What Is Capital Budgeting?

What Is Capital Budgeting?

Let me explain capital budgeting to you directly: it's the process businesses use to evaluate potential major projects or investments. Think of things like building a new plant or taking a large stake in an outside venture—these are the kinds of initiatives that require capital budgeting before management approves or rejects them.

In this process, a company assesses a prospective project's lifetime cash inflows and outflows to determine if the potential returns meet a sufficient target benchmark. You might also hear it called investment appraisal.

Key Takeaways

Companies use capital budgeting to evaluate major projects and investments, such as new plants or equipment. The process involves analyzing a project's cash inflows and outflows to see if the expected return meets a set benchmark. The major methods include discounted cash flow, payback analysis, and throughput analysis—I'll cover these in detail below.

How Capital Budgeting Works

Ideally, businesses would pursue every project that enhances shareholder value and profit, but capital is limited, so management uses capital budgeting techniques to pick which ones yield the best return over time. I'll walk you through the three most common methods: discounted cash flow, payback analysis, and throughput analysis.

Discounted Cash Flow Analysis

Discounted cash flow (DCF) analysis examines the initial cash outflow to fund a project, along with cash inflows from revenue and future outflows like maintenance costs. These cash flows, except the initial one, are discounted back to the present to get the net present value (NPV). We discount them because money today is worth more than the same amount in the future due to inflation.

Every project has an opportunity cost—the return you'd get from a different project instead. So, the project's revenue needs to cover initial and ongoing costs and exceed those opportunity costs. We discount future cash flows by the risk-free rate, like U.S. Treasury bonds, because the project must at least match that safe return.

If a company borrows to finance the project, it must earn enough to cover the cost of capital, which is a weighted average of debt and equity costs. The goal is to beat the hurdle rate—the minimum return needed to cover costs. Project managers use DCF to compare competing projects, favoring those with the highest NPV, while considering risks.

Payback Analysis

Payback analysis is the simplest capital budgeting method, though it's the least accurate. It's popular because it's quick and gives a rough idea of a project's value. It calculates how long it takes to recoup the investment by dividing the initial cost by the average yearly cash inflow.

For instance, if the initial outlay is $400,000 and it generates $100,000 per year, it takes four years to pay back. Companies with limited funds use this to see how quickly they recover investments, often choosing the shortest payback period. But it ignores opportunity costs and cash flows after payback, like salvage value, so it's more of a rough estimate than a true profitability measure.

Throughput Analysis

Throughput analysis is the most complicated method, but it's also the most accurate for deciding on projects. It treats the entire company as a single profit-generating system, measuring throughput as the amount of material passing through it.

The analysis assumes most costs are operating expenses, and to maximize profits, you need to maximize throughput through bottlenecks—the resources that take the longest. So, prioritize capital budgeting projects that increase flow through those bottlenecks.

What Is the Primary Purpose of Capital Budgeting?

The main goal of capital budgeting is to identify projects where cash flows exceed the project's cost for the company.

What Is an Example of a Capital Budgeting Decision?

Capital budgeting decisions often involve expanding operations, like a fast-food chain or retailer deciding to open a new store location.

What Is the Difference Between Capital Budgeting and Working Capital Management?

Working capital management evaluates current projects to see if they're adding value, while capital budgeting focuses on expanding operations or assets.

The Bottom Line

Capital budgeting is a tool for deciding whether to invest in new projects. Managers can use methods from simple to complex to make these choices.