Capital budgeting involves selecting projects that add value to the company. The capital budgeting process can involve almost anything, including the acquisition of land or the purchase of a fixed asset such as a new truck or machinery.
Companies use different metrics to track the performance of a potential project, and there are different methods of capital budgeting.
Key Things
- Capital budgeting is the process by which investors determine the value of a potential investment project.
- The three most common approaches to project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV).
- The payback period determines how long it would take the company to see enough in cash flow to recoup the original investment.
- The internal rate of return is the expected return on a project – if the rate is greater than the cost of capital, it is a good project.
- Net present value shows how profitable a project will be compared to alternatives and is perhaps the most effective of the three methods.
Understanding Capital Budgeting
Every year, companies often communicate between departments and rely on financial management to prepare annual or long-term budgets. These budgets are often operational and outline how the company’s income and expenses will shape up over the next 12 months.
However, another aspect of this financial plan is capital budgeting. Capital budgeting is a long-term financial plan for larger financial expenditures.
Capital budgeting relies on many of the same basic practices as any other form of budgeting. However, there are some unique problems with capital budgeting. First, capital budgets are often strictly cost centers; they do not generate income during the project and must be funded from an external source, such as income from another department. Second, because of the long-term nature of capital budgets, there are more risks, uncertainties, and things that can go wrong.
Capital budgeting is often prepared for a long-term effort and then reassessed as the project or venture progresses. Companies often reassess their capital budget regularly as a project progresses. In capital budgeting, it is important to proactively plan ahead for large cash outflows that should not stop once they start unless the company is willing to face large potential project delay costs or losses.
Why Do Businesses Need Capital Budgeting?
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project without understanding the risks and rewards involved would be considered irresponsible by its owners or shareholders. Furthermore, if a business has no way to measure the effectiveness of its investment decisions, it is likely that it would have little chance of surviving in a competitive market.
Companies are often in a situation where capital is limited and decisions are mutually exclusive. Management usually has to make decisions about where to allocate resources, capital, and labor time. Capital budgeting is important in this process because it outlines the expectations for the project. These expectations can be compared with other projects to decide which one is the most appropriate.
Businesses (except non-profits) exist to make profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project. While it may be easier for a company to predict what sales might be in the next 12 months, it may be more difficult to gauge how a five-year, $1 billion renovation of a manufacturing facility will go. Businesses therefore need capital budgeting to assess risk, plan ahead and anticipate problems before they occur.
A capital budgeting decision is both a financial commitment and an investment. By accepting a project, a business not only accepts a financial commitment, but also invests in its long-term direction, which is likely to influence future projects that the company considers.
Methods Used in Capital Budgeting
There is no single method of capital budgeting; in fact, companies may find it useful to prepare a single capital budget using the various methods described below. In this way, a company can identify gaps in a single analysis or consider implications across methods that it might not otherwise think about.
Analysis of Discounted Cash Flows
- Because capital budgeting will often span many periods and potentially many years, companies often use discounted cash flow techniques to assess not only the timing of cash flows, but also the dollar implications. As time passes, currencies often depreciate. A central concept in inflation facing economics is that today’s dollar is worth more than tomorrow’s dollar because today’s dollar can be used to generate income or income tomorrow.
- The discounted cash flow also includes the inflows and outflows of the project. Most often, companies can make an initial cash outlay for the project (a one-time outflow). Other times, there may be a series of outflows that represent regular payments for the project. In either case, companies may seek to calculate a target discount rate or a specific net cash flow value at the end of the project.
Payback Analysis
- Instead of strictly analyzing dollars and revenues, return on capital budgeting methods plan for when certain benchmarks are reached. For some companies, they want to track when the company breaks even (or when it has paid for itself). For others, they are more concerned with the timing of when the capital effort yields a certain amount of profit.
- With payback methods, capital budgeting requires the need to be especially careful when forecasting cash flows. Any variation in the estimate from one year to the next can materially affect when the company can achieve the payback metric, so this method requires a bit more care in timing. In addition, if a company wants to combine capital budgeting methods, the payback method and the discounted cash flow analysis method can be combined.
Throughput Analysis
- A dramatically different approach to capital budgeting is represented by methods that include throughput analysis. Throughput methods often analyze revenues and expenses across the organization, not just for specific projects. Throughput analysis through cost accounting can also be used for operating or non-investment budgeting.
- Throughput methods mean taking the company’s revenue and deducting variable costs. This method leads to an analysis of how much profit is made from each sale that can be attributed to fixed costs. Once the company pays all fixed costs, the entity retains all throughput as equity.
- Companies may aim not only to achieve a certain amount of profit, but also want to have a target amount of capital available after variable costs. These funds can be used to cover operating costs and management can target what capital budget they have to contribute back to operations.
Metrics Used in Capital Budgeting
- When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove profitable. Payback period (PB), internal rate of return (IRR), and net present value (NPV) methods are the most common approaches to project selection.
- Although the ideal capital budgeting solution is for all three metrics to indicate the same decision, these approaches often lead to conflicting results. Depending on management preferences and selection criteria, more emphasis will be placed on one approach over the other. However, these widely used valuation methods share advantages and disadvantages.
Payback Time
- The payback period calculates the time required to recoup the original investment. For example, if a capital budgeting project requires an initial cash outlay of $1 million, the payback tells you how many years it takes for cash inflows to equal $1 million in outflows. A short payback period is preferred because it indicates that the project would “pay for itself” in a shorter time frame.
- The payback period is usually used when liquidity is a major concern. If a company only has a limited amount of funds, it may only be able to carry out one large project at a time. Therefore, management will focus strongly on the return on their initial investment in order to implement subsequent projects.
- Another big advantage of using the payback period is that it can be easily calculated once the cash flow forecasts have been made.
- Using the return metric to make capital budgeting decisions has its drawbacks. First, the payback period does not take into account the time value of money (TVM). A simple return calculation provides a metric that places equal emphasis on payments received in the first and second year.
- Such a mistake violates one of the fundamental principles of finance. Fortunately, this problem can be easily modified by implementing a discounted payback period model. The discounted payback period basically affects TVM and allows you to determine how long it takes for an investment to pay back based on discounted cash flows.
- Another disadvantage is that both payback periods and discounted payback periods ignore cash flows that occur at the end of the project’s life, such as salvage value. Thus, return is not a direct measure of profitability.
- The payback method also has other disadvantages, which include the possibility that cash investments may be needed at different stages of the project. The lifespan of the asset that has been purchased should also be considered. If the life of the asset does not greatly exceed the payback period, then there may not be enough time to generate profits from the project.
- Because the payback period does not reflect the added value of capital budgeting decisions, it is usually considered the least relevant valuation approach. However, if liquidity is a vital factor, then payback periods are very important.
Internal Rate of Return
The internal rate of return (or the project’s expected return) is the discount rate that would result in a net present value of zero. Since a project’s NPV is inversely correlated with the discount rate—if the discount rate increases, then future cash flows become more uncertain and therefore worth less—the benchmark for IRR calculations is the actual discount rate the firm uses. after-tax cash flows.
An IRR that is greater than the weighted average cost of capital indicates that the capital project is profitable and vice versa.
The IRR Rule Is as Follows:
- IRR > Cost of Capital = Accept the project
- IRR < Cost of Capital = Reject Project
The primary benefit of implementing the internal rate of return as a decision-making tool is that it provides a benchmark for each project that can be assessed against the company’s capital structure. IRR typically makes the same types of decisions as net present value models and allows firms to compare projects based on return on invested capital.
Although IRR can be easily calculated using a financial calculator or software packages, there are some drawbacks to using this metric. Similar to the payback method, the IRR does not give a true sense of the value a project will add to the firm—it merely provides a benchmark for what projects should be accepted based on the firm’s cost of capital.
The internal rate of return does not allow an appropriate comparison of mutually exclusive projects; therefore, managers might be able to determine that both project A and project B are beneficial to the firm, but they would not be able to decide which is better if only one is accepted.
Another error that arises when using IRR analysis occurs when the project’s cash flow streams are unconventional, meaning that there are additional cash outflows after the initial investment. Unconventional cash flows are common in capital budgeting because many projects require future capital expenditures for maintenance and repairs. In such a scenario, IRR may not exist or there may be multiple internal rates of return
IRR is a useful valuation measure when analyzing individual capital budgeting projects, not mutually exclusive ones. It provides a better valuation alternative to the payback method, yet it falls short of several key requirements.
Net Present Value
- The net present value approach is the most intuitive and accurate approach to valuing capital budgeting problems. Discounting after-tax cash flows by the weighted average cost of capital allows managers to determine whether or not a project will be profitable. And unlike the IRR method, NPVs reveal exactly how profitable a project will be compared to alternatives.
- The NPV rule states that all projects with a positive net present value should be accepted, while those that are negative should be rejected. If funds are limited and not all projects with a positive NPV can be initiated, those with a high discounted value should be accepted.
- Some of the main advantages of the NPV approach include its overall utility and that NPV provides a direct measure of added profitability. It allows multiple mutually exclusive projects to be compared simultaneously, and although the discount rate may change, NPV sensitivity analysis can usually signal any overriding potential future concerns.
- Although the NPV approach is subject to fair criticism that the value added value does not take into account the overall scope of the project, the profitability index (PI), a metric derived from discounted cash flow calculations, can easily solve this problem.
- The Profitability Index (PI) is calculated by dividing the present value of future cash flows by the initial investment. A PI greater than 1 means that the NPV is positive, while a PI less than 1 means a negative NPV. The weighted average cost of capital (WACC) can be difficult to calculate, but it is a reliable way to measure the quality of investments.
What Are the Common Types of Budgets?
Budgets can be prepared as incremental, activity-based, value proposition or zero-based budgets. While some types, such as a zero-based budget, start with a budget from scratch, an incremental budget or an activity-based budget may separate from the previous year’s budget and have an existing baseline. Capital budgeting can be done using any of the above methods, although zero-based budgets are best for new endeavors.
How Do Capital Budgets Differ from Operating Budgets?
Capital budgets are more focused on the long term and often span multiple years. Operating budgets are often set for a one-year period with defined income and expenses. Capital budgets often cover different types of activities, such as remodeling or investment, while operating budgets track the day-to-day operations of the business.
Are Companies Required to Prepare Capital Budgets?
Not necessarily. Capital budgets (like all other budgets) are internal planning documents. These reports do not need to be published and are mainly used to support strategic management decision-making. Although companies are not required to prepare capital budgets, they are an integral part of planning and the long-term success of companies.
Bottom Line
A capital budget is a long-term plan that outlines the financial demands of an investment, development or major purchase. Unlike an operating budget that tracks income and expenses, a capital budget must be prepared that analyzes whether or not the long-term endeavor will be profitable. Capital budgets are often reviewed using NPV, IRR, and payback period to ensure that the return meets management’s expectations.
