Capital Budgeting

2549 Words Mar 15th, 2013 11 Pages
Capital Budgeting

One of the most important decisions a financial manager can make involves capital budgeting. Capital budgeting is used to determine which fixed assets should be purchased. The purchasing of fixed assets is a form of a long-term investment. Allocating funds in the capital account is a form of capital budgeting. A financial manager will determine if the purchase of a capital asset or fixed asset is worth more over that assets life then it is for the cost to purchase it. In other words, they make sure that the asset would get the amount it cost plus a profit in return.
Financial managers cannot seem to agree on a specific method that works better than the other when it comes to estimating and budgeting. Even in the
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There is no guarantee that the future estimates will reflect the actual cash flows. Errors are a common occurrence in forecasting, estimating and budgeting. The forecasting risk that there are errors that will lead to misinformation, causing the wrong decisions to be made on a proposal.
The Payback Rule When talking about “payback,” it is referring to the amount of time it takes to regain the amount it cost a business to pay for the investment. In other words, how many years does it take to generate enough cash flows from the investment to cover its costs. It can also be seen as the amount of time it takes for an investment to “breakeven.” The amount of time is a predetermined amount, and that amount is what is factored in when determining if the investment is a good investment. For example, if a company decides they want to invest in a capital asset that would take less than five years to payback, and after calculating the cash flows and determine it will take only three years to payback or generate enough from the investment, than the investment is a good investment. There is no set rule when determining how much time an investment should have for the payback. That is up to the discretion of the financial managers. One issue with the payback method is that it ignores time value. When estimating the cash flows and the payback, it is good to project over the entire allotted time span on what the cash flows would be.

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