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.

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.

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.

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.