This article explains capital budgeting in a practical way. After reading this article, you’ll understand the basics of this powerful financial management tool.
What is the definition of capital budgeting?
Capital budgeting, as the name implies, consists of two parts: capital and budgeting. In the context of capital budgeting, capital mostly relates to an organisation’s major capital expenditure. Capital expenditure is the use of funds for major expenses and purchases. These expenditures can range from fixed assets, equipment, research, to expansion. The other component is budgeting. This includes goal setting for projects. This is done to achieve maximum profitability. The entirety of capital budgeting is the process of evaluating investments and major expenditures, in order to get the best return on investment.
The techniques used for this generally fall into one of two categories: traditional methods and cashflow methods.
Why is capital budgeting important?
Capital budgeting is often applied in business. From investtime to time, every organisation is confronted with the challenge of choosing between two investments or projects. Sometimes, companies have to choose between repairing their equipment or buying a new set. In an ideal world, a company would like to invest in all profitable projects. However, due to limited resources, this is not possible. Therefore, an organisation has to use capital budgeting to find the right choice.
An everyday example of capital budgeting.
Everyone is confronted with capital budgeting in their day to day lives, but often with less major expenditures. Let’s say, Jeffrey drops and breaks his phone. He has two options: to get the phone repaired, or to buy a new one. By repairing the phone, its lifespan will probably be increased. However, it might be possible to buy a new phone for a price that is lower than the cost of repairing the old phone. To make the best choice, Jeffrey has to set a maximum budget for the purchase of a new phone, so that he can remain under the alternative cost of getting the phone repaired.
Time Value of Money (TVM)
The time value of money is the concept that money is worth more today than the same amount in the future, due to potential earning capacity. This means that every amount is worth more, the sooner it is received. This concept is also referred to as the present cash value.
The time value of money comes from the idea that investors would prefer to receive money today rather than later, as they see the potential for that money to grow in value over a certain period of time. To illustrate this, let’s look at the example of a rational investor. Imagine, this investor has the option to receive ten thousand dollars now, or the same amount in two years. It is reasonable to assume that most would choose the first option. Despite the equal value, ten thousand dollars has more value and use today, than the same amount in the future. Waiting for money involves costs. These are called alternative costs and could include potential profits from interest.
The capital budgeting process explained
Capital expenditures are often significant, and have an impact on business operations on the long term. As such, it is recommended to do a strong analysis beforehand. The capital budgeting process consists of the following steps.
Step 1: Identify various investment opportunities
First of all, a company needs an opportunity to invest capital. An investment opportunity could be anything. From a new location, to product expansion, to the purchase of new equipment. There will always be an alternative to that investment opportunity. Instead of adding new products to the current line-up, a company can also choose to upgrade the production facilities.
Step 2: evaluate the various investment opportunities
Once the options for investments are known to the company, the options must be evaluated. Once a decision has been made to add a new product to the line-up, the organisation must consider how they can and should obtain this product. This can be done in various ways. There is the option of in-house production. Also, production can be outsourced, or the product can be purchased in bulk.
Step 3: Select the profitable option
Once the options have been identified, and all proposals have been assessed, the organisation must decide which option is the most profitable. When selecting a project, an organisation must rank the list of options based on the return on investment and the availability of the options. It often makes sense to choose the most profitable option in each scenario. However, occasionally you must deviate from this. For instance, when production facilities are in need of replacement or repair, this takes precedence. This might jeopardise the flow of value within an organisation.
Step 4: Capital budgeting
During this step, the desired investment option is selected. The organisation must finance the project during this step. This can be done by identifying various financial resources, and appointing these to the investment. These resources can be anything: loans, reserves, third-party investments, or another resource.
Step 5: Performance reviews
The final step of the capital budgeting process is the evaluation of investments after time has passed. Initially, the organisation selected the option based on expected returns. Now the organisation can check if the expected performance indeed matches or exceeds the actual performance.
What are the different methods of capital budgeting?
This covers the following principles, among others:
Net Present Value (NPV)
Net Present Value (NPV) represents the value of all inflows and outflows generated by a project, as the present value. Every project represents a series of inflows and outflows of cash. Money has a time value, and so a comparison must be drawn between money received today and money to be received at a later time. To make an investment decision, all these inflows and outflows are converted to present value using a discount rate.
Discount rate example
A 500-dollar receipt is worth the same today. No discounts are given on this. A 500-dollar receipt in a year will be discounted. If the discount rate is five percent, the calculation is as followed:
500/1,05= 476.19 dollar
The discount rate includes more than just corrections for inflation. It represents all alternative costs. That is to say, the amount that the project has to generate in order to compete with the other options available to the organisation.
Payback Period (PP)
The Payback Period calculates how long it takes to earn back the costs of an investment. It is one of the simplest types of capital budgeting, but it’s also one of the least accurate. This method is still used often enough as it is easy to use, and managers can get an insight into the actual value of a proposed project. The Payback Period is calculated by dividing the initial investment in a project by the average annual cashflow that comes from the project.
Internal Rate of Return (IRR)
As previously discussed, organisations often have several options as to where they can allocate their resources. The surplus resources that are generated from other operations can be invested into other profitable operations. This way, returns comparable to previous activities can be generated. These resources can also be invested into a capital project, a new venture, or the expansion of an existing venture. A lot of projects within an organisation will even fight over financing.
The internal rate of return measures returns that the investment makes over the course of the project. This can be compared to returns on the stock market.
Discounted Cash-Flow (DCF)
Discounted Cash-Flow is another popular method for capital budgeting. This analysis examines the outgoing cash flow necessary to finance a project, the inflow in the shape of income, and future outflow. These costs are discounted to the present. The number that comes out of the DCF analysis is the net present value (NPV). Projects with the highest NPV should score higher than projects with lower NPVs, unless someone excludes the former option(s).
The Throughput-analysis is probably one of the most complicated methods of capital budgeting. It is also the most accurate method for supporting managers in project selection. According to this analysis the entire company is considered a single profiting system. Throughput is measured as the amount of material that passes through the entire system. Additionally, the tool assumes that almost all costs are business expenses, and that a company has to maximise throughput throughout the entire system to pay for expenses in such a way that profits are maximised. This means that managers will always choose projects with a higher priority than projects with a lower priority.
Key-points capital budgeting
- Capital investments often involve large sums of money. This impacts an organisations’ profitability. This is why capital budgeting is an incredibly important task
- Once investments have been made, it is either impossible or bad for budgeting to try and reverse them. At least not without losing a significant amount of money. The investment is sunk, as it were, and mistakes must be corrected until the project can be withdrawn or liquidated
- Investment decisions are one of the most important decisions that make sure a company turns a profit. This is measured according to the return on invested capital
- A good mix of capital investments is necessary to guarantee a suitable return
- Implications of capital investments and decisions on them are more extensive on the long term than decisions on the short term
- Capital investment decisions are subject to a great deal of risk and uncertainty
Benefits and drawbacks of capital budgeting
A number of benefits and drawbacks of capital budgeting and their relevant methods are described below:
Benefits of capital budgeting
- Capital budgeting helps companies make, and justify, strategic long-term investments
- Capital budgeting helps organisations estimate where they should spread their resources
- Capital budgeting helps show whether or not an investment will increase the value of the company
- It helps management to not invest too much or too little
- Capital budgeting helps the company by exposing the risks of various investments
- Capital budgeting can be a tool to fall back on in a highly competitive market
Drawbacks of capital budgeting
While capital budgeting has its benefits, it also has a number of drawbacks:
- Decisions on such a large amount of capital have far-reaching consequences for the future, and are usually irreversible
- The techniques used for capital budgeting are often based on estimates and assumptions, as the future is never completely certain. This means the models are not airtight
- Capital budgeting is not objective, as risk factors and discount factors are always subject to perception
- An incorrect decision on appointing resources that come from capital budgeting, can threaten the profitability and sustainability of a company. As such, this appointment must be done with expertise and by professionals
Now it’s your turn
What do you think? Do you recognise the explanation of capital budgeting? Do you have experience working with this financial tool? What do you know about other budgeting methods? Is this tool used in your own working environment? What other methods or aspects of capital budgeting would you like to learn more about?
Do you have any tips or comments?
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- Gitman, L. J., & Forrester Jr, J. R. (1977). A survey of capital budgeting techniques used by major US firms. Financial management, 66-71.
- Klammer, T. P., & Walker, M. C. (1984). The continuing increase in the use of sophisticated capital budgeting techniques. California Management Review, 27(1), 137-148.
- Schall, L. D., Sundem, G. L., & Geijsbeek, W. R. (1978). Survey and analysis of capital budgeting methods. The journal of finance, 33(1), 281-287.
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