Capital budgeting is the analysis of long-term projects. Long-term projects are worthy of special attention because of the fact that they frequently require large initial investments, and because the cash outlay to start such projects often precedes the receipt of profits by a significant period of time. In such cases, we are interested in being able to predict the profitability of the project. We want to be sure that the profits from the project are greater than what we could have received from alternative investments or uses of our money.

This handout focuses on how managers can evaluate long-term projects and determine whether the expected return from the projects is great enough to justify taking the risks that are inherent in long-term investments. Several different approaches to capital budgeting are discussed. These are the payback method, the net present value method, and the internal rate of return method. The latter two of these methods requires us to acknowledge the implications of the ``time value of money." We have indirectly alluded to such a time value of money previously, pointing out that we would prefer to defer tax payments to the future. Such deferment allows us the use of the money in the interim to earn additional profits.

Financial managers use a formalized approach to evaluate the time value of money. Such an approach is necessary because many of the problems we face in capital budgeting cannot be solved easily without a definite mechanical methodology. To give a rather elementary example, suppose that someone offered to buy your product for $250, and that they are willing to pay you either today, or one year from today. You will certainly prefer to receive the $250 today. At the very least, you could put the $250 in a bank and earn interest in the intervening year.

Suppose, however, that the buyer offered you $250 today or $330 in 22 months. Now your decision is much more difficult. How sure are you that the individual will pay you 22 months from now? Perhaps he or she will be bankrupt by then. What could we do with the money if we received it today? Would we put the $250 in some investment that would yield us more than $330 twenty-two months from today? These are questions that we have to be able to answer in order to evaluate long-term investment opportunities