What is Capital Budgeting?
Capital budgeting is a process which a business undertakes to evaluate major projects or investments. Example: A big investment in an outside venture or the construction of a new plant. For capital budgeting, a company may prospect the inflow of cash in the future to match sufficient targets. The process is also called investment appraisal.
Understanding Capital Budgeting
Businesses always undergo such opportunities that could increase their shareholder’s value. However, the amount of capital with any business is always limited. Therefore, the business uses management techniques to determine the project, which will yield the highest returns.
There are some methods, which are used by budgeting companies to determine the highest yielding projects. These methods are:
- Net present value (NAV)
- Internal rate of return
- Discounted cash flow
- Payback period
Methods of Capital Budgeting
There are three important methods of capital budgeting. These methods also help to determine the cash inflows and outflows of a particular business.
The methods of capital budgeting are:
- Throughput analysis
- Discounted cash flows
- Payback analysis
Throughput Analysis
This is the most complicated form of capital budgeting analysis. This analysis is most accurate in helping managers to understand which project to pursue. Under this method, the whole company is considered as a single profit-generating system. The analysis may also assume that nearly all costs are operating expenses. Especially those expenses that a company needs to maximize the throughput of the entire system. It helps to pay for the expenses which is the way to maximize the profits. The managers should always place a higher priority on capital budget projects. This also helps to increase the throughput passing through the bottleneck.
DCF Analysis
Discounted cash flows or DCF analysis determines the stating of cashflows or initial cash flows needed to fund a project. However in this analysis, the mix of cash inflows in the form of profits or revenues and future outflows in the form of maintenance costs or expenses. These costs are discounted back to the present date, except for the initial inflows. The number coming from the DCF analysis is the Net Present Value (NPV).
Payback Analysis
Payback analysis is the least accurate capital budgeting analysis and it also the simplest one. The reason behind its higher usage is that payback analysis is quick and can give managers a “back of envelope” understanding of the real value of the proposed project. However, though the analysis is not accurate, it helps to calculate how long it will take to recoup the costs of investment. The identifying payback period is found by dividing the initial investments of the projects from the average initial inflows.
Conclusion
Different companies around the world use capital budgeting. It also helps them to evaluate the major investments for initiating or executing a product. For example, investments involved in setting new plants and equipment. This process helps to analyze the cash inflows from the projects. It also determines the cash outflows from the projects. The combined inflows and outflows help to calculate the expected returns.
