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Every enterprise owns a set of assets used for generating profits. But what happens after earning those profits? The financial departments must take the profits, think about how the cash flow can be managed effectively, and decide what to do with inflows generated from the assets.

Those cash flows could be paid via repos or dividends, financial markets, or reinvested instead to ensure future profitability. In that case, relying on strategy and numbers is a must. It is what allows you to make an informed decision and define company goals, in addition to making clever assumptions regarding those goals and undertaking large-scale business projects.

This is where the capital budgeting process steps in. In this guide, we'll cover the basics of capital budgeting, examine its essential methods, and how they can provide you with a roadmap to make better financial decisions.

What Is Capital Budgeting?

Capital budgeting is the decision-making process that revolves around how a given company can spend money to maximize the return on investment and the return to your investors and stockholders.

It all comes down to risk and return. That's precisely what capital budgeting measures. It's about deciding whether to accept or reject an investment, how to rank projects according to profitability and figure out which investment is the best move at a given moment.

According to Investopedia, capital budgeting represents:

The process a business undertakes to evaluate potential major projects or investments. As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark.

Investopedia

Capital budgeting isn't just helpful in making data-based decisions. It can also help you establish the project outcome, allowing continuous evaluations, corrections, and redirections. In short, capital budgeting ensures the profitability of your company.

Capital Budgeting Methods

By carefully incorporating capital budgeting into your business process, you can successfully gauge the investments that will deliver more profits in the long run.

The capital budgeting process institutes accountability across the entire organization, given that nobody would react well when losing profits. To make a profitable capital budgeting-based decision, there are several main methods that you can take.

Net Present Value (NPV)

Net present value (NPV) is the most significant capital budgeting method. The idea behind the method is to add up the current value of each upcoming cash flow and weigh them against the starting investment.

Does the present value of the project's lifetime outweigh the investment you need to make to conduct the project? That's what NPV is, the net between the cash outflows and inflows.

If the profits exceed the costs, then you should invest. The net present value considers the expenses and profits from cash outflows and inflows and provides you with a transparent capital budgeting measurement.

NPV is calculated by taking the difference between the cash inflows and cash outflows present value over a given period, discounting cash flows at a rate derived considering the ROI with similar risk or investment debt cost.

NPV = Cash Flow / (1+i)^t - initial investment
i = Discount Rate Return
t = Time Periods

After subtracting the cash flows over different periods, the starting investment is taken from it. If the NPV is positive, then undertaking the project is acceptable. Conversely, when the NPV is negative, the investment is not feasible.

Let's say that a given project costs $1,000, providing the following cash flows in the next three years: $500, $300, and $800 over the next three years. If the required return rate is 8%, then the NPV would be calculated as follows:

NPV = $500 / (1 + 0.08)^1 + $300 / (1 + 0.08)^2 + $800 / (1 + 0.08)^3 - $1000 = $355.23

The return rate represents the discount rate for future cash flows. Thus, one USD today will be worth more than one USD the next day since the dollar can be utilized to earn a return.

Thus, when determining the PV of a future income, the future cash flows must be reduced to rationalize the delay.

In most cases, the projects with the highest NPV are worth pursuing. For example, if the company Acme has the following opportunities:

Investment X asks for an initial investment of $35,000, but in three years, it is expected to generate a revenue of $10,000, $27,000, and $19,000, respectively. Therefore, if the return rate is 12% and given the fact that cash inflows are not equal, the formula can be broken down as the following:

NPV of X = $10,000 / (1 + 0.12)^1 + $27,000 / (1 + 0.12)^2 + $19,000 / (1 + 0.12)^3 - $35,000 = $8,977

Investment Y also demands an initial spend of $35,000 and can generate up to $27,000/ yearly for two years. If the target rate remains 12% since each year generates an equal revenue, the calculation would be the following:

NPV of Y = $27,000 / (1 + 0.12)^1 + $27,000 / (1 + 0.12)^2 - $35,000 = $10,631

As evident, Investment X can produce a higher total income than Y. However, Investment Y has a better NPV due to the faster-generating income.

NPV's advantages include the fact that it considers the time value of money and helps the business management team to make good decisions. However, assessing the profitability with the help of NPV is dependent on assumptions.

Thus, there's always room for making a wrongful estimate, not to even mention that a given investment may often include unexpected expenses.

Some of the drawbacks of using NPV for capital budgeting include:

Discounting Rates: When it comes to capital budgeting with NPV, the rate of return must be assumed in advance. When you consider a higher rate of return, it can result in a false negative NPV, and vice versa, a lower return rate can result in a false profit.

Incomparability: You can't compare two investments that are not planned within the same period. Since most enterprises have a fixed amount of money to invest and must choose between at least two options, NPV can't compare the different periods and risks.

Assumptions: The NPV capital budgeting method involves assumptions about inflows and outflows, which in practice don't always go as expected.

Internal Rate of Return (IRR)

As a capital budgeting metric, the internal rate of return (IRR) is used for evaluating the investments' feasible profitability. In short, it's the discounting rate where the NPV has a value of zero.

In Excel, to calculate IRR, you can use a financial function that takes cash flows with regular intervals into account for performing the computation.

IRR = (Cash Flows)/(1+r)^i – Initial Investment
Cash Flows = Cash Flows in each period
r = Discount Rate
i = Timeframe

When the cash outflows and current inflows are identical, the investment can be viewed as favorable. However, if you must choose between multiple opportunities where the costs are virtually the same, IRR can help you pick the one that could deliver more significant profits.

Let's say that you want to invest in brand-new factory equipment that costs $500,000. The asset's lifetime is four years, it can bring up to $160,000 of extra yearly profits, and in the fifth year of its life span, you plan to sell the equipment for $50,000.

At the same time, there's another equipment which can generate up to 10% in profits, 2% higher than the current hurdle rate.

Using Excel to calculate an IRR of 13% from a financial POV, the purchase is profitable since the IRR is greater than the company's hurdle rate and the secondary investment's IRR.

Capital Budgeting 1

The IRR calculation is frequently used along with other capital budgeting methods. However, it has its drawbacks:

  • Disregarding Duration: If you must choose between two projects, Project 1 with 15% IRR and one-year duration and Project B with 20% IRR and five years duration, if the capital cost is 10%, both projects can bring profits. But still, Project B would be incorrect since the period is longer.
  • Assuming Reinvestments: IRR implies that cash flows are reinvested with the same rate instead of the capital cost, which is why it may not provide the most precise profitability picture in some cases.

Profitability Index (PI)

The Profitability Index (PI) capital budgeting method represents an index that outlines the relationship between the costs and benefits of a given investment. A higher PI is a validation that the investment is worth considering. The greater the PI, the more attractive the project/investment is.

The profitability index can be calculated using the following ratio:

Profitability Index = Future Cash Flows PV / Initial Investment

Since profitability index calculations can't be negative, they must be converted to positive figures before becoming beneficial. If the estimates are greater than 1.0, the upcoming discounted cash inflows are greater than the predicted discounted cash outflows.

On the other hand, the calculations less than 1.0 suggest that the outflows deficit is greater than the discounted inflows, and the investment shouldn't be pursued as a result.

The investment with the highest profitability index is feasible since it indicates the most constructive use of capital. Even though some investments will result in higher NPVs, they may not be considered mostly because they don't have the highest profitability index and don't indicate smart usage of assets.

Accounting Rate of Return (ARR)

The Accounting Rate of Return (ARR) capital budgeting method totals the prospective profitability from capital investments by dividing the investment's net income by the amount invested in obtaining the ARR.

ARR is also beneficial for conducting risk analysis and whether the investment would bring enough profits for covering the risk and if it's the right move overall. The ARR formula is as follows:

ARR = Average Annual Profits / Average Investment

Calculating ARR is pretty straightforward. For example, let's say that you want to purchase new company vehicles that would cost you $350,000, but they'd improve the company's annual income by $100,000 and increase the yearly expenses by $10,000.

If the vehicles’ estimated durability is 20 years, the ARR calculation would be:

Average Annual Profits = $90,000
Depreciation Expenses = $17,500
Real Average Annual Profits = $90,000 - $17,500 = $72,500
ARR = $72,500 / 350,000 = 20.71%

For every dollar that you'll invest, you'll receive $0.2071 in return, which is a reasonable profit and enough to convince you to invest.

Payback Period

The payback period is one of the less used capital budgeting methods that, in most cases, is used cautiously and by computing NPV first. A payback period is a necessary time for the initial cost of an investment to be recovered.

As a capital budgeting method, the payback period can be used to compare and derive the years it will take to return your investment. In short, the fewer years it takes for an investment cost to be returned, the more attractive the investment becomes.

The formula for computing the payback period of a given investment depends on period cash inflows. For example, if the cash flows are equal, the formula would be the following:

Payback Period = Initial Investment / Net Cash Flow per Period

On the other hand, with uneven cash inflows, you must calculate the cumulative cash flow first for each of the periods by using the following calculation:

Payback Period = Last Period with a Negative Cumulative Cash Flow + Absolute Value of the Negative Cash Flow at the end of the Period / Total Cash Inflow During the Period

The cumulative cash flow is the total sum of inflows minus the first outflow.

For example, let's say that you want to make an initial investment of $105 million, and you expect a $25 million in yearly net cash flow in the following seven years. The payback period calculation would be the following:

Payback Period = $105M / $25M = 4.2 years

On the other hand, with an uneven cash flow, if you want to make an initial investment of $50 million and you expect to produce a net cash flow of $10 million in the first year, $13 million in the second year, $16 million in the third year, $19 million in the fourth year and $22 million in the fifth, then the calculation would be the following.

Capital Budgeting 2

The greater the payback period for a given investment, the more risks it involves. If two projects offer similar returns, the shortest payback period should have the upper hand.

In essence, the decision of whether to start an investment depends on its risk appetite.

Higher risk can bring a higher return, and thus, the longer the payback period from the profitable investment is. Conversely, for lower returns on investment, the project is acceptable only if the risk is down, making the payback period shorter.

Given that cash flows that arrive later in the project's life span are uncertain, the project's payback period can indicate how confident the cash inflow is.

If you're facing a liquidity issue, the payback period can help you rank the projects that will bring you earlier returns. However, as a drawback, the payback period method doesn't take the time value of money into account, leading to bad investment decisions.

What is the Capital Budgeting Process?

Putting it all together, the net present value, IRR, and the payback capital budgeting methods can all be essential to help you realize the data that help you make a profitable financial decision.

The concept of the time value of money is ingrained within capital budgeting. When invested, over time, money is bound to earn some interest. For example, when invested at 5%, $100 today would be worth $105 next year, with a present value of $100 and a future value of $105.

However, contrasting the money of today with future funds is like comparing apples and oranges. When investing money, you must evaluate when that money would be worth more, now or in the future. When would the cash flow produce more value for you?

This is where NPV comes in handy, as the sum of the present value (PV) of the scheduled cash flow and the investment are discounted at the average cost of the invested capital.

When calculating the project's NPV, if the resulting value is positive, future cash flows PV should exceed the investment's PV. If that's the case, the project deserves further attention.

Conversely, if the NPV is negative, the investment wouldn't be profitable, and it wouldn't be reasonable to pursue it.

Let's say that Acme Corporation Accounting needs to purchase a fleet vehicle to make local, brief runs. Acme plans to acquire the fleet vehicle, use it for four years and sell it for a fair price after that.

Subsequently, Acme plans to use the sales income to advance a much more modern car, with a WACC of 14%.

Determining the Investment's Amount

The total value of your investment is the overall cost of the asset that you acquire, and in the case of Acme, that would be:

Capital Budgeting 3

Determining the Cash Flow Returns

In general, the investment cash flows represent the projected income statement. For Acme's new vehicle, it has the following projections.

Capital Budgeting 4

Determining the Annual Cash Flows

Determining the investment's annual cash flows can be accomplished by positioning cash flows with the time when they materialize and combining each of the periodic cash flows.

Capital Budgeting 5

Determining the Cash Flows NPV

As you're aware by now, the investment's NPV is the sum of each yearly cash flow PV.

Cash Flow PV = Cash Flow / (1 + Discount Rate) Year

Assuming the discount rate is 14%.

Capital Budgeting 6

If the NPV is positive, the investment will return more than the initially invested amount, crucial for business growth.

Running a Sensitivity Analysis

A positive NPV is a good validation that the investment is well worth it. However, it's not the only indication that needs to be considered when pursuing an investment. Don't forget to conduct additional analyses.

For example, suppose the vehicle costs more than $53,899? What if the operating cash flows are less than you predicted? Even an increase to 140% of the baseline estimate could result in a positive NPV.

Capital Budgeting 7

As illustrated, the NPV will diminish as the residual value declines, but even it drops towards $0, the NPV remains positive.

Considering that most of the successful businesses have their own tried and true capital budgeting practices in place, several practices are the benchmark:

  • Cash Flow Decision Making: Always make decisions based on the actual cash flow. To avoid distorting perceptions, sunk costs should not be considered when evaluating the investment's profitability.
  • Timing the Cash Flow: The sooner a cash flow is received, the better. Earlier cash flows can be used immediately and repurposed for every other feasible investment/ project.
  • Considering Opportunity Costs: Each project is assessed based on cumulative cash flows that can help you gauge why one project/investment is better than the other one. Capital budgeting provides an evaluating perspective that allows you to stay strategic even when the project's profitability is much harder to gauge.

Wrapping Up

In principle, every financial decision you'll make as a business is a balance of risks and returns. Of course, there's always a chance that the costs of a given investment can exceed the returns, mainly when you must compensate your stakeholders.

However, assessing both risks and potential profits of your capital budgeting projects is critical. Effective business leaders always make decisions that allocate the right capital resources to minimize risks and achieve company goals.

To sum up, staying proficient ensures that your capital resources are implemented to achieve a maximum ROI while navigating the business environment and executing decisions that deliver in the long run.

Martin Tolovski
Martin is Contributor at Layer.

Martin is a copywriter with 7+ years of experience, and a passion for providing data-driven value in every respect, represented by his B2B write-ups created during his work. He’s passionate about content marketing, tech innovations, and of course, data. When he’s not creating, you can find him geeking obsessively about all things design.

Originally published Aug 13 2021, Updated Aug 27 2021