What is capital budgeting?

Capital budgeting is the process of analyzing potential projects as you decide which one is a valuable investment and will provide your business with a high return on your funds. The projects you’re analyzing during the capital budgeting process are usually large projects that cost a significant amount of your business’ budget. These assets will improve your company’s productivity or efficiency, ultimately making you more profitable. They’re also things you’ll have long-term.

The capital budgeting process involves assessing the project inflows and outflows to decide if they’ll generate returns that reach the target benchmark in the capital budgeting approval process. If you have multiple projects you’re considering, but the budget is for only one, capital budgeting can help you choose between them. There are different ways to perform capital budgeting depending on the project and what you specifically want to evaluate.

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Reasons to use capital budgeting

It’s tempting to jump into projects you want to do, but responsible business owners need to do the analysis first to ensure the projects are financially feasible. Analyzing the projects carefully through the capital budget process can offer many benefits, including:

• Looking at the risks of the project to determine if they’re worth it
• Deciding between multiple projects to decide which one will be the most profitable
• Using set metrics to compare projects as thoroughly as possible
• Offering more value to shareholders by choosing a profitable project
• Ensuring expenses are controlled and incurred wisely
• Investing the right amount without over- or under-committing
• Options for using different calculation methods
• Gaining a better understanding of the financial commitment for each project

Potential drawbacks of capital budgeting

There are some potential drawbacks to using capital budgeting, including:

• Delays, going over budget and other unpredictable issues that can make your calculations inaccurate
• Inaccurate calculations due to lack of research or lack of knowledge on calculating the different methods
• High cost of hiring an accountant with the skills to do the calculations correctly
• Most decisions are irreversible and affect the company long-term, which can negatively impact your company if it’s a bad decision

How the capital budgeting process works

Capital budgeting is a formal process used to closely evaluate potential projects and determine which ones are more likely to maximize the company’s future profits. Here’s an example of capital budgeting and how it works:

1. Identifying opportunities and creating proposals for potential projects

Great ideas for potential projects can come from anyone in your business, from administrative employees to your executive team. If you believe these ideas could be valuable to invest in, note them as a potential project idea. A variety of projects require approval through the capital budgeting process, such as research and development, market research or industrial engineering. Evaluate potential projects by preparing a capital expenditure proposal. This proposal details a project’s:

• Initial cost
• Estimated revenue
• Expenses during the construction or implementation period
• Total cash inflow and outflow
• Any uncertainties or risks that could occur by investing in the project

2. Selecting a project

After you build your proposal, it goes through its first stage of the approval process. Shareholders analyze and rank each project to determine which to invest in. The three most common methods to help determine the best project for your business include:

• Net present value: This approach involves discounting the cash flows after taxes by the weighted average capital cost. This helps investors better understand how profitable a project will be compared to other alternatives. Most investors accept projects with positive net present values and reject negative ones.
• Payback analysis: This step of the decision-making process involves calculating how long it should take to recoup investment costs. You calculate this payback period by dividing the initial project investment by the average yearly cash inflow that you estimate the project will generate. While simple, this method can also be the least accurate project evaluation.
• Internal rate of return: This is the estimated return investors expect to receive on a project. Investors determine if it’s a worthwhile project if the rate of return is higher than the cost of capital. The internal rate of return is the discount rate that results in a net present value of zero. If your project’s discount rate heightens, then future cash flow will be more uncertain, making the project less viable.

After you make the calculations, shareholders decide whether to accept or reject a project.

3. Implementing your proposal

Once your investors and financial advisors approve a project, you’ll begin the proposal implementation process. Your plan describes how you’ll pay for the project, track costs and record incoming cash flows. Your implementation plan should also feature a timeline that projects key milestones and your estimated end date for the project. Once you implement this plan, your management team will oversee and delegate the tasks to the respective employees to ensure everything gets completed on time.

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4. Undergoing the performance review

When the project is complete, you’ll conduct a performance review with your financial professionals and shareholders to compare your final results with the projections. You’ll identify where you underperformed and explain why the actual result was different than what you estimated to better understand how to accurately estimate expenses and outcomes for future projects.

FAQs about the capital budgeting process

What type of projects would require capital budgeting before making a decision?

You typically use the capital budgeting process for larger, long-term budgets that will require a lot of money. Capital budgeting is a complex and often expensive process since a financial expert handles it, so you don’t need to do it for every little project. Some examples of when you might use capital budgeting include opening a new location, expanding into a new market, building your own warehouse or manufacturing plant, acquiring land, introducing a new product line and purchasing new machinery. Many projects that need capital budgeting require a large investment and have a long period before you start to see the returns.

Do you choose just one method of calculation for the capital budgeting process?

You can choose one or multiple calculation methods for capital budgeting. Since each method evaluates the projects from different perspectives, using multiple calculation methods can give you a well-rounded look at the options. Your timeline and budget can determine which methods you use. For example, if you want a quick, inexpensive evaluation, a payback analysis can fit your needs. However, you may want to do additional evaluations if the project meets approval based on the payback analysis.

How are projects that undergo capital budgeting funded?

Different sources can fund the projects you evaluate using capital budgeting. This might include company money, traditional business loans, private funding, grants or bonds. You might also use a mix of funding sources. For example, you might allocate some of your project budget and get a loan to cover the rest.