Loading the player...

What is 'Capital Budgeting'

Capital budgeting is the process in which a business determines and evaluates potential expenses or investments that are large in nature. These expenditures and investments include projects such as building a new plant or investing in a long-term venture. Often times, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the potential returns generated meet a sufficient target benchmark, also known as "investment appraisal."

BREAKING DOWN 'Capital Budgeting'

Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Various methods of capital budgeting can include throughput analysis, net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.

There are three popular methods for deciding which projects should receive investment funds over other projects. These methods are throughput analysis, DCF analysis and payback period analysis.

Throughput Analysis

Throughput is measured as the amount of material passing through a system. Throughput analysis is the most complicated form of capital budgeting analysis, but is also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered a single, profit-generating system.

The analysis assumes that nearly all costs in the system are operating expenses, that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place higher consideration on capital budgeting projects that impact and increase throughput passing though the bottleneck.

DCF Analysis

DCF analysis is similar or the same to NPV analysis in that it looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs. These costs, save for the initial outflow, are discounted back to the present date. The resulting number of the DCF analysis is the NPV. Projects with the highest NPV should be ranked over others, unless one or more are mutually exclusive.

Payback Analysis

Payback analysis is the most simple form of capital budgeting analysis and is therefore the least accurate. However, this method is still used because it's quick and can give managers a "back of the napkin" understanding of the efficacy of a project or group of projects. This analysis calculates how long it will take to recoup the investment of a project. The payback period is identified by dividing the initial investment by the average yearly cash inflow.

RELATED TERMS
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  2. Initial Cash Flow

    The amount of money paid out or received at the start of a project ...
  3. Profitability Index

    An index that attempts to identify the relationship between the ...
  4. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
  5. Capital Project

    A long-term investment made in order to build upon, add or improve ...
  6. Throughput

    In business, the rate at which an organization reaches a given ...
Related Articles
  1. Small Business

    An Introduction to Capital Budgeting

    Firms use capital budgeting to determine if a project, like building a new plant or developing a new product, is worth pursuing.
  2. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  3. A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  4. Small Business

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
  5. Personal Finance

    Project Manager: Job Description & Average Salary

    Discover more about the specific tasks that project managers are responsible for and the average salary that can be expected in such a position.
  6. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  7. Small Business

    What Exactly Do Project Managers Do?

    While supervision is one important part of the job, a lot more goes into project management than just watching everyone work.
  8. Managing Wealth

    What's a Hurdle Rate?

    Hurdle rate has two meanings. In the business world, a business typically makes a decision on a capital project based on the net present value approach. To determine the net present value, the ...
  9. Personal Finance

    Project Manager: Career Path & Qualifications

    Learn more about what project managers job, the qualifications necessary for the position and the most common careers for these professionals.
  10. Small Business

    Explaining the Cash Budget

    A cash budget is a plan for the inflows and outflows of cash for a business or an individual.
RELATED FAQS
  1. How do you use net present value to calculate a capital budget?

    Learn about the net present value calculation (NPV) and how the NPV rule is used in capital budgeting to compare the expected ... Read Answer >>
  2. How much debt is too much when calculating capital budgeting?

    Learn how companies determine how much debt is acceptable when funding a new project by using the net present value to estimate ... Read Answer >>
  3. What is the formula for calculating net present value (NPV) in Excel?

    Understand how net present value is used to estimate the anticipated profitability of projects or investments and how to ... Read Answer >>
  4. How do you use internal rate of return to calculate a capital budget?

    Learn about how the internal rate of return is used in the creation of a capital budget along with net present value and ... Read Answer >>
  5. Do you discount working capital in net present value (NPV)?

    Learn why changes in net working capital (NPV) should be included in net present value calculations for analyzing a project's ... Read Answer >>
  6. What are some of the limitations and drawbacks of using a payback period for analysis?

    Examine the payback period method of analyzing proposed capital investment projects, and learn about its advantages and disadvantages. Read Answer >>
Hot Definitions
  1. IRS Publication 970

    A document published by the Internal Revenue Service (IRS) that provides information on tax benefits available to students ...
  2. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  3. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  4. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  5. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  6. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
Trading Center