What Is Capital Budgeting?
Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. 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.
As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark. The process is also known as investment appraisal.
Understanding Capital Budgeting
Ideally, businesses would pursue any and all projects and opportunities that enhance shareholder value. However, because the amount of capital any business has available for new projects is limited, management uses capital budgeting techniques to determine which projects will yield the best return over an applicable period.
Some methods of capital budgeting companies use to determine which projects to pursue include throughput analysis, net present value (NPV), internal rate of return, discounted cash flow, and payback period.
- Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment.
- The process involves analyzing a project’s cash inflows and outflows to determine whether the expected return meets a set benchmark.
- The major methods of capital budgeting include throughput, discounted cash flow, and payback analyses.
Types of Capital Budgeting
Throughput analysis is the most complicated form of capital budgeting analysis but also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered as a single profit-generating system. Throughput is measured as an amount of material passing through that system.
The analysis assumes that nearly all costs 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 a higher priority on capital budgeting projects that will increase throughput passing through the bottleneck.
Discounted cash flow (DCF) analysis 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, except for the initial outflow, are discounted back to the present date. The resulting number from the DCF analysis is the net present value (NPV). Projects with the highest NPV should rank over others unless one or more are mutually exclusive.
Payback analysis is the simplest form of capital budgeting analysis but it's also the least accurate. It's still widely used because it's quick and can give managers a "back of the envelope" understanding of the real value of a proposed project.
This analysis calculates how long it will take to recoup the costs of an investment. The payback period is identified by dividing the initial investment in the project by the average yearly cash inflow that the project will generate.