What Is Capital Budgeting

The term capital refers to the funds employed to finance fixed assets used in production; a budget is a detailed plan of projected inflows and outflows over future periods. Capital budgeting is the process of planning expenditures that generate cash flows expected to extend beyond 1 year. The choice of 1 year is arbitrary, of course, but it is a convenient cutoff for distinguishing between classes of expenditures. Examples of capital outlays are expenditures for land, buildings and equipment, and for additions to working capital (e.g., inventories and receivables) made necessary by expansion. New advertising campaigns or research and development programs are also likely to have impacts beyond 1 year and come within the classification of capital budgeting expenditures.

Capital budgeting integrates the various elements of the firm. Although the financial manager generally has administrative control of the capital budgeting process, the effectiveness of a firm's capital investments depends on input from all major departments. The marketing department makes a key contribution by providing sales forecasts. Because operating costs must be estimated, the accounting, production, engineering, and purchasing departments are also involved. The initial outlay, or investment cost, must be estimated; again, engineering and purchasing typically provide input. Obtaining funds and estimating their cost are major tasks of the financial manager. Finally, these various estimates must be drawn together in the form of a project evaluation. Although the finance department generally writes up the evaluation report, top management ultimately sets standards of acceptability.

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