 Capital budgeting is the process companies undertake to plan, justify, and purchase long-term capital projects. Usually these projects require large sums of money. This picture is an example of items that would require capital budgeting to acquire. You can see the factory and some machinery, etc. These assets are commonly known as long-term plant assets or capital assets or property plant and equipment, PPNE, for short. Capital budgeting analysis depends on a number of things. I've simplified them here into three general categories. The availability of funds to undertake new projects, the importance and criticalness of the project, and risk and return of a project. Capital projects can either be stand alone projects where there are no competing alternatives or the company has funds available to acquire all the projects that meet minimum requirements or mutually exclusive projects which involve choosing from competing alternatives, usually because funds are limited. This concept of having to choose between various projects because funds are limited is called capital rationing. The data needed to complete capital budgeting depends a little on the techniques used, but in general we need to look at the cash outflows and the cash inflows created by the potential project. You can see some examples on the slide. The final piece of information needed is the cost of capital. This is the average rate a firm pays investors and creditors for the use of money. Firms finance capital projects with a combination of debt like loans and bonds and equity like stocks and retained earnings. We call the former debt financing and the latter equity financing. In general a project needs to create a return greater than the cost of capital. For example, if you borrow a thousand dollars from a bank at a rate of 5 percent interest and invest that in a project that earns 12 percent, you would be better off doing the project because the return is greater than the cost of funds invested. The cost of capital is often referred to as WAC which is the weighted average cost of capital or sometimes called the discount rate. There are four primary methods used to do capital budgeting techniques. They are the payback period method, the accounting rate of return method, net present value method, and the internal rate of return method. Although I don't know any company doing the accounting rate of return, I think that might be really old school. So there are examples of videos on the other methods which I strongly encourage you to watch. Finally, here are the six steps to capital budgeting analysis. They are 1. Identify potential projects. 2. Forecast the cash inflows and outflows for the project. 3. Analyze the project using appropriate capital budgeting techniques. 4. Choose from the best from the alternatives. 5. Apply capital rationing. Again, this is an important concept. Firms don't have unlimited resources so capital rationing basically means which projects they can do based on the limited amount of cash. And finally 6. A post audit. Usually companies go back after five years or so and see how the actual project performance compared to the initial budget.