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What Is the Process of Capital Budgeting?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 23 November 2016
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Capital budgeting is a term used to describe the process of analyzing the projects for which finances in a company may have been earmarked with a view toward assessing the merits and demerits of applying the funds to such projects in both the long and short term. This process is very important for businesses, because the efficient application of funds is essential due to the fact that when a business applies its limited funds to projects that may not soon yield results or that may not be profitable, it will suffer the consequences in the form of diminished capital. The parameters for determining the exact factors that will guide the process of capital budgeting depend on the type of business in question, the total capital it has to work with, and the expected benefits from the proposed project. In this sense, two businesses may apply the process of capital budgeting toward a similar project and come to different conclusions as a result of their individual circumstances.

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An example of the process of capital budgeting can be seen in the case of a ceramic company that is considering whether to open a new plant in another state. During the analysis of the company situation as part of the capital budgeting process, the company will consider its cash flowing in and out, its net worth, the disposable liquid cash it has to work with, and the profitability of the present plant in terms of production and output. All of these factors will help the company decide how much it can spare toward the attainment of the goal of investing in a new plant. Where the numbers fail to add up in a favorable manner, the company might decide to allocate the capital resources to other projects that will yield more positive results.

In terms of how the process of capital budgeting can be different for two companies that may be considering a similar venture, this can be seen in the case of another ceramic company that may also be deliberating the merits of opening a new plant in another state. The second company might have different circumstances that may make an investment in a new plant a good strategic business move. For instance, the demand for the products produced by that particular company might be so much that it would be beyond the capacity of the present plant.

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