Capital budgeting is the decision-making process that companies follow with capital-intensive projects they should pursue such as entering a new market or the research and development of new products. It is the most efficient method to feeling confident in the investment decisions of your company.
What Is Capital Budgeting?
Capital budgeting is a process of evaluating the costs and benefits of large-scale projects you are considering for your business. It is a long-term investment that improves your capital assets such as an office building, a piece of equipment, building maintenance, and renovation purchases. In order to get a loan, you need to prove that the investments you want to make in your business will increase your gains.
Capital budgeting helps financial decision makers make informed financial decisions that require a large capital investment. Projects include:
- Investing in new equipment, technology, and buildings
- Upgrading existing equipment and technology
- Renovation projects
- Expanding the workforce
- Developing new products
- Expanding into new markets
Capital Budgeting Methods
The following capital budgeting examples need to be reviewed so that your business makes solid investment decisions.
- Internal rate of return
- Net present value
- Payback period
- Discounted cash flow
Internal rate of return
This method measures the return percentage to expect from a specific project. Many companies pursue projects with a rate of return that is higher than the cost of capital.
Net present value
This method measures how profitable you can expect a project to be. Any project that has a net present value that is positive is acceptable. If it is negative, then it is not acceptable. The net present value method is a popular capital budgeting method because it helps you choose the projects that are expected to be the most profitable for your business.
This is the simplest capital budgeting method, but it is the least accurate. It is quick and can give managers a vague sense of how well a project is going to perform. The payback period measures the amount of time it takes for you to earn cash inflows from your project to recover the cash outflows that you invested in the project.
This method is popular for people who have limited funds to invest in a project and need to recover the investment costs before the continue with another project.
Discounted Cash Flow
Discounted cash is money adjusted for its time value.it is based on the idea that money can earn interest. This method tries to discover how much the project is worth today based on how much money it will make in the future.
Steps to Take
The key to capital budgeting is broken down into a few steps.
- Explore opportunities: seek the most cost-effective methods including timing, location, potential costs and more.
- Estimate the total cost of the project: gauge the total cost of the project and have multiple scenarios.
- Calculate your return on investment: a cash flow estimate will help you see a potential return on investment.
The Bottom Line
Capital budgeting is an extremely useful financial tool that can help any company plan big expenditures on long-term assets. It is important to know what you are getting to before you begin. A capital budget can help you take your company in the right direction. If you do not have capital budgeting in place, you are setting yourself up for more risk and less funds.