Capital Budgeting

In contrast with cost-benefit analysis, which takes a broad view, the assessment of projects within a company takes a narrower view. The view is narrowed by mainly considering the benefits or costs to the company, not to society. This is not to say that the companies do or should act irresponsibly; it is merely that the company’s viewpoint is that the main beneficiary of its investments should be itself. The activities within a company of assessing long-term opportunities and allocating capital to them are known as capital budgeting within the field of financial management.

It addresses essentially the same questions as engineering economics. Examples of capital budgeting decisions are the acquisition of land, buildings, equipment, and vehicles, amongst others, for productive use by the company.

Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.

Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.

Cost-benefit analysis, engineering economics and capital budgeting offer methods and techniques for the choice of investments in both the government and private sectors. The analysis of government projects is closer to economic cost benefit analysis than it is to capital budgeting, because government has a broader remit than does a company. Many of the infrastructure projects that government invests

in, such as dams, power schemes, and highways, are typically very long lived.

However, both government and company decisions are championed and made by people, not necessarily in the best interests of the public or the company, and are subject to the politics of the organization. In a company, it is the duty of the executive management to set the direction and the strategy of the company clearly, so that the most efficient choices can be made. The understanding of different viewpoints and the organization and the business context in which investment decisions are made is important, and is discussed in the following posts.

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