Growth is the lifeblood of any business—and smart capital budgeting is an important part of managing that process. Businesses need to spend money to operate smoothly, such as purchasing equipment or financing new projects. But how much is too much? And which products are worth pursuing? Smart business leaders strategically make these decisions to ensure the long-term success of their organization.
Capital Budgeting Explained
Capital budgeting—also referred to as investment appraisal—facilitates the sustained and enduring viability of an organization. Businesses do not always have the funding available to pursue all of their immediate needs or future goals. This is where capital budgeting comes in.
Essentially, capital budgeting helps businesses determine which opportunities are likely to return the most value. Once this is established, funding is allocated to high-priority projects that can render the most profits.
Capital Budgeting Techniques
Businesses have several different ways to decide how to allocate capital.
Here is a review of some popular methods:
- Payback Period: This method analyzes how long it will take before the capital investment pays back the initial investment of funds. This figure is usually arrived at by dividing the total investment by expected yearly revenue flow.
- Net Present Value: This technique is used to estimate the projected profitability of the capital investment. The assessment involves how much cash will flow in as a result of the investment vs. the cash outflow needed to fund a project. These numbers must be controlled for the time period involved since the value of money is not static. Remember, inflation renders future dollars less valuable.
- Internal Rate of Return: This technique allows you to compare the expected return of a capital investment against other potential forms of investment. Your internal rate of return is achieved by dividing the projected profit by the estimated cost. By calculating this, you will be able to determine which projects are worth pursuing.
The Bottom Line
If your business is considering a significant capital expenditure, make sure you practice sound capital budgeting techniques to help identify the best opportunities. Ultimately, capital budgeting is a tool to strategically maximize your company’s future profits. By mastering capital budgeting basics, you will be more effective in running your business and remaining fiscally viable in the long-term.