Capital budgeting

Definition

Capital budgeting involves the process of evaluating and selecting long-term investments that are in line with the goal of a firm's wealth maximization. It includes analyzing potential projects or investments to determine their profitability and risk.

5 Must Know Facts For Your Next Test

1. Net Present Value (NPV) is a key metric in capital budgeting that assesses the profitability of an investment.
2. The Internal Rate of Return (IRR) is another important measure used to evaluate the attractiveness of a project.
3. Capital budgeting decisions often involve comparing the expected cash flows from a project against its initial cost.
4. Payback period is a simple method to determine how long it will take for an investment to repay its initial cost.
5. Sensitivity analysis can be used in capital budgeting to assess how different variables impact the project's outcomes.

Review Questions

• What is Net Present Value (NPV) and why is it important in capital budgeting?
• How does the Internal Rate of Return (IRR) help in making capital investment decisions?
• What is the significance of sensitivity analysis in capital budgeting?

Related terms

Net Present Value (NPV):

A method used to determine the present value of future cash flows generated by an investment, minus the initial investment cost.

Internal Rate of Return (IRR):

The discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

Payback Period:

The amount of time it takes for an investment to generate enough cash flow to recover its initial outlay.