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What is capital budgeting?

In an ideal world, businesses would be able to pursue any type of project that has the potential to increase shareholder value. In reality, however, all businesses have a limited amount of capital, which means that they need to choose which projects to invest in wisely. Capital budgeting can help businesses determine which investments are likely to yield the best return, making it an important process for any business owner to have a handle on. Find out everything you need to know about the significance of capital budgeting, right here.

Capital expenditure budget definition

So, what is capital budgeting? Capital budgeting, sometimes referred to as investment appraisal, is the process by which businesses determine which investments or purchases should be pursued. Essentially, the capital budgeting process helps companies produce a quantitative view of each potential investment, giving them a more rational basis from which to make a decision about its viability. Capital budgeting can involve virtually any sort of investment, from purchasing fixed assets like machinery to mergers and acquisitions.

How does capital budgeting work?

There are three main approaches taken by businesses to a capital budgeting decision. While you might expect each method to produce a similar result, the results of these approaches are often wildly contradictory, which means you’ll need to decide where to put your emphasis for yourself. Here’s a little more information about each method:

  • Net present value (NPV) – Net present value identifies the net change in cash flows (i.e. the difference between your cash inflows and outflows) over the course of the project. When used in capital budgeting, you’ll simply select the project with the highest NPV. As it’s a direct measure of profitability, NPV is very easy to use and allows you to compare mutually exclusive projects.

  • Payback period – With the capital budgeting payback period method, you’ll need to calculate how long it will take to recoup the costs of your initial investment. This is a good method to use if liquidity is a major concern, and it’s especially easy to calculate once you’ve established your cash flow forecast. However, the capital budgeting payback period approach does have drawbacks. Most notably, payback period doesn’t account for the time value of money (TVM). Furthermore, payback period may ignore cash flows at the end of a project’s life, such as salvage value.

  • Internal rate of return (IRR) – The internal rate of return refers to the discount rate on a project/investment that results in a net present value of zero. IRR provides a benchmark figure you can use to assess the viability of projects with reference to your firm’s capital structure, although it’s important to note that it doesn’t convey the actual profitability of a project.

So, now that you know a little more about the capital budgeting process, let’s explore the significance of capital budgeting, and why it’s almost always a good idea.

The significance of capital budgeting

Investments are a major (not to mention irreversible) decision for all businesses, regardless of size or industry. If you make a bad call, you could end up facing enormous financial ramifications, including bankruptcy. If you’re considering making a large investment in a fixed asset, capital budgeting isn’t a “nice-to-have”, it should be a central part of your decision-making process. That way, you can move forward with the best possible information at your disposal.

However, it’s important to note that the significance of capital budgeting may not extend to smaller investments. In many cases, investments that take place on a smaller scale are more impactful if they’re made quickly, so it’s best to streamline your capital budgeting process in these instances. That’s not to say that you shouldn’t analyse these sorts of fixed asset proposals, but that the process should be expedited to ensure that your analysis isn’t standing in the way of a profitable return.

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