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.

  1. Capital Investment Analysis

    Capital investment analysis is a budgeting procedure that companies ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  3. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
  4. Profitability Index

    An index that attempts to identify the relationship between the ...
  5. Absolute Value

    Absolute value is a business valuation method that uses discounted ...
  6. Cash Budget

    A cash budget is an estimation of the cash inflows and outflows ...
Related Articles
  1. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  2. 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.”
  3. Financial Advisor

    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. 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.
  5. Investing

    DCF Valuation: The Stock Market Sanity Check

    Calculate whether the market is paying too much for a particular stock.
  6. Personal Finance

    A project manager's qualifications and career path

    Learn about a project manager's job, the qualifications necessary for the position, and the most common careers for these professionals.
  7. Investing

    Trends in Capital Flows: U.S. Equities

    Analyze asset flow data for U.S. equity mutual funds and ETFs from 2014 and 2015 to identify changes in demand, investor sentiment and outlook.
  1. 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 >>
  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. 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 >>
  4. How do you use discounted cash flow to calculate a capital budget?

    Learn how discounted cash flows are used in creating capital budgets as a part of the net present value and internal rate ... Read Answer >>
  5. How do you use DCF for real estate valuation?

    Learn how discounted cash flow analysis is used for real estate valuation and the various factors that go into calculating ... Read Answer >>
Hot Definitions
  1. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  2. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  3. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  4. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  5. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  6. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
Trading Center