What is Capital Budgeting?

Capital budgeting refers to the process in which a business ascertains and evaluates possible large investments or expenses. These investments and expenditures comprise projects like investing in a long-term venture or building a new plant. Most times, a company evaluates the lifetime cash inflows and outflows of a prospective project to ascertain if the potential returns gotten meet the desired target benchmark, also referred to as "investment appraisal."

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How Does Capital Budgeting Work?

Typically, businesses should pursue every project and opportunity which improves shareholder value. However, because there is a limitation to the amount of capital available for new projects, management needs to utilize capital budgeting strategies in determining which projects would yield the highest return obedience an applicable timeframe. Various capital budgeting methods exist including net present value, discounted cash flow, payback period, throughput analysis, and internal rate of return. Three popular methods exist for deciding the projects that should get investment funds over other projects. The methods include throughput analysis, payback period analysis, and DCF analysis.

Capital Budgeting with Throughput Analysis

Throughput is measured as the amount of material passing through a system. Throughput analysis is the most complex capital budgeting analysis type, but is also the most precise in assisting managers decide which projects to embark on. Under this method, the whole company is a single system which generates profit. The analysis assumes that almost every cost in the system is operating expenses, that in order for the company to pay for expenses it has to maximize the entire systems throughput, and that maximizing profits involves maximizing the throughput passing through a bottleneck operation. A bottleneck is the systems resource which needs the longest time in operations. This implies that managers should give more preference to capital budgeting projects which affect and increase throughput passing through the bottleneck.

Capital Budgeting Using DCF Analysis

DCF analysis is synonymous to or the same as NPV analysis in that it examines the first cash outflow required to fund a project, the combination of cash inflows assuming revenue forms, and other future outflows assuming maintenance and other cost forms. These costs, save for the first outflow, are discounted back to the current date. The NPV is the resulting number of the DCF analysis. Projects having the highest NPV should rank over other projects except in situations where one or more are mutually exclusive.

The Most Simple Form of Capital Budgeting

Payback analysis is the easiest form of capital budgeting analysis, thus making it the least accurate. However, managers still utilize this method because of its speed and its ability to give managers a quick understanding of the effectiveness of a project or group of projects. This analysis estimates how long it would take to recoup a projects investment. One can know the payback period by dividing the initial investment by the average yearly cash inflow.