Definition of Capital Budgeting Decisions
Capital budgeting assists in the investment decisions regarding assets that will have an impact on more than one year.
Some capital budgeting models use cash flows that are discounted for the time value of money. The time value of money recognizes that a dollar today is more valuable than a dollar received in the future. Other capital budgeting models use cash flows without discounting them, while others use the accrual accounting revenues and expenses and also ignore the time value of money.
Since the investments have an impact over many years, the preferred methods for capital budgeting decisions are those which use discounted cash flows. (In addition to using the discounted cash flow models, a company is likely to also calculate some non-discounted accrual accounting amounts to see how the investments will impact its future financial statements.)
Examples of Capital Budgeting Models
The following are capital budgeting models that use cash flows which are then discounted to recognize the time value of money:
The discounting of cash flows can be done using computer software, financial calculators, or present value factors.
The capital budgeting models that do not recognize the time value of money include the following:
- Payback period which uses the cash flow amounts but ignores the time value of money by not discounting the future cash flows
- Return on investment (ROI) which uses the accrual accounting revenues and expenses (not the cash flows) and also ignores the time value of money