Capital budgeting is the selection of projects that add value to a business. The capital budgeting process can involve almost anything, including buying land or buying capital assets like a new truck, building, equipment/machinery.
Companies are often required, or at least recommended, to undertake projects that will increase profits and thus improve shareholder wealth. However, the rates of returns or profits considered acceptable or unacceptable are influenced by other companies and project-specific factors. For example, a social or charitable project is often not approved based on profitability, but on a company’s desire to foster goodwill and give back to their community.
Capital budgeting is important because it creates accountability and measurability. Any company that seeks to invest its resources in a project without understanding the risks and returns involved will be walking on stormy waters. Furthermore, if a company has no way to measure the effectiveness of its investment decisions, it is likely to have little chance of surviving in a competitive market.
Businesses (other than nonprofits) exist to make a profit. The capital budgeting process is a measurable way for companies to determine the long-term economic and financial returns of any capital project.
Different companies use different evaluation methods to accept or reject capital budgeting projects. Although the net present value (NPV) method is the most preferred by analysts, the internal rate of return (IRR) and time to payback (PB) methods are also commonly used in some cases. Managers can have the most confidence in their analysis when all three approaches point to the same course of action.
How to make a working capital budget?
When a company is presented with a capital budgeting decision, we advise that one of its first tasks should be to determine if the project is profitable. Some methods that can be used for decision-making are; the period of payback (PB), internal rate of return (IRR) and net present value (NPV), these methods are the most common methods for project selection. Although an ideal capital budgeting solution is that all these three methods drive the same decision, sometimes, these methods may produce conflicting results. In such cases, depending on a company’s management preference and selection criteria, one approach will be given more importance than another.
However, it should be noted that there are general pros and cons associated with these widely used valuation methods. NB: A capital budgeting decision is both a financial commitment and an investment. By committing to a project, the company commits itself financially and invests in a longer-term project, which will likely affect future projects the company considers either positively or negatively.