Capital budgeting and financing are tools used by companies to determine what new operations or projects they will invest in and how they will finance them. Most companies seek new opportunities to generate higher profits and cash flows to increase their company’s value.
As companies build cash reserves from their operations, they will develop capital budgets to find new business opportunities increasing company profitability. Capital budgets are created annually for management to find new business opportunities.
New business opportunities are selected based on the highest return rate for money spent on the capital budget item. Capital budgeting focuses on maximizing company returns utilizing the least amount of company resources.
Cost of Capital
Capital financing decisions start with the interest rate, or cost of capital, companies must pay to borrow money for the new capital budget item. The cost of capital is usually different based on the type financing used by the company.
Several types of capital financing is available to companies--business bonds, stock issuance or bank loans are the most popular types of capital financing. Companies will determine the cost of capital for each financing type before making a decision.
The net present value (NPV) is a popular tool used in capital budgeting and financing decisions. The NPV utilizes both the cost of capital and the capital budget amounts to value new projects.