What is Capital Budgeting? – Definition, Process & Techniques
Capital budgeting involves using several formulas to assess the profitability of a business opportunity or asset, such as when entering a new market or buying new machinery.
You’d use the process of capital budgeting to make a strategic decision whether to accept or reject a proposed investment project.
This guide will cover the importance of capital budgeting, how the process looks, and common techniques you can use to reach an investment decision.
The Importance of Capital Budgeting
If a business owner chooses a long-term investment without undergoing capital budgeting, it could look careless in the eyes of shareholders. The capital budgeting analysis helps you understand a project’s potential risks and potential returns. A capital budget can also assist with securing additional financing from banks or investors when pursuing a new investment project.
Capital Budgeting Process
There are 5 steps involved in the capital budgeting process.
- Identify potential opportunities: For any problem, there are various possible solutions. This step is about identifying which opportunity makes sense logistically and within your overall business strategy.
- Estimate incremental cash flow: Research and gather data on similar projects to estimate expected cash inflows and outflows to determine if the project will be profitable enough.
- Assess risks: Capital investment decisions can bring about risks that can't be ignored (in extreme cases, bankruptcy).
- Implement: Create an implementation plan to determine how you’ll monitor the project, pay for it, track progress, and record cash flow.
- Review and audit: Analyze and compare cash flow forecasts with actual results to refine the process of making future capital budgeting decisions.
Understanding the Concept of Time Value of Money (TVM)
TVM supports the belief that $500 today is worth more than $500 tomorrow. This is because money today can be invested and earn interest. In other words, cash flow timing is important.
The formula to determine the future value of money is:
Future value = Present value x (1 + rate of interest)
And if you’re trying to figure out the future value in 2+ years:
Future value = Present value x (1 + rate of interest)number of years
For example, let’s use the interest rate of 3% (or .03). How much would $100 be worth in year 3?
- Future value= $100 x (1.03)3
- Future value = $109.27
Capital Budgeting Techniques
There are various capital budgeting formulas and techniques. Some companies may choose to use only one technique, while another company may use a mixture.
Three key techniques of capital budgeting are:
- Payback period method
- Net present value (NPV)
- Internal rate of return
With this capital budgeting method, you’re trying to determine how long it’ll take for the capital budgeting project to recover the original investment. In other words, how long it'll take for the major project to pay for itself.
The payback period method doesn’t consider TVM.
If the estimated profits are $500 for each of the next 3 years, and your initial investment was $1000, then your projected payback period is 2 years ($1000 / $500).
Net Present Value
NPV considers today’s value of a future cash flow meaning it considers TVM. If the projected profit in the next 3 years is $500 per year, it may seem the answer is simply $500x 3 = $1500.
However, because NPV considers TVM, we have to figure out the discounted cash flow for the cash flow stream. The formula is similar to the TVM formula.
NPV = cash flow for specific period / (1 + discount rate)time period
The discount rate used will be different from company to company, but it’s usually the weighted average cost of capital. The weighted average cost of capital is basically the rate of return needed to pay off a business’ providers of capital.
Next, we add all the present values up and subtract the initial cash outlay to see the potential return on investment. An NPV greater than 0 is considered good, and an NPV of 0 or lower is bad.
Internal Rate of Return
This technique is interested in finding the potential annual rate of growth for a project. Generally, the potential capital projects with the highest rate of return are the most favorable. An acceptable standalone rate is higher than the weighted average cost of capital.
To figure out the internal rate of return, we use the same NPV formula. The main difference is that we make NPV= 0 and calculate the discount rate instead. Excel has three main functions to help calculate this (IRR, XIRR, and MIRR function).
Capital budgeting helps organizations make strategic decisions regarding significant investments. Failing to do a capital budget can have serious consequences.
Knowing how to make quick and strategic decisions has never been more important than in today’s fast-paced world. Using capital budgeting along with the other types of managerial accounting will give you a competitive advantage.
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