash Flow?) which is related to the purchase of a fixed asset. Then, they should discount the amounts to their present value. A comparison should be made between all the proposed purchases that have positive net present values, and business owners should choose those with the highest values until the company runs out of funds.

Payback period

When using the payback period, business owners need to identify the time needed for the company to generate enough cash flow to pay for the initial investment it has made in the project. This method focuses on the period that an investment is risky in a way that it may not be returned to the business.

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