Capital Budgeting: Definition, Methods, and Examples (2024)

What Is Capital Budgeting?

Capital budgeting is a process that businesses use to evaluate potential major projects or investments. Building a new plant or taking a large stake in an outside venture are examples of initiatives that typically require capital budgeting before they are approved or rejected by management.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns it would generate meet a sufficient target benchmark. The capital budgeting process is also known as investment appraisal.

Key Takeaways

  • Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment.
  • The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark.
  • The major methods of capital budgeting include discounted cash flow, payback analysis, and throughput analysis.

Capital Budgeting: Definition, Methods, and Examples (1)

How Capital Budgeting Works

Ideally, businesses could pursue any and all projects and opportunities that might enhance shareholder value and profit. However, because the amount of capital any business has available for new projects is limited, management often uses capital budgeting techniques to determine which projects will yield the best return over an applicable period.

Although there are a number of capital budgeting methods, three of the most common ones are discounted cash flow, payback analysis, and throughput analysis.

Discounted Cash Flow Analysis

Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs.

These cash flows, except for the initial outflow, are discounted back to the present date. The resulting number from the DCF analysis is the net present value (NPV). The cash flows are discounted since present value assumes that a particular amount of money today is worth more than the same amount in the future, due to inflation.

In any project decision, there is an opportunity cost, meaning the return that the company would have received had it pursued a different project instead. In other words, the cash inflows or revenue from the project need to be enough to account for the costs, both initial and ongoing, but also to exceed any opportunity costs.

With present value, the future cash flows are discounted by the risk-free rate such as the rate on a U.S. Treasury bond, which is guaranteed by the U.S. government, making it as safe as it gets. The future cash flows are discounted by the risk-free rate (or discount rate) because the project needs to at least earn that amount; otherwise, it wouldn't be worth pursuing.

In addition, a company might borrow money to finance a project and, as a result, must earn at least enough revenue to cover the financing costs, known as the cost of capital. Publicly traded companies might use a combination of debt—such as bonds or a bank credit facility—and equity, by issuing more shares of stock. The cost of capital is usually a weighted average of both equity and debt. The goal is to calculate the hurdle rate or the minimum amount that the project needs to earn from its cash inflows to cover the costs. To proceed with a project, the company will want to have a reasonable expectation that its rate of return will exceed the hurdle rate.

Project managers can use the DCF model to decide which of several competing projects is likely to be more profitable and worth pursuing. Projects with the highest NPV should generally rank over others. However, project managers must also consider any risks involved in pursuing one project versus another.

Payback Analysis

Payback analysis is the simplest form of capital budgeting analysis, but it's also the least accurate. It is still widely used because it's quick and can give managers a "back of the envelope" understanding of the real value of a proposed project.

Payback analysis calculates how long it will take to recoup the costs of an investment. The payback period is identified by dividing the initial investment in the project by the average yearly cash inflow that the project will generate. For example, if it costs $400,000 for the initial cash outlay, and the project generates $100,000 per year in revenue, it will take four years to recoup the investment.

Payback analysis is usually used when companies have only a limited amount of funds (or liquidity) to invest in a project, and therefore need to know how quickly they can get back their investment. The project with the shortest payback period would likely be chosen. However, the payback method has some limitations, one of them being that it ignores the opportunity cost.

Also, payback analysis doesn't typically include any cash flows near the end of the project's life. For example, if a project that's being considered involves buying factory equipment, the cash flows or revenue generated from that equipment would be considered but not the equipment's salvage value at the conclusion of the project. As a result, payback analysis is not considered a true measure of how profitable a project is, but instead provides a rough estimate of how quickly an initial investment can be recouped.

Salvage value

Salvage value is the value of an asset, such as equipment, at the end of its useful life.

Throughput Analysis

Throughput analysis is the most complicated method of capital budgeting analysis, but it's also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered as a single profit-generating system. Throughput is measured as an amount of material passing through that system.

The analysis assumes that nearly all costs are operating expenses, that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place a higher priority on capital budgeting projects that will increase throughput or flow passing through the bottleneck.

What Is the Primary Purpose of Capital Budgeting?

Capital budgeting's main goal is to identify projects that produce cash flows that exceed the cost of the project for a company.

What Is an Example of a Capital Budgeting Decision?

Capital budgeting decisions are often associated with choosing to undertake a new project that will expand a company's current operations. Opening a new store location, for example, would be one such decision for a fast-food chain or clothing retailer.

What Is the Difference Between Capital Budgeting and Working Capital Management?

Working capital management is a company-wide process that evaluates current projects to determine whether they are adding value to the business, while capital budgeting focuses on expanding the current operations or assets of the business.

The Bottom Line

Capital budgeting is a useful tool that companies can use to decide whether to devote capital to a particular new project or investment. There are several capital budgeting methods that managers can use, ranging from the crude but quick to the more complex and sophisticated.

Capital Budgeting: Definition, Methods, and Examples (2024)


Capital Budgeting: Definition, Methods, and Examples? ›

Capital budgeting is a process that businesses use to evaluate potential major projects or investments. Building a new plant or taking a large stake in an outside venture are examples of initiatives that typically require capital budgeting before they are approved or rejected by management.

What are the capital budgeting techniques explain with example? ›

Capital budgeting technique is the company's process of analyzing the decision of investment/projects by taking into account the investment to be made and expenditure to be incurred and maximizing the profit by considering following factors like availability of funds, the economic value of the project, taxation, ...

What is the definition of a capital budgeting method? ›

Capital budgeting is defined as the process used to determine whether capital assets are worth investing in. Capital assets are generally only a small portion of a company's total assets, but they are usually long-term investments like new equipment, facilities and software upgrades.

What are the 5 steps to capital budgeting and give an example? ›

The capital budgeting process consists of five steps:
  • 1.Identify and evaluate potential opportunities. ...
  • 2.Estimate operating and implementation costs. ...
  • 3.Estimate cash flow or benefit. ...
  • 4.Assess risk. ...
  • 5.Implement. ...
  • The $15,978 Social Security bonus most retirees completely overlook.
Nov 29, 2015

What is capital budgeting in short answer? ›

Capital budgeting is the process by which investors determine the value of a potential investment project. The three most common approaches to project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV).

What are the 5 methods of capital budgeting? ›

In this article, we will discuss the top 5 capital budgeting methods for financial management and their advantages and disadvantages.
  • 1 Net Present Value (NPV) ...
  • 2 Internal Rate of Return (IRR) ...
  • 3 Payback Period (PP) ...
  • 4 Profitability Index (PI) ...
  • 5 Discounted Payback Period (DPP) ...
  • 6 Here's what else to consider.
Sep 25, 2023

What are the steps of capital budgeting process? ›

There are 6 steps in the capital budgeting process.
  • Identifying the investment opportunities. ...
  • Gathering investment proposals. ...
  • Deciding on projects for capital budgeting. ...
  • Preparation and Appropriation in Capital Budgeting. ...
  • Implementation of Capital Budgeting. ...
  • Performance review.
Apr 8, 2024

What is capital structure with example? ›

It represents the way that a company finance its assets and is essential in determining its financial health and risk profile. For instance, a company may have a capital structure of 60% equity and 40% debt, indicating that 60% of its funds are raised through equity, and 40% through debt.

What is capital budgeting explain its need and importance? ›

Capital budgeting assists financial decision-makers in making well informed financial decisions for projects that involve huge capital investment and which may last for a year or longer. Projects like these may include: Investments in new equipment, technology and infrastructure.

What are the three methods of capital budgeting? ›

3 Techniques Used In Capital Budgeting and Their Advantages
  • Payback method.
  • Net present value method.
  • Internal rate of return method.

What is the best capital budgeting method? ›

NPV Method is the most preferred method for capital budgeting because it considers the cash flow in the tenure and the cash flow uncertainties through the cost of capital. Moreover, it constantly boosts the company's value, which is void in the IRR and profitability index.

What are the 6 processes of capital budgeting? ›

The process of capital budgeting includes 6 essential steps and they are: identifying investment opportunities, gathering investment proposals, decision-making processes, capital budget preparations and appropriations, and implementation and review of performance.

What are the 7 capital budgeting techniques? ›

Various techniques like payback period, NPV, accounting rate of return, IRR, and profitability index help in making informed decisions. Capital budgeting aims to enhance shareholder wealth and secure long-term financial success.

What is the use of capital budgeting techniques in businesses? ›

Capital budgeting is one of the most important areas of financial management. There are several techniques commonly used to evaluate capital budgeting projects namely the payback period, accounting rate of return, present value and internal rate of return and profitability index.

Which of the following capital budgeting techniques? ›

The capital budgeting process is the process of allocating funds to available investment alternatives so that the overall profitability is maximized. Examples of these techniques are the net present value method, internal rate of return method, profitability index method, and payback period method.

Which of the following is the type of capital budgeting technique? ›

Capital budgeting methods include Net Present Value, Accounting Rate of Return, Internal Rate of Return, Discounted Payback Period, Payback Period, Profitability Index.

Top Articles
Latest Posts
Article information

Author: Melvina Ondricka

Last Updated:

Views: 6015

Rating: 4.8 / 5 (68 voted)

Reviews: 91% of readers found this page helpful

Author information

Name: Melvina Ondricka

Birthday: 2000-12-23

Address: Suite 382 139 Shaniqua Locks, Paulaborough, UT 90498

Phone: +636383657021

Job: Dynamic Government Specialist

Hobby: Kite flying, Watching movies, Knitting, Model building, Reading, Wood carving, Paintball

Introduction: My name is Melvina Ondricka, I am a helpful, fancy, friendly, innocent, outstanding, courageous, thoughtful person who loves writing and wants to share my knowledge and understanding with you.