The Basics of Capital Budgeting: Introduction

Firms use capital budgeting for their long-term asset investment decisions. Capital budgeting is important because fixed asset investment decisions chart a company's course for the future. Capital budgeting is similar in principle to -Select-(interest analysis, risk analysis, security valuation) in which future cash flows are estimated, risks are appraised and reflected in a cost of capital discount rate, and all cash flows are evaluated on a -Select-(compound, present, future) value basis. The primary methods used in this process are: Net present value, Internal rate of return, Modified internal rate of return, and Payback. Projects that firms consider are either independent or mutually exclusive. In addition, projects may have normal cash flows or nonnormal cash flows. Whether a project is independent or mutually exclusive will impact the firm's capital budgeting analysis as we will see when we discuss the different decision rules.