Capital budgeting is a step by step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company's growth initiatives, involves determining the investment rate of return that such a project will generate. However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project. For example, a social or charitable project is often not approved based on rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplace.
Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project.
Capital budgeting is also vital to a business because it creates a structured step by step process that enables a company to:
- Develop and formulate long-term strategic goals – the ability to set long-term goals is essential to the growth and prosperity of any business. The ability to appraise/value investment projects via capital budgeting creates a framework for businesses to plan out future long-term direction.
- Seek out new investment projects – knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry.
- Estimate and forecast future cash flows – future cash flows are what create value for businesses overtime. Capital budgeting enables executives to take a potential project and estimate its future cash flows, which then helps determine if such a project should be accepted.
- Facilitate the transfer of information – from the time that a project starts off as an idea to the time it is accepted or rejected, numerous decisions have to be made at various levels of authority. The capital budgeting process facilitates the transfer of information to the appropriate decision makers within a company.
- Monitoring and Control of Expenditures – by definition a budget carefully identifies the necessary expenditures and R&D required for an investment project. Since a good project can turn bad if expenditures aren't carefully controlled or monitored, this step is a crucial benefit of the capital budgeting process.
- Creation of Decision – when a capital budgeting process is in place, a company is then able to create a set of decision rules that can categorize which projects are acceptable and which projects are unacceptable. The result is a more efficiently run business that is better equipped to quickly ascertain whether or not to proceed further with a project or shut it down early in the process, thereby saving a company both time and money.
In addition to a financial decision, a company is also making an investment in its future direction and growth that will likely have an influence on future projects that the company considers and evaluates. So to make a capital investment decision only from the perspective of either a financial or investment decisions can pose serious limitations on the success of the project.
In December 2009 ExxonMobil, the world's largest oil company, announced that it was acquiring XTO Resources, one of the largest natural gas companies in the U.S. for $41 billion. That acquisition was a capital budgeting decision, one in which ExxonMobil made a huge financial commitment. But in addition, ExxonMobil was making a significant investment decision in natural gas and essentially positioning the company to also focus on growth opportunities in the natural gas arena. That acquisition alone will have a profound effect on future projects that ExxonMobil considers and evaluates for many years to come.
The significance of these dual decisions is profound for companies. Executives have been known to lose jobs over poor investment decisions. One can say that running a business is nothing more than a constant exercise in capital budgeting decisions. Understanding that both a financial and investment decision is being made is paramount to making successful capital investment decisions.
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