Everyone has to have a budget for their big purchases, and companies are no different. How companies arrive at what's worth spending money on and what's not is a thorough process called capital budgeting.
What is capital budgeting?
What is capital budgeting?
Capital budgeting is more than just assigning capital as a budget item, as the name might suggest. In fact, it's a whole process that companies use to examine potential projects or other investments to determine if they're viable and profitable. This process is also sometimes called "investment appraisal," which is a far more descriptive term.
Capital budgeting might be used to decide if a company should build a new factory or simply remodel an old one, for example. With capital budgeting techniques, the company will know which is the best financial move and what can be reasonably expected. But, since capital projects tend to be longer term, there is always the potential for the unexpected to occur.
Why it matters
Why capital budgeting matters to investors
Capital budgeting is a really important process for any business, but it's doubly important for one that's publicly traded. Rather than rushing into a new investment, workforce expansion, or other big expenditure, capital budgeting forces company decision makers to slow down, take a very hard and long look at the potential move they're making and see how it will affect the company today, tomorrow, and into the future.
Capital budgeting also allows those same decision makers to compare two or more different projects to find the project that will make the most sense for the business and shareholders. They're often looking for not just a high amount of profit from the project but a lot of value, which might include longevity or a way to invest in the business to give it more ways to expand in the future.
Methods
Capital budgeting methods
Capital budgeting is the idea of examining capital projects carefully, but there are a variety of methods that can be used to achieve this. Sometimes, they're all used at the same time to really get a good sense of what's going on and what could happen in the future. Common capital budgeting methods include:
Discounted cash flow analysis. With discounted cash flow analysis, you can look at cash flows, both inflow and outflow, that are part of the project and its longer-term maintenance, discounted back to today's monetary value. Since inflation tends to devalue a dollar, this sets project costs in current dollars to compare with other current income and expenses.
Payback analysis. Although the least accurate of capital budgeting methods, payback analysis gives a quick look at the value of a project. In essence, payback analysis figures out how long it takes to recapture the cost of an investment and whether or not that timeline makes sense for the project.
Throughput analysis. Throughput analysis is far more complicated than either of the above-mentioned methods, but it looks at the problem of capital budgeting from an efficiency perspective. It wants to see how much it can increase profits by increasing production through the widening of bottlenecks in the system.
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Important metrics
Important capital budgeting metrics
Just like there are different methods to determine which capital project is the best option, there are also different metrics that are being evaluated. Sometimes these metrics won't line up, but sometimes they're in agreement. The end goal of the company will help determine the very best metrics to focus on, but these are a few commonly used metrics in capital budgeting:
Payback period. Everyone wants to know that they can pay back their investment in as short of a time as possible. Although this might not be the most important metric in every scenario, it's certainly one that should always be considered.
Internal rate of return. The internal rate of return can also be thought of as the expected return on a project. It should be obvious that you want that to be more than the cost of borrowing the money to do the project, but it's important to actually model this so you can be more certain before investing millions of dollars into something new.
Net present value. Net present value allows you to see how much profit is possible with a new project after the cost of the capital is considered. Net present value looks at after-tax cash flow, which can give a better idea of just how profitable a project is. This is especially important if funds are limited.