How Does Capital Budgeting Work? - SmartAsset

Capital budgeting aims to highlight the risks and rewards of a business’s major investment proposals to determine if the ideas are really worth it. To do this, capital budgeting attempts to quantify the anticipated costs and benefits of each acquisition or project under consideration. Often, when two or more capital investments are being considered, capital “budgeters” assign a numerical value to each option and rank them in order of preference. Here’s how the process works.

Consider working with a financial advisor to ensure that your budgeting process fits your goals and resources.

Well-run businesses use budgets to determine when and how to spend money. When it comes to large expenses, the risks of making an error are higher. The costs for activities such as acquiring real estate, constructing factories, purchasing equipment and buying fleets of vehicles can be significant enough to put the company’s survival at risk if a mistake is made. Hiring a lot of workers, beginning a big research and development project and entering a market can call for similarly big outlays.

Capital Budgeting Considerations

Capital budgeting attempts to help business managers base investment decisions on how an investment in a capital asset will affect future cash flow. All else equal, an investment that consumes less future cash while increasing future incoming cash will be preferable to a capital investment that will cost more up front and generate less cash later. Timing is also important. The time value of money implies that generating cash sooner is better than generating cash later.

Scale is another consideration. A large enterprise may need to focus resources on assets that can produce large amounts of cash, even if they cost a great deal, in order to have a noticeable effect on the bottom line. A smaller enterprise may have to pass on an opportunity that promises rapid and sizable cash flows because the size of the required investment exceeds the company’s resources.

In any size company, the degree of effort spent on capital budgeting will be tailored to match the potential downside of a bad bet or the possible benefits of a good decision. A more modest capital expenditure will generally justify a less detailed budgeting analysis than one that could threaten the company with bankruptcy if it goes wrong.

When doing capital budgeting, analysts ignore sunk costs. Managers may wish to justify funds that already have been spent investigating and pursuing an investment in an asset. However, capital budgeting focuses on how the investment will affect future cash flows, not on past expenditures.

Cash Flow Budgeting Tools

Incremental cash flows are central to cash flow budgeting and managing. Only capital expenditures that promise to increase cash flows over current levels are likely to rank highly after a cash flow budgeting process. Budget analysts attempt to forecast how much a given investment in, for instance, developing a new product line, will increase the company’s cash flow. This will take into consideration added revenue the products will generate as well as the costs they will add.

Calculating the net present value of a capital investment is part of most capital budgeting processes. This expresses the value of future cash flows over the life of the asset. It then discounts these future cash flows to their present value to help compare the investment alternatives currently being considered.

Internal rate of return is a capital budgeting technique that figures out the rate of return an investment would earn based on the cash flows it will generate. A higher internal rate of return is preferable. Whether higher or lower than alternatives, the internal rate of return always needs to be more than it will cost to acquire the necessary capital through borrowing or other means.

The payback period is the length of time that will be required for the added cash flow, as indicated in a cash flow statement, to amount to more than the cost of the investment. Shorter payback periods are generally seen as better when doing capital budgeting. Until the initial investment is paid back, there is still a risk that the capital investment will be a money-loser.

The Bottom Line

Capital budgeting is a process used to assess large expenditures and increase the chances of the company investing wisely in major initiatives. Capital budgeting is especially useful in situations where a venture is big enough that it could sink the company if it fails. It’s commonly used before purchasing real estate, acquiring new equipment, constructing buildings, developing new products and other big-ticket activities. The general idea is to quantify risk and reward and invest to generate the most payback, the soonest.

Tips for Business Owners

Consider working with an experienced financial advisor before investing in a capital asset. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Another tool that helps business owners decide whether to green light a proposal is the capital asset pricing model. It’s a key tool for determining whether an investment is worth the risk.