Capital Budgeting: Meaning, Objectives, Process, Techniques (2024)

Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital expenditure is the spending of funds for large expenditures like purchasing fixed assets and equipment, repairs to fixed assets or equipment, research and development, expansion and the like. Budgeting is setting targets for projects to ensure maximum profitability.

What is Capital Budgeting?

Capital Budgeting: Meaning, Objectives, Process, Techniques (1)

Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.

An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments. Capital budgeting as a concept affects our daily lives.

Let’s look at an example- Your mobile phone has stopped working! Now, you have two choices: Either buy a new one or getthe same mobile repaired. Here, you mayconclude that the costs of repairingthe mobile increases the life of the phone. However, there could be a possibility that the cost to buy a new cell phonewould be lesser thanits repair costs. So, you decide to replace your cell phone and youproceed tolook at different phones that fit your budget!

What are the objectives of Capital budgeting?

Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:

Selecting profitable projects

An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.

Capital expenditure control

Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.

Finding the right sources for funds

Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.

Capital Budgeting Process

Capital Budgeting: Meaning, Objectives, Process, Techniques (2)

The process of capital budgeting is as follows:

Identifying investment opportunities

An organization needs to first identify an investment opportunity. An investment opportunity can be anything from a new business line to product expansion to purchasing a new asset. For example, a company finds two new products that they can add to their product line.

Evaluating investment proposals

Once an investment opportunity has been recognized an organization needs to evaluate its options for investment. That is to say, once it is decided that new product/products should be added to the product line, the next step would be deciding on how to acquire these products. There might be multiple ways of acquiring them. Some of these products could be:

  • Manufactured In-house
  • Manufactured by Outsourcing manufacturing the process, or
  • Purchased from the market

Choosing a profitable investment

Once the investment opportunities are identified and all proposals are evaluated an organization needs to decide the most profitable investment and select it. While selecting a particular project an organization may have to use the technique of capital rationing to rank the projects as per returns and select the best option available. In our example, the company here has to decide what is more profitable for them. Manufacturing or purchasing one or both of the products or scrapping the idea of acquiring both.

Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund the project it needs to identify the sources of funds and allocate it accordingly. The sources of these funds could be reserves, investments, loans or any other available channel.

Performance Review

The last step in the process of capital budgeting is reviewing the investment. Initially, the organizationhad selected a particular investment for a predicted return. So now, they will comparethe investments expected performance to the actual performance.

In our example, when the screening for the most profitable investment happened, an expected return would have been worked out. Once the investment is made, the products are released in the market, the profits earned from its sales should be compared to the set expected returns. This will help in the performance review.

Capital Budgeting Techniques

To assist the organization in selecting the best investment there are various techniques available based on the comparison of cash inflows and outflows. These techniques are:

Payback period method

In this technique, the entity calculates the time period required to earn the initial investment of the project or investment. The project or investment with the shortest duration is opted for.

Net Present value

The net present value is calculated by taking the difference between the present value of cash inflows and the present value of cash outflows over a period of time. The investment with a positive NPV will be considered. In case there are multiple projects, the project with a higher NPV is more likely to be selected.

Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or average investment to derive at the most profitable investment.

Internal Rate of Return (IRR)

For NPV computation a discount rate is used. IRR is the rate at which the NPV becomes zero. The project with higher IRR is usually selected.

Profitability Index

Profitability Index is the ratio of the present value of future cash flows of the project to the initial investment required for the project. Each technique comes with inherent advantages and disadvantages. An organization needs to use the best-suited technique to assist it in budgeting. It can also select different techniques and compare the results to derive at the best profitable projects.


Capital budgeting is a predominant function of management. Right decisions taken can lead the business to great heights. However, a single wrong decision can inch the business closer to shut down due to the number of funds involved and the tenure of these projects.

Capital Budgeting: Meaning, Objectives, Process, Techniques (3)

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Capital Budgeting: Meaning, Objectives, Process, Techniques (2024)


Capital Budgeting: Meaning, Objectives, Process, Techniques? ›

Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark.

What are the objectives of capital budgeting techniques? ›

Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.

What is the 4 techniques for capital budgeting? ›

The process of capital budgeting requires calculating the number of capital expenditures. An assessment of the different funding sources for capital expenditures is needed. Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.

What are the 6 processes of capital budgeting? ›

The process of capital budgeting includes 6 essential steps and they are: identifying investment opportunities, gathering investment proposals, decision-making processes, capital budget preparations and appropriations, and implementation and review of performance.

What are the five steps involved in the capital budgeting process? ›

Five Steps to Capital Budgeting
  • Identify and evaluate potential opportunities. The process begins by exploring available opportunities. ...
  • Estimate operating and implementation costs. The next step involves estimating how much it will cost to bring the project to fruition. ...
  • Estimate cash flow or benefit. ...
  • Assess risk. ...
  • Implement.

What is the use of capital budgeting techniques in businesses? ›

Capital budgeting is one of the most important areas of financial management. There are several techniques commonly used to evaluate capital budgeting projects namely the payback period, accounting rate of return, present value and internal rate of return and profitability index.

What are the three 3 commonly used capital budgeting techniques? ›

Capital budgeting is the process by which investors determine the value of a potential investment project. The three most common approaches to project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV).

What is the best capital budgeting technique? ›

NPV Method is the most preferred method for capital budgeting because it considers the cash flow in the tenure and the cash flow uncertainties through the cost of capital. Moreover, it constantly boosts the company's value, which is void in the IRR and profitability index.

What are the four 4 main types of budgeting methods? ›

There are four common types of budgets that companies use: (1) incremental, (2) activity-based, (3) value proposition, and (4) zero-based. These four budgeting methods each have their own advantages and disadvantages, which will be discussed in more detail in this guide.

What are the principles of capital budgeting? ›

Capital budgeting decisions are based on incremental after-tax cash flows discounted at the opportunity cost of funds. Financing costs are ignored because both the cost of debt and the cost of other capital are captured in the discount rate.

What are the 7 capital budgeting techniques? ›

What are the seven capital budgeting techniques? The seven techniques include net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period, discounted payback period, modified internal rate of return (MIRR), and real options analysis.

Which of the following is an objective of capital budgeting quizlet? ›

Answer and Explanation: One of the objectives of capital budgeting is to earn a satisfactory return on investment.

What is the objective of a capital budgeting project quizlet? ›

The goal of the capital budgeting decisions is to select capital projects that will decrease the value of the firm. When two projects have cash flows that are tied to each other, the projects may be classified as independent.

What are the objectives of capital budgeting Wikipedia? ›

Capital budgeting in corporate finance, corporate planning and accounting is an area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development ...

Why capital budgeting techniques are considered important for entrepreneurs? ›

Long-lasting effect on profitability

Further, it also influences the company's costs, profitability and growth. Hence, if the expenditures are done based on the budget plan, definitely the profitability of the business will increase.

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