Asset Management

Capital Budgeting Simply Explained

Last updated Friday, December 30, 2022

Capital budgeting sounds complicated at first, but understanding it is not only easy but vital for every accountant, manager, or investor out there. In this article, we’ll break down everything you need to know—read on to find out why capital budgeting is immensely efficient and crucial at the same time.

What Is Capital Budgeting?

Choosing initiatives that add value to a company is part of capital budgeting. Almost anything can be part of the capital budgeting process, from buying land to buying fixed assets like a new truck or machinery. Most of the time, corporations are required or at least encouraged to take on projects that will make them more money and increase the wealth of their shareholders.

But what makes a rate of return acceptable or not depends on other things that are unique to the company and the initiative. For instance, a social or charitable project is often approved not because of how much it will bring but because the business wants to build goodwill and give back to the community.

Read more in detail about The Balance Sheet And Income Statement.

Main Takeaways

  • Capital budgeting is how investors figure out how much a project they might want to invest in is worth.
  • Internal rate of return (IRR), payback period (PB), and net present value (NPV) are the three most common ways to choose a project.
  • The payback period shows how long it would take for a business to get enough money back from cash flows to cover the initial investment.
  • The expected return on a project is called the internal rate of return. If the rate is higher than the cost of capital, the project is a good one.
  • The net present value (NPV) indicates how profitable a project will be compared to other options, and it might just be the best of the three ways for the purpose

Capital Budgeting: What You Need to Know

Capital budgeting is important because it gives people something to answer for and something to measure. The owners or shareholders of a business would think it was irresponsible for it to put money into a project without knowing what the risks and rewards are.

Also, if a business doesn't have a way to measure how well its investments are working, it probably won't be able to stay in business in the tough market.

Aside from non-profits, businesses are meant to make money. The capital budgeting process gives businesses a way to figure out how economically and financially profitable an investment project will be in the long run.

Note:

A capital budgeting decision is both an investment and a financial commitment. When a business takes on a project, it makes a financial commitment. It is also making an investment in its long-term direction, which is likely to have an effect on the projects it takes on in the future.

Different businesses use different ways to figure out if a capital budgeting project is worth doing or not. Analysts tend to prefer the net present value (NPV) method, but the payback period (PB) and internal rate of return (IRR) methods are also often used in certain situations. Managers tend to be the most confident when all three methods show the same course of action.

How Does Capital Budgeting Work?

When a company has to make a capital budgeting decision, one of the first things it has to do is figure out if the project will make money or not. The most common ways to choose projects are the payback period (PB), the internal rate of return (IRR), and the net present value (NPV) methods.

Even though the best solution for capital budgeting is for all three metrics to point to the same decision, this is not always the case. Depending on what management wants and how they choose, one approach will be given more weight than another. Still, these common ways of figuring out how much something is worth have common pros and cons.

  • Payback Period (PB) Simply Explained The payback period figures out how long it will take to get back the initial investment. For example, if a capital budgeting project has an initial cash outlay of SAR 2 million, the PB shows how many years it will take for the cash inflows to equal the $1 million outlay. A shorter PB period is better because it shows that the project will "pay for itself" in less time.

  • Internal Rate Of Return (IRR) Simply Explained

The internal rate of return also called a project's expected return, is the discount amount that would make the NPV zero. Since the net present value of a project is inversely related to the discount rate—if the discount rate goes up, future cash flows become less certain and worth less—the rate used by the company to discount after-tax cash flows is used as a benchmark for IRR calculations.

  • Net Present Value (NPV) Simply Explained

The net present value method is the easiest and most accurate way to figure out how much something is worth when it comes to capital budgeting problems. Managers can figure out if a project will make money or not by discounting the after-tax cash flows by the weighted average cost of capital.

NPVs are better than IRRs because they show exactly how profitable a project will be compared to other options.

The NPV rule says that projects should be accepted if their net present value is positive and rejected if it is negative. If there aren't enough funds to start all positive NPV projects, the ones with the highest discounted value should be chosen.

At the end of the day, capital budgeting is nothing more than a few methods that help management, investors, and accountants make important financial decisions.

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