What is Capital Budgeting?

Capital budgeting is like planting a garden…

There’s only so much space for you to grow vegetables in your yard. Planting squash might mean there won’t be space for carrots. In the spring, you need to make a plan for how you want to use your limited space, so that you can reap the rewards in the fall. Likewise, capital budgeting is a planning process to spend limited dollars. The idea is that, in the future, companies earn revenues from those investments.

In corporate finance, there are two budgets companies need to consider each year. There’s the budget for cash outflows, which are short-term expenses within the year. The other, capital budget, is for deciding how a company wants to invest capital in growing the business long-term.

Capital budgeting is the process of determining how to allocate the limited amount of money available for investment. The goal is to buy fixed assets or invest in new opportunities that generate the highest return on investment. Because capital is limited, capital budgeting decisions require finding the right combination of investments that create a well-balanced portfolio.

There are several general characteristics or features involved in capital budgeting. Here are a few:

Capital projects are usually large, expensive, and have long-lasting implications. They tie up capital up several years, but typically generate a long-term stream of revenues. Spending money in this way, to acquire or improve long-term assets (aka capital expenditures or CAPEX) usually requires reducing the asset’s value in the company’s balance sheet for a period of time (aka depreciation). That means investments in capital projects are not immediately tax deductible when the company files its corporate income taxes. Instead, the capital expenditures can be recoverable over time through the process of annual tax deductions via depreciation.

Once a company decides to move forward with a capital project, it begins negotiating contracts and committing money toward it. So, capital projects are often irreversible once enough capital becomes sunk costs. A sunk cost is an expense you can’t recover. For example, once a company invests large funds in expensive assets, those assets can’t be sold for the same price that they were purchased if the company changes its mind. The company has no choice but to either go through with the project to try and generate returns on its investment over time, or decide to cut its losses and walk away from the project without reaping any financial gains on its investment.

When a company commits to a significant project, it becomes part of the corporate identity. Product lines, factory locations, and market segments redefine a company’s brand and lock it into new revenue and spending patterns. Capital budgeting can have substantial impacts on shaping the company’s identity for a long time.

The objective of capital budgeting is to find the best use of the company’s money. Making a poor investment decision can lead to losses. Choosing the wrong use of limited capital can result in less net income than other choices might generate. Capital budgeting is a strategic decision-making process that, ideally, results in the most profitable outcome.

Capital budgeting requires a thorough financial analysis of each project a company is considering for investment. Not only does the company need to do its due diligence that the capital investment is worth considering, it also needs to compare different potential projects to choose that which has the most profitable outcome. There are a few types of capital budgeting techniques that a company might use to conduct its evaluation.

One of the most common checks on whether an investment is worth considering is how long it takes to get the investment back. Some companies set a maximum number of years in the payback period as part of their capital budgeting process.

The DCF method converts future expenditures and revenues into present dollars to account for the time value of money. For example, receiving $1,100 next year is equivalent to having $1,000 today and investing that $1,000 in something that generates 10% interest. Another way to look at it is that the net present value (NPV) of a $1,100 payment in the future is $1,000 today. The DCF method involves calculating the NPV of possible projects (the present value of cash inflows minus the present value of cash outflows) and a series of other numbers:

• Discounting: Converting future values into their present value equivalents.
• Discount rate: The assumed interest rate used to determine the NPV
• Discounted cash flow: The sum of the NPV of all future payments and expenses.

Once possible projects are converted to their NPV, they can be directly compared to see which projects represent the most value. A project should have a positive NPV to be considered in the capital budgeting process.

Net present value (NPV) — the present value of cash inflows minus the present value of cash outflows — is a dollar value, so in theory, projects that require more significant investment should have higher NPVs. But in some cases, it may make more sense to look at a project’s potential returns as a percentage rather than a dollar amount. For example, a $1M project that generates $1M in earnings (100%) may be better than a $10M project that makes $2M in profits (20%). Converting earnings to percentages can help you see the relative size of the investment to its potential returns. Calculating the internal rate of return (IRR) is one way to do that. The IRR is the assumed interest rate used to determine the NPV (aka discount rate) that results in an NPV of zero — Cash invested should equal the present value of future cash flows. Comparing IRRs is another way to decide on which projects are worth pursuing.

Companies might use an index to rank prospective investments. A profitability index is the NPV (the present value of cash inflows less the present value of cash outflows) divided by the amount of the investment. For example, if the present value of the investment’s future cash inflows is $10,000 and the amount of the initial investment is $10,000, the profitability index would be 1.0. If the profitability index is less than 1.0, that indicates the investment may not generate enough value to justify the initial investment. The higher the profitability index, the higher priority the investment opportunity tends to have.

Some companies might focus their approach on making their business operations more efficient. Rather than looking for new ventures and prospective projects, the company would try to increase the output from its existing infrastructure.

In a constraint analysis (aka throughput analysis), a company identifies the processes, equipment, or supply chain links that prevent the company from expanding. These are called bottlenecks, because they cause everything that happens next to slow down. Capital budgeting that focuses on constraint analysis is also called debottlenecking.

When companies consider making a major investment, say, in a new piece of equipment or project, they usually need to consider the alternatives. For example, repairing an old piece of equipment or renovating a mature facility might be cheaper, but how long will those renovations last? It’s usually important to compare a capital project to possible alternatives in order to get the most from the money invested (aka capital outlay).

When companies go about their capital budgeting, they tend to follow a series of calculations and analyses. Here’s how it generally works:

• Step 1: The capital budgeting process usually begins with identifying investment opportunities. The business development unit might look for ways to improve the current process, locate new assets, new product lines, or find ways to add value to existing real estate.
• Step 2: Staff members or consultants may then evaluate the investment prospects to ensure they meet minimum investment criteria. The proposed projects are then ranked based on some valuation metrics for the management team to consider.
• Step 3: The management team, or board of directors, review the project proposals. They then eliminate projects that don’t align with the company’s strategy or risk tolerance.
• Step 4: Leadership determines the amount of money available for capital projects. This process involves looking at revenue projections, operating budget needs, and the company’s capital structure. The decision-makers (typically the Chief Financial Officer and other executive leadership roles) then consider how to deploy the company’s cash inflows (money going into a business) and whether the cost of capital justifies a potential need to borrow money for capital projects.
• Step 5: The executive team gets direction on which projects will move forward in the current budget cycle and begins implementing the capital spending plan.
• Step 6: The team reports the progress of capital projects to the management team in a review process. The lessons learned from past capital budgeting cycles can influence the company’s practices the next time around.

Capital budgeting is important to the success of a business. Without investing in new opportunities, a company may not be able to grow. That said, investing in the wrong prospects can also hurt the firm’s financial health. In some cases, a capital project can be so large that its failure would bankrupt the company. Capital budgeting is a necessary process to ensure that the company is taking the right amount of risks that weigh the desire for growth against the stability of the firm.

Shareholders are interested in capital budgeting because it has a direct impact on the value of their investment. If someone owns common stock in a company, investment projects represent the potential risk and reward of ownership: If a capital project is successful, the company’s value could increase; the failure of a capital project could reduce the value of the stock. What’s more, investing in capital projects might come at the opportunity cost of a company paying a more substantial dividend (distribution of earnings to shareholders). Shareholders might not be happy if the company opted to pay a smaller dividend to make a bad investment.