Capital Budgeting and Its Importance in Business

Acquisition and management of fixed assets

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To understand capital budgeting, it helps to understand both parts of the term. "Capital," in this context, represents investments in long-term, fixed assets, such as the capital investment in a building or machinery. The "budget" represents the plan that details out anticipated revenue and expenses related to the investment during a particular time period, often the duration of a project.

The term "capital budgeting" is the process of determining which long-term capital investments should be chosen by the firm during a particular time period based on potential profitability, and thus included in its capital budget.

Capital budgeting is extremely important to firms since capital investment projects make up some of their most important financial investments. These projects often involve large amounts of money and making poor capital investment decisions can have a disastrous effect on the business.

Capital Versus Expense Budgeting 

The process of budgeting for capital investment projects, such as buying a piece of equipment, and budgeting for the expenses needed to operate the business require different methodologies, even though they both represent money the firm plans on spending.

Businesses can create certain capital projects based somewhat on a "wish list" of future goals, while expenses are often driven by need or requirement. Companies often must incur expenses that don't directly generate a profit, such as warehouse rent, administrative labor costs, and business insurance, while the company can earn a profit and have more influence over the costs of their capital projects through good financial management.

Investment Project Types

Capital investment projects can be divided up into two types: independent projects and mutually exclusive projects. Independent capital investment projects are those projects that do not affect the cash flows of other projects. 

Mutually exclusive capital investment projects are those projects that are the same or so similar to other capital investment projects that they do impact the cash flows of other projects.

The difference between these two types of investment projects requires financial analysis that is tailored to accommodate all of the factors required to select or reject investment projects.

Selecting a 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.

Companies often use a decision rule that says, if the rate of return is greater than the firm's weighted average cost of capital, then accept and invest in the project. If the rate of return of the project is less than the weighted average cost of capital, then reject and do not invest in the project.

This rate of return represents an opportunity cost. In other words, the rate of return equates to the cost of investing in one project as opposed to another.

Capital Investment Decision Factors

Comparing the rate of return of a project to the firm's weighted average cost of capital is not as simple as it sounds. The process involves some relatively complex financial analysis that the business owner needs to conduct to find the answer. Consider professional assistance from a finance or accounting consultant.

The business owner must estimate the cash flows that will be generated by the selected project for the capital budget. 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.