It is the process of allocating resources for major capital, or investment, expenditures.
[1] An underlying goal, consistent with the overall approach in corporate finance,[2] is to increase the value of the firm to the shareholders.
One example of a firm type where capital budgeting is possibly a part of the core business activities is with investment banks, as their revenue model or models rely on financial strategy to a considerable degree.
Cash flows are discounted at the cost of capital to give the net present value (NPV) added to the firm.
In such a case, if the IRR is greater than the cost of capital, the NPV is positive, so for non-mutually exclusive projects in an unconstrained environment, applying this criterion will result in the same decision as the NPV method.
In some cases, several solutions to the equation NPV = 0 may exist, meaning there is more than one possible IRR.
It may be impossible to reinvest intermediate cash flows at the same rate as the IRR.
The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.
The highest ranking projects should be implemented until the budgeted capital has been expended.
Debt capital is borrowed cash, usually in the form of bank loans, or bonds issued to creditors.
Equity capital are investments made by shareholders, who purchase shares in the company's stock.