Capital budgeting refers to the analysis that companies conduct in order to assess whether an investment in a new project (including plant and machinery) is worthwhile. Lets say for example that company X has limited funds and is seeking for opportunities to grow and generate additional profits. The company will have a array of options at its disposals and will use capital budgeting to understand :
1. The funding available
2. The limitations of the funding (period in which is available, terms of funding, cost of funding)
3. The options or the projects that are available to invest in.
The next step is to conduct analysis and compare the project by using a variety of techniques which include (but no limited to) : Internal Rate of Return, Net Present Value, Accounting Rate of Return and Payback Period.
The company will have to face additional parameters. First of all, are these projects mutually exclusive? In other words, if it chooses project A, would be it possible to choose project B too? Another question is if the projects are divisible or not. For example, can the company invest in project A and also invest what is left in a part of project B?
The importance of capital budgeting is quite clear since it gives the companies a systematic analytical tool to identify and assess their growth opportunities.