Budgeting Basics and Beyond

Chapter 20. Capital Budgeting: Selecting the Optimum Long-term Investment

Capital budgeting relates to planning for the best selection and financing of long-term investment proposals. Capital budgeting decisions are not equally essential to all companies. The relative importance of this function varies with company size, the nature of the industry, and the growth rate of the firm. As a business expands, problems regarding long-range investment proposals become more important. Strategic capital budgeting decisions can turn the tide for a company.

The types of scarce resources that may be committed to a project include cash, time of key personnel, machine hours, and floor space in a factory. When estimating costs for a proposed project, the allocation of the company 's scarce resources must be converted in terms of money.

The two broad categories of capital budgeting decisions are screening decisions and preference decisions. Screening decisions relate to whether a proposed project satisfies some current acceptance standard. For instance, a company may have a policy of accepting cost reduction projects only if they provide a return of, say, 15 percent.

Preference decisions apply to selecting from competing courses of action. For example, a company may be looking at four different manufacturing machines to replace an existing one. The selection of the best machine is referred to as a preference decision.

The basic types of investment decisions involve selections between proposed ...