What is capital budgeting, and why is it important for a business?
Capital budgeting is how business entities make investment decisions on long term assets or significant projects. It is the process by which a business evaluates whether it is worth investing in a particular project, considering that not all investment opportunities are rewarding. Investment in an outside venture or construction of a big plant are projects that might require capital budgeting.
As a part of this process, a company might evaluate a particular project’s lifetime cash outflows and inflows. Following this, the management will decide whether the returns that the project can generate would meet a set target benchmark.
Importance of capital budgeting
Aside from knowing what capital budgeting is, it is also essential to understand the importance of this process in a business organisation. Here are a few pointers that highlight its importance:
- Helps increase business profitability
Having a long-term vision is highly crucial for achieving organisational growth. Making long-term goals is a critical area for an organisation, and any wrong decision can severely impact the business’s profitability. The capital budgeting process aids a business in making long-term goals while providing the idea of future costs and expected cash flows.
- Evaluates future cash flows
The capital budgeting process also helps a company evaluate future cash inflows and outflows. It is done by considering the discounted rate of return and various other techniques. Thus, an organisation gets an idea about its net profitability and the total future value of a present investment through capital budgeting.
- Helps manage expenditure
For an organisation to attain growth, careful expenditure management is highly crucial. The capital budgeting process provides an idea of the future cash flows within a business, helping the company monitor and assess the total expenditure and future costs.
- Maximises wealth
The investment ideas of potential shareholders in a company depend hugely on its long-term investment decisions. If a company implements effective long-term investment decisions, it boosts shareholders’ confidence, attracting them to invest more in the company. This, in turn, helps in the wealth maximisation of the firm.
Process of capital budgeting
Mentioned below are a few pointers that highlight the capital budgeting process in detail:
- Generating projects
Identifying and generating investment opportunities is the first and foremost step to capital budgeting. A business can invest for various reasons, such as adding new machinery or a new product line. Further, one could also suggest an increase or decrease in production costs.
- Project evaluation
A company needs to select the required criteria for judging a proposal during this step. In addition, a business manager must also weigh all the pros and cons of a project before deciding.
- Project selection
There is no defined method for selecting a project because different businesses have different requirements. Thus, project selection is made as per the criteria of a particular firm. It is undertaken by keeping in mind the primary objectives of the investment.
- Implementation of the project
After selecting a project, implementation is the next crucial step toward an effective capital budgeting method. Upon that, a company manager monitors the overall impact of implementing a project.
- Performance review
A company undertakes this process to analyse and evaluate a selected project’s overall outcome. It assists the management in identifying possible flaws and eliminating them for future propositions.
A glimpse at capital budgeting techniques
Capital budgeting helps an organisation determine the cash inflows and outflows through various techniques.
It might seem that the most preferred capital budgeting approach is the one that produces positive answers on all metrics. However, most often, these approaches extend contradictory results.
Here are the few most common methods of capital budgeting:
- Payback period method
The agenda behind this technique is to choose a project that produces the quickest payback.
Payback period = initial cash investment/ annual cash flow
Despite being a convenient method, capital budgeting through the payback period method cannot be considered optimum. This method does not consider the time value of money.
- Net Present Value (NPV)
NPV is the difference between the current value of cash inflows and outflows. This method is used in investment planning to determine the profitability of a project.
Net Present Value = Rt/ (1+i)t .
Here, t = time of cash flow, i = discount rate, and Rt = net cash flow.
- Internal Rate of Return (IRR)
IRR comes into play when the NPV is zero. Such a situation indicates that the cash inflow rate is equal to cash outflow.
As per this method, a company accepts a particular project if the IRR exceeds the average cost of capital. Otherwise, it rejects the project. If a company gets multiple projects, it chooses a project that offers the highest IRR.
- Profitability index
A profitability index lower than 1.0 indicates a reduced cash inflow than the initial investment. In contrast, an index value greater than 1.0 would show better cash inflows. Thus, a company is likely to accept that particular project.
Profitability index = present value of cash inflows/ initial investment
The capital budgeting process helps an organisation make strategic investment and financial decisions for the future. Ineffective techniques can result in sudden cost increases, delays in project development and hamper cash management.
Thus, every company must incorporate an efficient capital budgeting process before initiating investment in a long-term project. If it impacts the working capital, businesses can rely on unsecured business loans to cover the financial gap.
What is an example of capital budgeting?
Analysing whether a technological upgrade is a good investment for the organisation is one example where capital budgeting comes into play.