As the name implies, capital budgeting is the infusion of capital into the business or any developmental activities. It consists of two parts; money and budgeting. In other words, capital budgeting is the process a company undertakes to evaluate investments. In the situation of capital budgeting, capital mostly associates with the organization’s major capital expenditure. Capital expenditure is the use of assets for major outlays and purchases. These outlays can range from fixed assets, machinery, research to expansion. The other element is budgeting. Capital budgeting comprises goal setting for business development. It is done to realize maximum profitability. The sum of capital budgeting is the process of estimating investments and major expenditures to get the best return on investment.
Importance of capital budgeting
The capital budgeting process is an investment evaluation. As a part of capital budgeting, a company should look for future inflows and outflows, which are determinant factors of potential returns and the growth of a particular business. To meet a sufficient target benchmark, there should be the right budgeting and capital allocation. Capital budgeting is a way to find the right choice among multiple selections. For example, suppose you want to start a new venture. In that case, you have to assess how much asset allocation can be incorporated and evaluate the outcome of your new footstep, including the success ratio.
Capital budgeting is both an economic commitment and an investment. By taking on a project, the business is making a monetary commitment. Still, it is also investing in its longer-term direction that will likely affect upcoming projects the company considers.
Capital budgeting in day to day lives
We all are confronting contexts of capital budgeting in our daily lives. We want to attain our goals by spending less. When our PC hangs continuously, we have two options: getting repaired or buying a new one. If purchasing the PC is less expensive than repairing the old one, you will quickly decide to buy a new PC. However, the old PC has more features than the new one, and the repair will make the PC perfect as olden days, you may be going with repairing even if the repairing cost is higher. So, assessing the prospect and returns and performance you get from the old PC is the basis of your capital budgeting.
Methods of capital budgeting
Different organizations use different evaluation methods to decide whether to accept or reject a project based on capital budgeting. Capital budgeting methods cover a set of principles.
Net Present Value (NPV)
This approach is the most intuitive and accurate valuation of capital budgeting issues. NPV refers to the value of all inflows and outflows generated by a project. Every project signifies a sequence of inflows and outflows of cash. Money has a time value, and so you must draw a comparison between money received today and money to be received later (you could easily understand the time value of money if you are a trader in OPTION segment of the stock market). Finally, you must convert all these inflows and outflows to present value using a discount rate to make an investment choice.
Payback Period (PP)
The payback period is calculated based on the duration of an investment and how long it takes to give returns on investment. PP is one of the simplest forms of capital budgeting, but it’s also one of the least accurate. Nevertheless, this approach is still used often enough as it is easy to use, and managers can get an insight into the actual value of a proposed project. The Payback Period is calculated by dividing the opening investment in a project by the average annual cash flow that comes from the project.
Payback analysis is generally used when companies have only a limited amount of funds (or liquidity) to invest in a project. Therefore, they need to understand how quickly they can get back their investment.
Internal Rate of Return (IRR)
The internal rate of return is the discount rate that would result in an NPV of zero. It calculates returns that the investment makes throughout a project. Organizations can be invested their surplus into other profitable operations. So, IRR is an estimate of an expected annual rate of return; it should not be confused with the actual gain of the company. This way, you can generate incomes comparable to previous activities. These resources can also be invested into a capital project, a new venture, or expanding a current experience.
This is the most complicated analysis of capital budgeting. But also the most accurate in helping managers decide which projects to follow. Under this technique, the entire company is considered as a single profit-generating system. Throughput is calculated as the amount of material passing through that system. The analysis assumes that nearly all costs are operating expenditures, that a company requires to maximize the throughput of the whole system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a rigid operation.
Discounted Cash-Flow (DCF)
DCF analysis looks at the initial cash outflow required to fund the project; it includes the mix of cash inflows in revenue and all other future outflows in the shape of maintenance and additional costs.
Capital budgeting is either required huge sum of money or it required small amount. In most cases, capital investment involves a huge sum. If you are allocating a large sum of funds, you often look for huge returns. In this way, capital budgeting is an essential key task to determine the impact of an organization’s profitability. Investment decisions are one of the most significant decisions that make sure a company turns to profit. This is calculated according to the return on invested capital. Capital budgeting methods offer a good mix of capital investments to get guaranteed returns.
About the Author:
Pramod Kumar is a teacher, trainer, and a writer passionate about academic writing. His favorite subjects include psychology and economics. He is always exploring innovative theories and how it can be implemented in everyday lives. He is also a regular content contributor for Slidebazaar.com, a website dedicated for PowerPoint Templates.