What Is Capital Budgeting?

By Sean Stevenson – Latest Revision March 28th, 2021

Defining Capital Budgeting

Capital budgeting is used by companies of every denomination and size.  It is a means of evaluating and actively planning the allocation of business funding.  Most often, this funding goes toward improving different aspects of a business model.

This form of internal investing allows a company to better itself through use of its own capital.  These investments can provide new equipment, better infrastructure, or even an entirely new plant for production.

Depending on the needs of the business, capital budgeting can allow for important improvements to become a reality.

Most companies have their own internal methodology for approving or rejecting the capital budgeting process.  When it is brought forward by an appropriate authority, the plan will be reviewed and carefully deliberated.

If the allocation of capital is deemed appropriate -and is likely to procure a desirable result- then it will be approved.  If the plan is flawed, unnecessary, or proves too expensive in nature, then it will likely be rejected on those grounds.

A key aspect of this deliberative process is the assessment of the inherent value of the project.  Normally, a management team will attempt to boil down this value to a few key metrics.  This will make assessing the value benchmarks of a potential project much easier.  It will also make communicating and discussing these ideas far more straightforward during board meetings.

Example

Jim Ferguson brings his capital budgeting plan to his corporate superiors. 

During the meeting, he describes the inherent value of adding a new assembly line to their thriving plant.  Jim is careful to note that the projected profitability of the new line is greater than the sum of any of their other two lines combined.

This is because the new product that would be made on this line, is generally more expensive.  It can thus be sold for higher prices to consumers.

Since Jim is known as a prudent and careful planner -along with his plan and reasoning being deemed sound- his plan is approved by corporate.

Key Takeaways

  • Companies use capital budgeting to better allocate their monetary resources towards improving an existing business model.
  • Capital budgeting tends to carefully consider monetary returns on investment, along with the timeframes involved.

Capital Budgeting In Practice

Due to the limited nature of capital in any business practice, it is necessary for allocation of funds to be a meticulous process.

The diligent duty of management, therefore, is to find the best use for each dollar available.  To this end, a prudent and carefully crafted analysis is essential. 

Determining the best return on a prospective investment can take months -even years- to fully determine.  Analysts often require extensive amounts of information before an effective study can be conducted.

It is never advisable to rush this process.  If important details are missed, then any investment made could prove an unnecessary waste of important resources, time, and capital.

Further, it is highly suggestible to ascertain the most fundamentally important aspects of a given business model.  From that point, learning how to best increase existing profits should remain the key area of focus.

What Is Capital Budgeting

"A debt problem is, at its core, a budgeting problem."

-Natalie Pace

Methods of Capital Budgeting

There are numerous (perhaps innumerable) methods for effective capital budgeting.  Below are several that remain some of the most common in modern practice:

The Payback Analysis

As its very name implies, payback analysis is a way of calculating how long a potential project will take to reimburse its initial costs.

This is often considered the most simplistic method of capital budgeting.  However, it tends to be less accurate also.

Despite the potential drawbacks, it is still widely used.  Mostly, this is due to the “quick glimpse” it can offer analysts into how profitable a project may be.

For smaller companies, or organizations with little funding, payback analysis can be highly effective.  It can offer insight into the fastest payback periods available for a given concern.

However, it should be noted that payback analysis does not account for opportunity cost.  It also fails to detail a comparative analysis.  Thus, potential returns in other areas may go unnoticed.

Despite these and other drawbacks, it still remains a viable method for estimating how long it will take to recoup the original investment made on a specific project.

Discounted Cash Flow Analysis (DCF)

Discounted cash flow analysis focuses upon the initial capital required to start and finish a given project.  This includes any potential revenue, maintenance, required materials, and other associated costs.

Present Value

The initial outflow of capital is considered expenditure, whereas potential cash flows are reflected back to the current date.

In short, this gives a window into the potential “earnings” of the future.  This offers an investor’s perspective and insight into the (potential) monetary value of a given project, as it relates to their current circumstance.

Under the DCF method, the opportunity cost is itself considered an immediate loss in pursuit of future gain.

All of this serves to direct a consideration of the present value.  The general rule for any project is that it must be profitable in nature.  Any costs incurred must pave the way for generous future earnings that far outstrip the initial payments made.

If the future earning potential does not at least pay for the initial costs incurred, then it is not worthy of capital budgeting.

Cost of Capital

The cost of capital refers to borrowed money that was lent to the company.  This means that any project which uses cost of capital (a lender) to finance its projects, must also consider the added cost of interest and external capital on outstanding loans.

The project must now not only account for general costs and upkeep, but also the terms of the loan itself.  It must pay for all of these with its future earnings.  Ideally, it will also prove highly profitable, exceeding performance far beyond these initial terms.

Publicly traded companies use the cost of capital as an important instrument in their operations.  The raising of money through stock options allows a company to tap into its own equity.  It can then leverage this financing into desirable projects that will create further value for existing shareholders.

A company may also choose debt instead of equity.  This means it would pursue bonds or a bank credit, rather than publicly traded shares to finance its project(s).

All of these financial instruments would represent the cost of capital.  These are financially potent methods for obtaining additional funding in the pursuit of new projects and infrastructure.

Throughput Analysis

Throughput analysis is perhaps the most complex variant of capital budgeting.  Yet, it also tends to be far more definitive and factual.

For any leadership seeking to pursue new projects, the throughput analysis is highly advisable.

Using this methodology, the entire business is put under the same “profitability umbrella.”  The amount of gains and materials the business as a whole produces, can thus be brought down to one single -simplified- metric.

Throughput analysis considers all expenditure as a single entity.  By its nature, it demands optimization of the entire business system.  This means maximizing profitability and minimizing all expenses.

It lists any throughputs as passing through various “bottlenecks” of operational capacity.  This is a way of understanding where focus areas are in the company’s production line.  The longer the time spent in certain operations, the greater the bottleneck.

Leadership and management must focus their capital budgeting on these bottlenecks, so as to maximize efficiency.  At the same time, they also must identify unnecessary expenditures, so as to minimize the inherent costs of doing business.

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