Capital budgeting is the process by which you evaluate the financial potential for each of one or more possible capital investments. In those cases where several options are available but the corporation has enough resources to pursue only one, each option must be compared against the others in order to determine which one will yield the greatest returns.
Just about everything corporations spend money on can be considered an investment. Because corporations manage other people’s money, nothing they spend that money on is supposed to be for personal gain or enjoyment; rather, it’s supposed to be used to generate returns for the owners of the corporation, who are the stockholders.
So, every dollar a corporation spends should contribute to the increased value of the corporation in some way. But that’s not always the case, because many corporations are very wasteful. Plus, you don’t really need to measure the returns on every single dollar. For example, nobody cares how much value a paper clip adds to the total output of a corporation.
When it comes to larger expenditures, though, you start to run into matters of potential returns and capital budgeting. When a corporation is considering buying land, a new plant, or new machinery; offering a new line or product; or starting a new project; all these undertakings need to be carefully analyzed from a financial standpoint to determine their potential returns and risk before any action is taken.
This is where capital budgeting comes into play. The name may be a little misleading, because capital budgeting really has more to do with evaluating the potential of capital investments than actual budgeting; but the process was originally used to budget resource allocations, which is why it’s called capital budgeting.
The implications of the evaluation go beyond simply making allocation decisions, though. The information that you derive from these financial valuations plays a big role in the financial projections for the entire corporation, its resource budgeting, its liquidity and asset management, and almost every other aspect of the corporation’s finances and operations.
The exact nature of the corporation’s capital investments determines what production volume the corporation is capable of handling, how profitable and financially efficient it will be, and even how it sets its pricing strategies. The operational and cost efficiencies that the entire corporation experiences are largely influenced by its capital budgeting decisions.