What Is Capital Budgeting and Why Is It Important In Business?
How capital investment projects impact a business's long-term growth
Capital budgeting is the process of determining which long-term capital investments are worth spending a company's money on, based on their potential to profit the business in the long-term.
"Capital," in this context, means investments in long-term, fixed assets, such as capital investment in a building or in machinery. The "budget" refers to the plan that details anticipated revenue and expenses related to the investment during a particular time period, often the duration of a project.
Capital budgeting is important to businesses' long-term stability since capital investment projects are major financial decisions. These projects often involve large amounts of money. Making poor capital investment decisions can have a disastrous effect on a business.
Capital Budgeting Versus Expense Budgeting
The process of budgeting for capital investment projects and budgeting for the everyday operational expenses require different methodologies.
Though they both represent money the firm plans on spending, capital budgeting involves planning for the long-term future of the company and understanding when an investment will pay back its original cost, known as its payback period. Capital projects are often based on a "wish list" of future goals, which can be invested in one by one as a business grows.
Expenses are often driven by need or requirement. Companies often incur expenses that don't directly generate a profit, such as rent, administrative labor costs, and business insurance. Expenses pay back their cost by keeping the business in operation. These expenses are sometimes referred to as an operating budget.
A company can earn a profit and have more influence over the costs of their capital projects through good financial management.
Types of Capital Investment Projects
Capital investment projects can be divided up into two types: independent projects and mutually exclusive projects.
- Independent: Capital investment projects that do not affect the cash flows of other projects.
- Mutually exclusive: Capital investment projects that impact the cash flows of other projects due to similarities between the two investments.
Most companies will have both independent and mutually exclusive capital investment projects that they must choose between as their business grows.
How to Analyze and Select a Capital Investment Project
When considering a capital project and its budget, a business owner must compare the rate of return that the project will earn against its calculated weighted average cost of capital, or what the company pays to obtain the debt or equity financing it will use to pay for the project.
If the rate of return is greater than the firm's weighted average cost of capital, companies will generally decide to invest in the project. If the rate of return of the project is less than the weighted average cost of capital, the project may not be a sound investment.
This rate of return represents an opportunity cost. The rate of return equates to the cost of investing in one project as opposed to another.
Comparing the rate of return of a project to the firm's weighted average cost of capital involves financial analysis to estimate the cash flows that will be generated by the project. Often, the cash flows become the single hardest variable to estimate when trying to determine the rate of return on the project.
Both the quantity and timing of the project's cash flows must be considered. If you are writing a business plan, for example, you need to estimate about three to five years' worth of cash flows. Usually, cash flows are estimated for the economic life of the project using project assumptions that strive to create as much accuracy as possible.
For many firms, especially small or growing businesses, it is worth investing in professional analysis to ensure that you are making the right decision for the long-term growth and financial stability of your company.
Texas Southern University: Jesse H. Jones School of Business. "Capital Budgeting." Accessed Jan. 9, 2020.
City of Austin, Texas. "How Does The City's Capital Budget Differ From Its Operating Budget?" Accessed Jan. 9, 2020.
Iowa State University. "Capital Budgeting Basics." Accessed Jan. 9, 2020.