Capital Budgeting

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 capital budgeting process is also known as investment appraisal.

Understanding Capital Budgeting

Ideally, businesses would pursue any and all projects and opportunities that enhance shareholder value and profit. However, because the amount of capital or money 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.

Although there are numerous capital budgeting methods, below are a few that companies can use to determine which projects to pursue.

Discounted Cash Flow Analysis

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.

Present Value

These cash flows, 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). The cash flows are discounted since present value states that an amount of money today is worth more than the same amount in the future. With any project decision, there is an opportunity cost, meaning the return that is foregone as a result of pursuing the project. In other words, the cash inflows or revenue from the project needs to be enough to account for the costs, both initial and ongoing, but also needs to exceed any opportunity costs.

With present value, the future cash flows are discounted by the risk-free rate such as the rate on a U.S. Treasury bond, which is guaranteed by the U.S. government. The future cash flows are discounted by the risk-free rate (or discount rate) because the project needs to at least earn that amount; otherwise, it wouldn't be worth pursuing.

Cost of Capital

Also, a company might borrow money to finance a project and as a result, must at least earn enough revenue to cover the cost of financing it or the cost of capital. Publicly-traded companies might use a combination of debt–such as bonds or a bank credit facility–and equity–or stock shares. The cost of capital is usually a weighted average of both equity and debt. The goal is to calculate the hurdle rate or the minimum amount that the project needs to earn from its cash inflows to cover the costs. A rate of return above the hurdle rate creates value for the company while a project that has a return that's less than the hurdle rate would not be chosen.

Project managers can use the DCF model to help choose which project is more profitable or worth pursuing. Projects with the highest NPV should rank over others unless one or more are mutually exclusive. However, project managers must also consider any risks of pursuing the project.

Payback Analysis

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.

Payback 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. For example, if it costs $400,000 for the initial cash outlay, and the project generates $100,000 per year in revenue, it'll take four years to recoup the investment.

Payback analysis is usually used when companies have only a limited amount of funds (or liquidity) to invest in a project and therefore, need to know how quickly they can get back their investment. The project with the shortest payback period would likely be chosen. However, there are some limitations to the payback method since it doesn't account for the opportunity cost or the rate of return that could be earned had they not chosen to pursue the project.

Also, payback analysis doesn't typically include any cash flows near the end of the project's life. For example, if a project being considered involved buying equipment, the cash flows or revenue generated from the factory's equipment would be considered but not the equipment's salvage value at the end of the project. The salvage value is the value of the equipment at the end of its useful life. As a result, payback analysis is not considered a true measure of how profitable a project is but instead, provides a rough estimate of how quickly an initial investment can be recouped.

Throughput Analysis 

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 or flow passing through the bottleneck.