What Is Capital Budgeting?

Most businesses cannot dip into their working capital to help cover costs for large expenses such as investing in new equipment. Most companies go through a process called capital budgeting to determine whether the investment is worthwhile or not.

What is Capital Budgeting?

Capital budgeting is the process in which organizations evaluate several different high-cost opportunities to see which one will deliver the most value to shareholders. Based on the information that capital budgeting provides it can prioritize products accordingly and choose which ones to move forward with and which to leave behind.

The Five Methods of Capital Budgeting

Not every capital budgeting project is the same. There are five capital budgeting methods to help business owners figure out which projects are worth prioritizing.

Net present value (NPV)

Net present value represents the difference between cash inflows and outflows over a period of time. When a project has a NPV that is positive, it means that the project will bring in more revenue than you will to pay out to complete it. Projects with negative NPV should be avoided at all costs.

Internal rate of return (IRR)

The IRR refers to how much an investment is expected to grow over a period of one-year. It is determined using the same formula as NPV except in this case the NPV value is zero. This method is helpful for comparing expected annual returns of different projects over one year.

Profitability index

The profitability index is a simple equation where you divide the prevent value of expected future cash flows by the associated capital expenditure. When a project has a profitability index over 1, it will likely be a worthwhile investment.

Accounting rate of return (ARR)

ARR compares a project’s expected average revenue to how much money the organization invested to make it all happen. ARR does not consider cash flow or time value of money like the other capital budgeting methods. However, it is still helpful in determining how much revenue you can expect to generate across a number of projects.

Payback period

The payback period metric tells you how long it will take to break even on a capital project. It is similar to ARR in that it does not consider time value of money either.

Advantages and Disadvantages of Capital Budgeting

Here will take a look at some of the pros and cons of capital budgeting so you can decide if it makes sense for your business or not.

Advantages

• Helps you compare different kinds of projects along the same metrics to make the best decisions based on data
• Gives you a number of different techniques to use to make wise investments
• Enables you to deliver more value to stakeholders by increasing the chances you make the best decisions

Disadvantages

• Can give you false security because you are dealing with hypotheticals; if a project gets delayed or runs over budget, what good are your calculations?
• When you make a decision, the implications can be significant; the wrong decision could seriously hurt your organization
• Finding skilled accountants with bandwidth to make these calculations can be a tall order—and a pricey endeavor

The Bottom Line

Capital budgeting is a helpful tool for deciding which capital projects to pursue and which ones to pause. Your capital budgeting calculations are theoretical and not set in stone. It is important to note that the significance of capital budgeting may not extend to smaller investments. Investments that take place on a smaller scale are more impactful if they are made quickly, it is best to streamline your capital budgeting processes in these instances.