![]() ![]() ![]() If this is higher than the company's cost of capital, the specific investment will create value for the company's shareholders.Īs the asset allocation process is led on a continual basis, the financial manager must measure constantly the profitability of the firm's investment activity. It is, then, possible to conclude that the financial manager must judge a certain investment project according to its expected return. In order to increase shareholders' wealth, a project must yield more than the cost of funds used to undertake the capital expenditure. The financial manager must carry out those projects that maximize the incremental value for the company's shareholders. The latter aspect is taken into account in drawing up the financial plan, where the financial manager verifies the compatibility of the cash flows related to the project under consideration with those that happen at the overall company's level. In fact, the first step in undertaking any allocation project is the analysis of its economic and financial profile. Since financial managers need to keep under control the asset allocation process so as to grant the maximum value to their shareholders, it can be said confidently that one of the most important corporate finance functions is the economic valuation of investment projects. In fact, not only does any investment decision contribute to determine the company's profitability (and its ROI) and, then, the shareholders' value, but also the capital budgeting process vitally affects all departments of a firm (such as production, marketing, finance, to mention a few). A number of factors make capital budgeting one of the major financial management decisions. Before a company undertakes an expensive investment such as the purchase of a new plant, the launch of a new product, or the signature of a commercial agreement, it needs to plan how to raise funds required for that specific project. Another reason that highlights the relevance of the capital budgeting process is that asset expansion typically involves substantial expenditures. An effective process of capital budgeting aims at improving the timing of asset acquisitions and the quality of assets purchased. A related problem is how to properly phase the availability of capital assets in order to have them ‘working’ at the correct time. ![]() On the other hand, if a company has not invested enough in new production capacity it may lose a portion of its customers to rival firms. ![]() If the company invested too much in fixed assets overestimating its potential growth, it would incur unnecessarily heavy expenses that would reduce its return on investments. Capital budgeting must be integrated with strategic planning as excessive investments or inadequate investments could cause serious consequences for the future of the firm. Since we stated that investment decisions must be made so that they maximize shareholders' value, capital budgeting decisions forcedly must be related to the firm's overall strategic planning. Marta Renzetti, in International Encyclopedia of the Social & Behavioral Sciences (Second Edition), 2015 Investments ValuationĬapital budgeting involves the entire process of planning capital expenditures whose returns are normally expected to extend beyond 1 year. ![]()
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