What Is Capital Budgeting?

Many businesses have to make not only operational decisions but capital decisions too to determine the best projects to invest in to ensure the business grows and is profitable in the future. This is where capital budgeting comes into play. Read on to understand the basics of capital budgeting and why it is important for businesses.

Capital Budgeting Defined

Capital budgeting is the process of evaluating costs and benefits of potential large-scale projects for your business. Without capital budgeting, your business can make a big mistake because you could accept a project or purchase without thinking of how it can damage the health of your business. A business cannot and should not pursue every opportunity that comes across the way because you only have so many resources and sometimes it might not even be profitable for your business. With capital budgeting you are able to distinguish between the good projects from the bad ones.

Why Is Capital Budgeting So Important?

  • There is a lot of risk not using capital budgeting: there is a lot at stake with large capital expenditures so capital budgeting will help decision makers make the best decision on the project going forward.
  • It is flexible: there are many more companies using capital budgeting due to its various uses.
  • Can be used for risk assessment: financial analysts can assess various risk scenarios and give company decision makers a road map in advance that reveals risks in pursuing the project and get information needed to make the best decisions in the future.
  • Create a project checklist: capital budgeting can help a company in the implementation of projects from beginning to the end.
  • Helps clarify decisions: it will help you determine which project seems the most sense to pursue now or put off until the future.

Capital Budgeting Methods

There are several ways to analyze the potential capital of each project. To estimate cash flows, you need to know how much the project will make for your business. The following methods will help your business make the best investment decision.

  • Internal Rate of Return (IRR) – in this method, the rate of return vs the weighted average cost of capital is considered. Many companies pursue projects that have a rate of return that is higher than the weighed average cost of capital. A higher IRR is better as you would pay the investment back faster than if it was a low IRR.
  • Discounted cash flow – discounted cash is money adjusted for its time value you need to look at all the cash flows, money to fund the project and income the project will generate. You need to use the discount rate to figure out what that amount is worth in today’s dollars which is the net present value.
  • Payback period – although this method is simple, it is not very accurate. It can give you a vague sense of how well a project will perform. If you do not have the resources to use the previous methods listed above, this one will give you a basic idea of the financial breakdown.

Payback period = project cost / annual cash inflows

The Bottom Line

Capital budgeting is a great financial tool to help any company plan and implement any big expenditures on long-term assets. There are several methods of capital budgeting you can use, and they can get complex. Asking for help of a professional can also make the decision easier for you and they will help you make the most profitable decision with the least risk.