Last editedFeb 20222 min read
When it’s time to choose between two projects, how do you know which will yield better returns? The capital budgeting process can help you narrow down your options to make the most rational, profitable decisions. We’ll take a look at the capital budgeting definition below, as well as some of the most commonly used methods.
Capital budgeting definition
Corporations are required to choose projects designed to increase profit and shareholders’ equity, looking at factors like rate of return to assess profitability. The capital budgeting process narrows down investments or projects to those that add the most value.
It can be used to select between competing projects, make sounder investments, or for purchasing fixed assets like machinery and vehicles. Through a variety of capital budgeting methods, you can gain a better sense of each option’s investment potential to make a logical decision.
Capital budgeting methods
There’s no single capital budgeting process to follow. Instead, you can tailor the following methods to best suit your business plan and desired outcomes. Ideally, all methods will steer you to the same conclusion. However, at times you’ll find conflicting information which can make capital budgeting decisions more difficult. In these situations, use your best judgement. Here are four of the most common capital budgeting methods:
1. Payback period
The payback period works out the length of time it will take for a project’s cash flow to pay for its initial investment. This is extremely useful when making capital budgeting decisions. For example, if one project pays for itself much faster than a similar option, it involves less risk and would be a better solution. Another advantage of using the payback period method is that it’s easy to calculate alongside cash flow forecasting.
2. Net present value (NPV) analysis
The second option is to use a net present value analysis as part of your capital budgeting process. To work out net present value, you must first calculate the net change in cash flows associated with your intended purchase. The net change is then discounted to the present value. According to the net present value rule, all projects with a positive NPV should be accepted, and those with a negative NPV should be rejected. You can work out net present value for multiple projects, accepting the options with the highest value.
3. Internal rate of return
Another common method used in capital budgeting is to work out a project’s internal rate of return. If this figure is higher than the weighted average cost of capital, it indicates that the project will be profitable. It’s a relatively quick and easy way to make capital budgeting decisions, giving a useful benchmark to track. Although internal rate of return is sometimes used interchangeably with return on investment, it gives a more precise, mathematically accurate view of the returns a project will generate.
4. Constraint analysis
If you’re considering purchasing fixed assets, a constraint analysis might be useful for decision-making. This requires that you identify the bottleneck in your production process, investing in fixed assets that boost utility under constraint. It’s better to invest in areas upstream from the identified bottleneck, improving production capacity.
Why is capital budgeting important?
Few companies have enough cash on hand to purchase all assets and invest in every project. When investments fail, they can bring the business down along with them. Capital budgeting gives clear, measurable metrics that make it much easier to assess investment risk vs reward.
This is particularly important for corporations with shareholders involved. The business must make the decisions that will earn the greatest profits for shareholders, and capital budgeting provides accountability. For all these reasons, the capital budgeting process is a vital activity to maximize business resources.
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