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Capital budgeting

Capital budgeting is the process businesses use to evaluate the future profitability of proposed projects, so that they can best determine where to allocate limited capital funds.

Expanded Definition

Capital funds pay for capital expenditures, which are large projects or ones that won't see a return for at least one year, and probably longer. (These differ from operational expenditures). Successful companies have a continuing need for capital investment to, for instance, upgrade equipment to continue existing operations. They can also need to expand in the case of a growing product line or division. Acquisitions also present opportunities to grow a business.

But you can't have it all. Growth of a business can be limited by the availability of capital. When capital is limited, allocating that resource properly is a critical skill which involves crunching current numbers as well as taking into consideration future market conditions, such as inflation and demand for a certain product.

Some capital investment can be funded out of cash flow, profits and/or retained earnings. Beyond a point, other financing is necessary. Sale of stock and/or borrowing are the usual methods. The method chosen usually depends on the company's finances and factors like interest rates and market conditions at the time.

Calculations used when determining where best to spend resources include looking at internal rate of return, net present value, discounted cash flow, and the profitability index.

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