Understanding Capital Budgeting

Capital budgeting, also known as an investment appraisal, is a financial management tool to measure a project’s potential risks and expected long-term return on investment. Companies may have limited resources for new projects, so they carefully consider the capital investment a project requires and the amount of value they expect to receive.

Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected. However, companies have several different valuation methods they can use to determine whether a project is likely to be valuable and worth pursuing.

Capital budgeting can be classified into two types, which are traditional and discounted cash flow, and within each type are several budgeting methods that can be used.

TRADITIONAL TECHNIQUE METHODS

1. Payback period

The payback period method is the simplest way to budget for a new project. It measures the amount of time it will take to earn enough cash inflows from your project to recover what you invested. It is popular for those people who have a limited amount of funds to invest in a project and need to recover their initial investment cost before they can start another project.

2. Average rate of return (ARR)

The accounting rate of return (ARR) method is also known as the return on investment (ROI) method. It uses accounting information obtained from financial statements to measure the profitability of a possible investment.

DISCOUNTED CASH FLOW METHODS

Discounted methods are also known as time-adjusted techniques, and they consider the time value of money while evaluating the costs and benefits of a project. The cash flows associated with the project are discounted at the cost of capital. These methods also take into account all benefits and costs occurring during the project’s life cycle.

The net present value capital budgeting method measures how profitable you can expect a project to be. When using this method, any project with a positive net present value is acceptable, while any project with a negative net present value is not acceptable. The NPV method is one of the most popular capital budgeting methods because it helps you to choose the most profitable projects or investments.

2. Internal rate of return (IRR)

The internal rate of return method measures the return percentage you can expect to receive from a specific project. When using this method, the more the rate of return percentage exceeds the project’s initial capital investment percentage, the more appealing the project becomes. It is common for a company to use the IRR method to choose between conflicting project options.

The Goals of Capital Budgeting

Capital Budgeting as a part of budgeting more specifically, focusing on long-term investment, major capital and capital expenditures. The main goals of capital budgeting are not only to control resources and provide visibility, but also to rank projects, for example, from highest profitability to lowest profitability. It is also needed to raise funds, for example, public trading corporations gain funding either through corporate bonds or preferred stock.

The Importance of Capital Budgeting

Capital budgeting is a valuable tool, because it provides a means for evaluating and measuring a project’s value throughout its life cycle. It allows you to assess and rank the value of projects or investments that require a large capital investment. For example, investors can use capital budgeting to analyze investment options and decide which ones are worth investing in.

Before a company approves a specific project, capital budgeting helps them create a budget for the project’s costs, estimate a timeline for the project’s return on investment and decide whether the project’s potential value is worth its necessary capital investment. Once a project begins, they can use capital budgeting to measure the project’s progress and the effectiveness of their investment decisions.