Capital Budgeting: What Is It and Best Practices (2024)

“Capital” is a popular term in the world of finance. The word on its own usuallyrefers to a company’s available funds, such as its retained earnings or availablecredit or owner’s capital. When a company spends or invests its capital on a long-termasset, like a piece of machinery, it’s called “capital spending,” and themachinery is a “capital asset.” Further, the process of evaluating how best toinvest a company’s capital, by making “capital expenditures,” is called“capital budgeting.” All of these “capital” terms share two commondogmas: that capital is finite and capital expenditures should be prioritized to get themost bang for the buck. The world of finance provides frameworks and tools to help businessleaders objectively determine which capital projects to pursue or prioritize. This articleexplores different methods of capital budgeting, best practices and steps in the process—because capital spending is too important to rely on gut instinct.

What Is Capital Budgeting?

Capital budgeting is the process of analyzing, evaluating and prioritizing investment inlarge-scale projects that typically require significant amounts of funds, such as thepurchase of a new facility, fixed assets or real estate. Capital budgeting provides anobjective means of determining the best way to use capital to increase the value of abusiness and is useful to companies of all sizes and industries. Consider these scenariosthat call for capital budgeting:

• Should a large automobile manufacturer build a new factory to make electric vehicles orbuy a company that already specializes in building them?
• Should a midsize retailer invest in automated inventory control software?
• Should a small restaurant owner buy a second pizza oven?

These examples challenge decision-makers to determine whether their spending will bringenough future benefits to their businesses. Business managers often have to weigh multipleprojects that are competing for the same investment funds, which means the decisionneeds to be based on some kind of ranking rather than a simple yes or no. Capital budgetingis a structured way to approach these questions by incorporating the expected cash outlaysand inflows, and to help manage the financial risks involved in these capital-intensive andstrategically important projects.

Key Takeaways

• Capital budgeting is the process of determining whether a large-scale project is worththe investment and will increase a company’s value.
• Using a formal process for capital budgeting increases the likelihood of betteroutcomes.
• Some capital budgeting methods are somewhat subjective, while others are based onfinancial formulas.
• High-quality data increases the usefulness of capital budgeting.

Capital Budgeting Explained

Capital budgeting is a type of financial managementthat focuses on the cash flow implications of makingan investment, rather than resulting profits (to avoid complicating calculations withaccounting conventions, such as depreciation). It involves estimating the amount and timingof cash outflow — money that leaves the business to pay for a purchase or investment,suchas new equipment — and cash inflow, or new sources of cash that come into the company,suchas increased sales revenue made possible by the increased output from the new equipment. Insome cases, a reduction in cash outflows can be considered a cash inflow for capitalbudgeting purposes — for example, when a new piece of equipment reduces the cost toproducea product. Different capital projects can be evaluated by comparing their amounts of cashoutflow and cash inflow.

Two important concepts that underlie many capital budgeting methods are opportunity cost andthe time value of money. Both apply due to the long-term nature of most capital projects.

Opportunity cost can be described as the value of the road not taken. Assuming that capitalfunds are not infinite, the opportunity cost represents benefits that are forgone bychoosing one investment over the next best one. A simple example is choosing to keep cashsitting in a cookie jar, rather than in an interest-bearing bank account. The forgoneinterest income that could be earned is the opportunity cost of keeping cash in the cookiejar. Opportunity cost is especially relevant in capital budgeting when evaluating oneproject against another and is used to determine a “hurdle,” or minimum targetreturn, that a capital project must meet.

The time value of money is a financial concept that considers the potential rate of return onan investment and the reduction in purchasing power over time caused by inflation. Itsessential precept is that a dollar today is more valuable than that dollar will be at somepoint in the future. In other words, the farther into the future, the less valuable thedollar. Time value of money is based on the idea that if a person had a dollar today, theycould invest and grow it based on some investment rate, so they’d have more than adollar at the end of the investment term. If instead they opted to get that dollar in thefuture, they’d forgo that investment growth. Capital budgeting also includes a focuson the timing of the cash flows to reflect the time value of money.

Capital Budgeting Steps

How a company manages the capital budgeting process depends on its organizational structure.Some large organizations have a capital budgeting committee who oversees all capitalprojects. In small and midsize businesses, capital budgeting decisions are made by the owneror a small group of executives, often supported by analysis from their accountants. In allcases, it’s important to keep the company’s strategic goals in mind beforejumping into the first of five steps that govern the process.

1. Identifying and generating projects. Gather ideas and proposals, whichcan come from anywhere in the organization. It’s helpful to have a procedure forsubmission, which may include using templates, but always require cash flow, cost andbenefit estimates. It’s common for a growing business to have many proposalscompeting for available funds.
2. Evaluating the projects. This step focuses on establishing thefeasibility of the various proposals, beginning with screening to ensure that theycontain all the right information and that the sponsor has done their due diligence.It’s common to require proposals to be vetted and reviewed by different areas ofthe company, obtaining endorsem*nts from accounting, sales or operations managers priorto submission. Another part of project evaluation involves establishing the criteria tobe used to assess the proposals, such as tolerable risk, hurdle rates and spendingthresholds. Criteria are at management’s discretion, with the goal of increasingthe company’s value.
3. Selecting a project. Proposals are analyzed, and then those that meetthe evaluation criteria and are considered a good business move are given the greenlight. The timing and priority of competing projects often play a part in selection,especially in situations where proposals exceed the company’s available funding orbandwidth for execution.
4. Implementing a project. Once a proposal is approved, an implementationplan is developed. This plan describes key factors for accomplishing the project, suchas how it will be funded and methods of tracking cash flows. It also sets a projecttimeline, including various milestones and a target end date. Additionally, theimplementation plan identifies key personnel involved in the project, authority levelsand a process for escalation of exceptions, such as delays or budget overages.
5. Review project performance. The final step in the capital budgetingprocess is to review the actual results of the project compared with the approvedproposal. It’s a good idea to do this at predetermined implementation milestonesas well as at the end of the project. Learning from one project can help inform futurecapital projects.

Ranking Projects With Capital Budgeting

Keeping in mind the goal of maximizing business value, it’s important to invest abusiness’s capital wisely. This requires business leaders to prioritize capitalprojects because it’s unlikely that any organization can, or should, undertake everyproposal. Ranking projects is one way to objectively prioritize which projects to approve,defer or reject. Ranking narrows down viable alternatives and is part of step 3 in thefive-step capital budgeting process described in the previous section. There are severalmethods a business can use to value capital projects and develop a ranking, as outlined inthe next section.

Capital Budgeting Methods

Businesses can choose to use one or more types of capital budgeting methods, described below,to help value and evaluate capital projects. The methods serve to eliminate projects thatfall short of a company’s minimum performance thresholds. They are also helpful incomparing competing projects and developing rankings.

Payback Period

This method focuses on how quickly a company recoups its capital investment. It compares theinitial cash outflow to the subsequent cash inflows to determine the point in time when theproject has “paid for itself.” The payback period approach does not place avalue on a project; instead, it concludes that a project might take a specific amount oftime to pay back the initial investment. Shorter payback periods are preferable to longerones. This method’s advantage is its simplicity, but there are two main drawbacks:One, payback period isn’t a complete model because the calculations cut off once theproject is paid back and, two, it ignores project profitability and terminal values, such assalvage prices for equipment at the end of the project life.

Discounted Payback Period

This method is an improved version of the payback period method because it also reflects thetime value of money, which always decreases as the years pass. To account for this, cashflows in future periods are “discounted” so as to revalue them in present valueterms. As a result, the discounted cash flows are less than the non-discounted cash flows,which causes the discounted payback period to be longer than the non-discounted paybackperiod. This difference between the discounted method and non-discounted period increaseswhen the payback period is longer or the discount rate is higher. The discount rate can be acompany’s cost of capital or its required internal rate of return. The advantage ofthis method is that it more accurately calculates the payback period reflecting the timevalue of money. However, the discounted payback period maintains the disadvantages ofignoring periods beyond payback and terminal values.

Net Present Value Analysis

The net present value (NPV)of a project represents the excess of cash inflows beyond cash outflows. It adjusts bothincoming and outgoing streams for the time value of money, using a discount rate. The endresult of NPV is a monetary value that can be positive or negative, with a positive valueadding to a firm’s value and a negative value reducing it. Clearly, projects with alarger, positive NPV are preferred over those with smaller or negative NPVs, assuming theprojects have similar levels of risk. NPV is applied to the entire life of a project,including any terminal values. NPV is a common standard for capital budgeting because itreflects value from the entire project and adjusts for the time value of money. Challengesof using NPV include the complexity of the calculation and the reliance on selecting theappropriate discount rate. NPV calculations change significantly depending on whether thediscount rate is based on a company’s cost of capital (its all-in borrowing rate), itsinternal cost of capital (akin to an opportunity cost), a specific rate of return expectedby external investors or an internally generated threshold rate of return.

Profitability Index

The profitability index is a technique that calculates the cash return per dollar invested ina capital project. This index is calculated by dividing the NPV of all the cash inflows bythe NPV of all the outflows. Projects with an index less than 1 are typically rejected,since, by definition, the sum of the project cash inflows is less than the project’sinitial investment when the time value of money is factored in. Conversely, projects with anindex greater than 1 are ranked and prioritized. The profitability index is helpful todetermine which capital projects make sense to greenlight, especially when analyzing severalprojects drawing on a fixed amount of investment capital. However, the profitability indexis less useful for projects with a high amount of sunk costs — money already spent andirretrievable — and for comparing projects with different life terms.

Equivalent Annuity Method

The equivalent annuity method is a way to evaluate the NPV of capital projects that aremutually exclusive and have different project lengths. It does this by creating an annualaverage to smooth out the individual discounted cash flows. The first step in this method isto calculate the NPVs of each cash flow over the life of the projects. Projects withpositive, higher equivalent annual annuity are preferred. The equivalent annuity method isespecially helpful when evaluating different proposed capital projects with varying lifeterms. However, a disadvantage is that the underlying calculations to derive the averageassume that projects can be repeated into perpetuity, which is unlikely to be the case.

Internal Rate of Return

The internal rate of return(IRR) method looks to find the discount rate that causes a project’s NPV to bezero. That’s a mouthful. More simply, this method generates a yield percentage on aproject, rather than a dollar value. The percentage is the embedded rate that causes thetotal of all the discounted cash inflows and outflows to be even. Capital projects that havea higher IRR are typically selected first, all else being equal. Additionally, a companymight compare the IRR to its cost of capital or to an internal threshold in order todetermine whether to undertake a capital project. IRR is a helpful way to compare projectsagainst each other and against a required hurdle rate. However, a primary disadvantage ofIRR is that it doesn’t reflect a project’s size or impact on a business’soverall value.

Modified Internal Rate of Return (MIRR)

This method is an extension of the IRR. It also calculates a yield percentage on a projectwhen the NPV is zero, but in a more complex and accurate way. The MIRR uses different ratesfor discounting cash inflows than for cash outflows when calculating the NPV. Cash inflowsare discounted using a company’s reinvestment rate, and the cash outflows, like theinitial capital investment, are calculated using the company’s financing rate. Using areinvestment rate for cash inflows tends to be more realistic than using a single rate forboth financing and reinvestment, as in NPV and IRR. It also gives a better comparison forprojects of different sizes. However, the use of multiple discount rates also makescalculating the MIRR more difficult.

Constraint Analysis

Constraint analysis is a criterion used in capital budgeting to help select capital projectsbased on operational or market limitations. Unlike the quantitative methods previouslydescribed, this approach looks at company processes, such as product manufacturing, anddetermines which stages of the process make the most sense for investment. A key concept inconstraint analysis is identifying bottlenecks — pinch points in the process thatwould makedownstream investments of no use. For example, if a dine-in only restaurant had a finitenumber of tables, it might not make sense to invest in more kitchen equipment, since salesare constrained by the number of diners. A constraint analysis might indicate that prioritybe given to an investment in expanding the dining area instead. The advantage of thisapproach is that it helps a business avoid undertaking projects that may not increaseprofitability. However, identifying constraints can be challenging and somewhat subjective.

Cost Avoidance Analysis

Cost avoidance analysis draws on the concept of opportunity cost to approachcapital-budgeting decisions. Using this method, a business evaluates capital projects usingan estimate of costs that can be eliminated in the future by undertaking the project. Forexample, investing in automated accounting software could negate a company’s need tohire additional bookkeepers in the future. Capital projects that avoid more costs thanothers are prioritized first. Quantifying capital projects using cost-avoidance analysis ischallenging since it is a theoretical exercise — if the correct capital decision ismade,the costs never materialize and never hit a financial statement.

Real Options Analysis

Many times, business leaders must make capital budgeting decisions with imperfect informationdue to uncertainties about future conditions, especially since capital projects tend to belong-term in nature. Consider the cyclical disruptions in technology that present challengesor opportunities for capital projects in that industry. The real options analysis attemptsto determine a value for a capital project’s flexibility. It does this as an extensionof NPV, using probability estimates and assuming changes in the discounted cash flows forproject adjustments, such as asset choice, investment timing, growth options andabandonment. Consider a manufacturing capital project that is altered halfway through theproject life because different, cheaper raw materials became available. The real optionsmethod is helpful because it reflects dynamic changes a project might offer over its life,beyond a simple, static “go/no-go” approach. However, it can becomeextraordinarily complex depending on the number of uncertainties considered.

Which Method Should Your Business Use?

The capital budgeting methods discussed above all have advantages and disadvantages. Some arecomputational while others are more qualitative and process-oriented. Determining whichapproach to use is really a matter of the specific situation, the sophistication of theperson or team evaluating a project and the company’s objective. In addition, the sizeof the capital spending relative to the available funds might make more sophisticatedanalysis appropriate. In other cases, simpler methods can be beneficial when time is of theessence. In practice, a company might use several of the techniques.

Capital Budgeting Best Practices

Capital spending deals with big-ticket items and projects with long lives, so it’simportant to fine-tune the capital budgeting process as much as possible. Some bestpractices to consider include:

• Focus on cash flows. Use cash flows, rather than net income, for modelingcapital projects. Incorporate cash flows from all sources, including changes in working capital, suchas increases and reductions in accounts receivable and accounts payable.
• Be conservative with estimates. This means tempering enthusiasm for thebenefits of a project when estimating potential cash inflows and taking more of aworst-case viewpoint when estimating cash outflows.
• Project timing carefully. The time value of money is an importantconcept for capital budgeting, so it follows that projecting the timing of cash flow asprecisely as possible is a priority.
• Ignore certain costs. Exclude certain costs, such as tax, amortization, depreciation andfinancing costs, to keep capital budgeting calculations purely focused on the impact ofthe capital project.
• Establish a procedural framework. Set up clear accountability andresponsibility for capital projects. This includes procedures to track costs, schedulesand quality in a controlled environment.
• Incorporate review. Knowledge gained from past proposals and capital budgetingcycles can improve future projects. It’s helpful to conduct a formalreview and document findings at various stages of a project as well as at its end.

Capital Budgeting Limitations

While capital budgeting is a necessary process to help a company estimate and evaluate itsoptions for capital spending, it is inherently limited by the compound effect of estimates.Predicting any one of these variables is a challenge; when they are put together, the effectcan lead to misleading information and suboptimal decision-making. Capital budgetshortcomings can occur due to:

• Incorrect cash flow estimates. Over- or underestimating the cash flowinto or out of the company can cause capital projects to be incorrectly accepted orrejected.
• Inaccurate timing estimates. The timing of cash flow is almost asimportant as the amount of the cash flow. The longer a project’s term, the moredifficult these estimates can be, which can have a significant impact on NPVcalculations.
• Determining the right rates. Choosing the right discount rates forcapital budgeting is not always as easy as it sounds. It may take a bit of calculatingto determine a company’s true cost of capital and financing rate. Even setting ahurdle rate — the least acceptable rate of return on an investment — may notbe sosimple. Using an incorrect discount rate can upend many of the common capital budgetmethods.

NetSuite Has All Your Budgeting and Financial Planning Needs in One Place

The capital budgeting process helps business leaders make better informed decisions about howto invest their company’s capital. The quality of the data used in the process isimportant to ensure the best analyses are made. NetSuite Planning andBudgeting can help. The automated, collaborative tool offers complex modelingfeatures that can help elevate the most investment-worthy capital budgeting proposals at thefront end of the process. In addition, the software can help track actual project cashinflows and outflows against the estimates as the project is implemented. It also reducesbudgeting cycling time and improves the accuracy of forecasts.

Capital budgeting is the process of evaluating long-term investments. Taking a formalapproach increases the likelihood of selecting the projects that are more likely to increasebusiness value. A variety of methods exist to help quantify the impact of capital projectsand compare them, most using the financial concepts of opportunity cost and the time valueof money. Choosing the best options and understanding their limitations can help ensure thatthe right information is analyzed. Planning and budgeting software can make all five stagesof the capital budgeting process easier and more accurate.

Capital Budgeting FAQs

What is the primary purpose of capital budgeting?

Capital budgeting is the process of analyzing, evaluating and prioritizing investment oncapital-intensive projects. It’s an objective way to determine the best use of fundsto increase the value of a business.

What is an example of a capital budgeting decision?

An example of a capital budgeting decision is a small restaurant owner contemplating buying asecond pizza oven. The owner must decide whether this investment is the best use of capitalor if the opportunity cost of spending that money is too high. She might determine that theinternal rate of return on the purchase is lower than the interest rate she could earn bysimply leaving her cash in an interest-bearing savings account, representing the hurdlerate. She could also use the payback period to determine how long it would take to sellenough pizzas to make back the initial outlay of cash for the new pizza oven. But if hers isa dine-in only restaurant with a finite number of tables, constraint analysis might indicatethat it doesn’t make sense to invest in more kitchen equipment, since sales areconstrained by the number of diners.

What is the difference between capital budgeting and working capitalmanagement?

Working capital refers to a company’s current assets, like cash and currentliabilities, such as accounts payable. Working capital management is a process to optimize acompany’s current assets and liabilities to meet short-term goals. Capital budgetingis the process of evaluating the best way to invest money in long-term projects thatincrease the value of a business, such as purchasing machinery, building facilities orinvesting in new product development.

What is meant by capital budget?

When a company spends or invests its capital on a long-term asset, like a piece of machinery,it’s called capital spending, and the machinery is called a capital asset. The processof evaluating how best to invest a company’s capital, by making capital expenditures,is called capital budgeting.

What is capital budgeting and an example?

Capital budgeting is the process of evaluating long-term investments. Examples include theaddition or replacement of a fixed asset, like machinery, or a large-scale project, such asbuying real estate or another company.

What are the 3 methods of capital budgeting?

Several capital budgeting methods are used to help value capital projects. The valuationsserve to screen out projects that fall short of a company’s minimum performancethresholds. They are also helpful to compare competing projects and develop rankings. Threecommon methods of capital budgeting are the payback period, net present value analysis andthe profitability index.

What is the capital budgeting process?

A capital budgeting process typically includes the following five steps:

1. Identifying and generating projects.
2. Evaluating the projects.
3. Selecting a project.
4. Implementing a project.
5. Reviewing project performance.