Capital Budgeting: Definition, Methods and Importance

Capital Budgeting refers to the process of evaluating potential projects for future investments. Projects such as construction of offices, purchase of equipment or acquisition of another company are alternative projects; but each project has different costs and returns. Capital budgeting allows the company to analyze the costs and expected returns of each project in order to choose the best option. A company can evaluate the lifetime cash inflows and cash outflows of each project against a set benchmark. Capital budgeting is also known as investment appraisal, and it helps in making investment decisions.

The aim of capital budgeting is to identify and pursue opportunities that provide the highest profit and greatest shareholder value. This process makes sense because companies face the challenge of scarcity of resources. Capital budgeting processes enable the company to determine the projects that will require the least resources and produce the highest possible returns.

There are numerous capital budgeting techniques that can be used to assess the viability of investment projects. We have seen that capital budgeting methods can be classified into two broad categories: Discounted and non-discounted cash flow analysis.

Discounted cash flow methods include:

  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)
  • Profitability Index (PI)

Non-discounted cash flow methods are:

  • Payback Period (PBP)
  • Accounting Rate of Return (ARR)

Discounted cash flow methods consider the time value of money. It considers the initial cash flow used to fund the project, plus the mix of cash inflows in form of revenue and other cash outflows that may be incurred in form of maintenance, depreciation, and other costs. The present value of an investment is the discounted cash inflow minus the discounted cash outflow of future investments. For example, the revenue from a project in the second year is discounted using an applicable discount rate to get its present value. The concept of present value suggests that the amount of money earned today is worth more than the same amount in future.

Any investment project involves an opportunity cost, which means that the company or individual forgoes something else to invest in a particular project. For instance, if you decide to buy land, you forgo the return of depositing the money in an interest-earning bank account. The amount you earn from purchasing land should exceed the amount you could have earned if you deposited the money in a bank. 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

Non-discounted cash flow analysis includes payback period, which allows a company to analyze the number of years that a project takes to return the initial investment. The payback period method is usually used by companies that have limited financial resources so that they can know how quickly they will recoup their investment capital. On the other hand, the accounting rate of return looks at the accounting profits that project will earn compared to the investment’s costs.

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