Capital budgeting is a process companies use to determine whether projects are worth pursuing. Capital budgeting helps companies decide whether to do things like purchase new equipment, expand their facilities, invest in new software, or take other steps to improve the business on a long-term basis.
The ultimate goal of capital budgeting is to figure out which projects will be the most financially beneficial in the long run. In order to figure this out, a company must take several factors into account during the capital budgeting process. Here are the most important ones.
As part of the capital budgeting process, a company must determine how much money it will need to spend on a given project. If a company is considering buying new equipment, for example, this calculation must account for both the initial purchase price and any ongoing maintenance costs.
A company must figure out how long it will take to recoup the money spent on its initial investment. The payback period is calculated by taking the total cost of a given project and dividing it by the amount of cash it is expected to generate each year. If a parking garage is considering adding another level to its facility, and the cost to do so is $200,000, the company must figure out how long it will take to recoup that investment. Let's say the garage determines that it can generate additional cash flow of $40,000 per year by expanding. In this case, it would be looking at a five-year payback period ($200,000/$40,000).
Not only is the payback period easy to calculate, but it grants insight into how much risk a given project entails.
Net present value
Net present value is used to calculate the difference between the cost of a given project and the cash flow it is expected to generate. It is used to compare the amount of the initial investment to the present, or current, value of the cash that the investment might generate in the future.
The idea behind net present value is that money earned in the future is not worth as much as money earned today. Since money has the ability to generate some sort of return, even if it's a small one, money is automatically deemed worth more when it is received sooner. As such, future cash flow is discounted, or assigned a reduced rate, to compensate for its lower value than that of cash that's currently available. The benefit of using net present value is that it's a strong measure of whether a given investment will increase a company's value.
Internal rate of return
The internal rate of return is the rate at which a given investment approaches breakeven, assuming the net present value of all cash flows is equal to zero. As its name implies, the internal rate of return does not take external factors such as inflation into consideration. If a company's internal rate of return is higher than the cost of capital needed for a given project, then it should consider pursuing that project. The higher a project's internal rate of return, the more desirable it becomes.
As with net present value, the advantage of using internal rate of return is that it's a good measure of whether an investment is likely to increase a company's value.
Overall advantages of capital budgeting
Because it uses several calculations to determine which projects are most worthwhile, capital budgeting helps companies make thorough, informed investment decisions. By creating a structured process for evaluating new opportunities, companies can develop long-term goals, estimate future cash flows, and control capital expenditures. Just as importantly, once capital budgeting methods are put in place, it can streamline the decision-making process, which can save companies both time and money.
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