Capital budgeting is a quantitative decision-making approach for evaluating and choosing between one or more investment projects under consideration by an organization. Through the use of the capital budgeting structured approach, the organization attempts to identify the profitability and risk complexion of an investment alternative.
Essentially, the capital budgeting approach is all about making well informed investment decisions. The quantitative process entails assessing the profitability and risk complexion of an investment decision under consideration. The contemplated profitability resulting from an investment decision based on the systematic capital budgeting approach serves as the justification for making the decision in the first place. Rather than simply winging it when selecting and embarking on a capital expenditure, the capital budgeting approach provides the support upon which responsible managers rely.
As noted in this informational video, the capital budgeting decision-making process is typically applied to investment projects concerning capital assets such as real estate (buildings, land), heavy equipment, machinery, and vehicles. The unique challenges encountered when budgeting for capital assets can be summarized as follows:
The eventual outcome is uncertain.
Large amounts of money are involved.
The investment decision represents a long-term commitment.
The investment decision may be difficult or impossible to reverse.
The capital budgeting process involves calculating one or more of what are called “capital budgeting metrics” and evaluating those metrics alongside the organization’s corresponding financial goals.
Examples of suitable capital budgeting metrics frequently used in industry are as follows (as noted in this Wikipedia list):
An effective capital budgeting project shouldn’t necessarily be limited to evaluating just one of these foregoing metrics. Rather, each of these metrics tends to bring something unique to the table. Management should be encouraged to use more than one of these metrics in unison when evaluating an investment project in order to obtain a more well-rounded, comprehensive picture of how the project’s contributions will achieve the organization’s financial goals.
The most frequently used metrics from this list are the following:
- Net present value: Evaluates the present value of future cash inflows net of future cash outflows. The general rule of the NPV method is that independent projects are accepted when NPV is positive and rejected when NPV is negative. In the case of mutually exclusive projects, the project with the highest NPV should be accepted.
The advantage? It takes into account the time value of money.
The disadvantage? It’s more complex to calculate. The evaluation of the investment project could potentially be penalized if an unreasonable discount rate is used. Furthermore, future cash flows are not guaranteed.
- Internal Rate of Return (“IRR”): The IRR is the interest rate that when applied to the future net cash flows will yield a net present value equal to 0.
A capital project must produce an IRR that is higher than the company's cost of capital. Once this hurdle is surpassed, the project with the highest IRR would be the wiser investment, all other things being equal (including risk).
The advantage? It is relatively easy to arrive at. It introduces a time value of money influence to the investment analysis.
The disadvantage? The IRR is an internal metric in the sense that it ignores the impact of external environmental factors such as inflation.
While not a perfect tool, the capital budgeting process introduces a systematic and rational tool for either deciding to move forward with a particular investment project or deciding to forego the investment project. A suggested approach to mitigating the imperfection of the process is to calculate and evaluate multiple metrics rather than confining the view to only one metric.
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