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Capital budgeting is a fiscally responsible process that is designed to manage available resources to select the long term projects that demonstrate the highest degree of potential to yield a high return on the investment of those resources. Capital budgeting requires understanding the balance between the amount of resources that will be expended, the rate at which those resources will be utilized, and how quickly the investment will begin to show a return, reach the break even point, and eventually begin to show a profit.
The basic formula for capital budgeting is a very simple one. Essentially, capital budgeting involves comparing the discounted cash flow with the internal rate of return. Discounted cash flows have to do with the value of resources that are involved in the initial launch of the project, allowing for gradual reductions or discounts for each year of the project. Rates of return, in particular the internal rate of return, are the average rates that are earned by each resources that is invested in a project during specified period of time.
In order for the capital budgeting for a project to be attractive, the projections have to indicate several factors that will make up the outcome of the project. First, the project is expected to recoup the resources invested in the launch of the project within a reasonable period of time. Often, the earlier in the process that the investment can be covered by generated revenue, the sooner that investors begin to see profits from the venture.
Next, the project needs to be perpetuating. That is, the project must continue to generate revenue after the initial launch on a long-term basis. This factor makes fad items that are expected to have a shelf life of no more than a few months unworthy of capital budgeting. Last, the amount of resources needed to sustain the momentum of the project should be considerably less than at the point of launch. This factor indicates that the level of profitability will continue to rise for a time before leveling out.
The preparation of a capital budget is a task that requires attention to detail, the ability to analyze and investment opportunity thoroughly, and an understanding of how to prepare projections that are based on solid facts. This means that financial experts are the best choice to manage capital budgeting. Experts of this type can view the data objectively and create a realistic budget that will accurately reflect the circumstances surrounding the investment opportunity.
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