Capital Budgeting: What It Is and How It Works

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything, including acquiring land or purchasing fixed assets like a new truck or machinery.

Companies use different metrics to track the performance of a potential project, and there are various methods to capital budgeting.

Understanding Capital Budgeting

Every year, companies often communicate between departments and rely on financial leadership to help prepare annual or long-term budgets. These budgets are often operational, outlining how the company's revenue and expenses will shape up over the subsequent 12 months.

However, another aspect to this financial plan is capital budgeting. Capital budgeting is the long-term financial plan for larger financial outlays.

Capital budgeting relies on many of the same fundamental practices as any other form of budgeting. However, there are several unique challenges to capital budgeting. First, capital budgets are often exclusively cost centers; they do not incur revenue during the project and must be funded from an outside source, such as revenue from a different department. Second, due to the long-term nature of capital budgets, there are more risks, uncertainty, and things that can go wrong.

Capital budgeting is often prepared for long-term endeavors, then reassessed as the project or undertaking is underway. Companies will often periodically reforecast their capital budget as the project moves along. The importance of a capital budget is to proactively plan ahead for large cash outflows that, once they start, should not stop unless the company is willing to face major potential project delay costs or losses.

Why Do Businesses Need Capital Budgeting?

Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project without understanding the risks and returns involved would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are the business would have little chance of surviving in the competitive marketplace.

Companies are often in a position where capital is limited and decisions are mutually exclusive. Management usually must make decisions on where to allocate resources, capital, and labor hours. Capital budgeting is important in this process, as it outlines the expectations for a project. These expectations can be compared against other projects to decide which one(s) is most suitable.

Businesses (aside from nonprofits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project. While it may be easier for a company to forecast what sales may be over the next 12 months, it may be more difficult to assess how a five-year, $1 billion manufacturing headquarters renovation will play out. Therefore, businesses need capital budgeting to assess risks, plan ahead, and predict challenges before they occur.

Methods Used in Capital Budgeting

There is no single method of capital budgeting; in fact, companies may find it helpful to prepare a single capital budget using the variety of methods discussed below. This way, the company can identify gaps in one analysis or consider implications across methods that it would not have otherwise thought about.

Discounted Cash Flow Analysis

Because a capital budget will often span many periods and potentially many years, companies often use discounted cash flow techniques to assess not only cash flow timing but also implications of the dollar. As time passes, currencies often become devalued. A central concept in economics facing inflation is that a dollar today is worth more than a dollar tomorrow, as a dollar today can be used to generate revenue or income tomorrow.

Discounted cash flow also incorporates the inflows and outflows of a project. Most often, companies may incur an initial cash outlay for a project (a one-time outflow). Other times, there may be a series of outflows that represent periodic project payments. In either case, companies may strive to calculate a target discount rate or specific net cash flow figure at the end of a project.

Payback Analysis

Instead of strictly analyzing dollars and returns, payback methods of capital budgeting plan around the timing of when certain benchmarks are achieved. For some companies, they want to track when the company breaks even (or has paid for itself). For others, they're more interested in the timing of when a capital endeavor earns a certain amount of profit.

For payback methods, capital budgeting entails needing to be especially careful in forecasting cash flows. Any deviation in an estimate from one year to the next may substantially influence when a company may hit a payback metric, so this method requires slightly more care on timing. In addition, the payback method and discounted cash flow analysis method may be combined if a company wants to combine capital budget methods.

Throughput Analysis

A dramatically different approach to capital budgeting is methods that involve throughput analysis. Throughput methods often analyze revenue and expenses across an entire organization, not just for specific projects. Throughput analysis through cost accounting can also be used for operational or noncapital budgeting.

Throughput methods entail taking the revenue of a company and subtracting variable costs. This method results in analyzing how much profit is earned from each sale that can be attributable to fixed costs. Once a company has paid for all fixed costs, any throughput is kept by the entity as equity.

Companies may be seeking to not only make a certain amount of profit but also want to have a target amount of capital available after variable costs. These funds can be swept to cover operational expenses, and management may have a target of what capital budget endeavors must contribute back to operations.

Metrics Used in Capital Budgeting

When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The payback period (PB), internal rate of return (IRR), and net present value (NPV) methods are the most common approaches to project selection.

Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management's preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods.

Payback Period

The payback period calculates the length of time required to recoup the original investment. For example, if a capital budgeting project requires an initial cash outlay of $1 million, the payback reveals how many years are required for the cash inflows to equate to the $1 million outflow. A short payback period is preferred, as it indicates that the project would "pay for itself" within a smaller time frame.

In the following example, the payback period would be three and one-third years, or three years and four months.

Payback periods are typically used when liquidity presents a major concern. If a company only has a limited amount of funds, it might be able to only undertake one major project at a time. Therefore, management will heavily focus on recovering their initial investment in order to undertake subsequent projects.

Another major advantage of using the payback period is that it is easy to calculate once the cash flow forecasts have been established.

There are drawbacks to using the payback metric to determine capital budgeting decisions. First, the payback period does not account for the time value of money (TVM). Simply calculating the payback provides a metric that places the same emphasis on payments received in year one and year two.

Such an error violates one of the fundamental principles of finance. Luckily, this problem can easily be amended by implementing a discounted payback period model. Basically, the discounted payback period factors in TVM and allows one to determine how long it takes for the investment to be recovered on a discounted cash flow basis.

Another drawback is that both payback periods and discounted payback periods ignore the cash flows that occur toward the end of a project's life, such as the salvage value. Thus, the payback is not a direct measure of profitability.

The following example has a payback period of four years, which is worse than that of the previous example, but the large $15,000,000 cash inflow occurring in year five is ignored for the purposes of this metric.

There are other drawbacks to the payback method that include the possibility that cash investments might be needed at different stages of the project. Also, the life of the asset that was purchased should be considered. If the asset's life does not extend much beyond the payback period, then there might not be enough time to generate profits from the project.

Since the payback period does not reflect the added value of a capital budgeting decision, it is usually considered the least relevant valuation approach. However, if liquidity is a vital consideration, then payback periods are of major importance.

Internal Rate of Return

The internal rate of return (or expected return on a project) is the discount rate that would result in a net present value of zero. Since the NPV of a project is inversely correlated with the discount rate -- if the discount rate increases, then future cash flows become more uncertain and thus become worth less in value -- the benchmark for IRR calculations is the actual rate used by the firm to discount after-tax cash flows.

In the example below, the IRR is 15%. If the firm's actual discount rate that it uses for discounted cash flow models is less than 15%, then the project should be accepted.

The primary advantage of implementing the internal rate of return as a decision-making tool is that it provides a benchmark figure for every project that can be assessed in reference to a company's capital structure. The IRR will usually produce the same types of decisions as net present value models and allows firms to compare projects based on returns on invested capital.

Despite the IRR being easy to compute with either a financial calculator or software packages, there are some downfalls to using this metric. Similar to the payback method, the IRR does not give a true sense of the value that a project will add to a firm -- it simply provides a benchmark figure for what projects should be accepted based on the firm's cost of capital.

The internal rate of return does not allow for an appropriate comparison of mutually exclusive projects; therefore, managers might be able to determine that project A and project B are both beneficial to the firm, but they would not be able to decide which one is better if only one may be accepted.

Another error arising with the use of IRR analysis presents itself when the cash flow streams from a project are unconventional, meaning that there are additional cash outflows following the initial investment. Unconventional cash flows are common in capital budgeting, since many projects require future capital outlays for maintenance and repairs. In such a scenario, an IRR might not exist, or there might be multiple internal rates of return. In the example below, two IRRs exist: 12.7% and 787.3%.

The IRR is a useful valuation measure when analyzing individual capital budgeting projects, not those that are mutually exclusive. It provides a better valuation alternative to the payback method, yet falls short on several key requirements.

Net Present Value

The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems. Discounting the after-tax cash flows by the weighted average cost of capital allows managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison with alternatives.

The NPV rule states that all projects with a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, then those with the high discounted value should be accepted.

In the two examples below, assuming a discount rate of 10%, project A and project B have respective NPVs of $137,236 and $1,317,856. These results signal that both capital budgeting projects would increase the value of the firm, but if the company only has $1 million to invest at the moment, then project B is superior.

Some of the major advantages of the NPV approach include its overall usefulness and that the NPV provides a direct measure of added profitability. It allows one to compare multiple mutually exclusive projects simultaneously, and even though the discount rate is subject to change, a sensitivity analysis of the NPV can typically signal any overwhelming potential future concerns.

Although the NPV approach is subject to fair criticism that the value-added figure does not factor in the overall magnitude of the project, the profitability index (PI), a metric derived from discounted cash flow calculations, can easily fix this concern.

The profitability index (PI) is calculated by dividing the present value of future cash flows by the initial investment. A PI greater than 1 indicates that the NPV is positive, while a PI of less than 1 indicates a negative NPV. Weighted average cost of capital (WACC) may be hard to calculate, but it's a solid way to measure investment quality.

The Bottom Line

A capital budget is a long-term plan that outlines the financial demands of an investment, development, or major purchase. As opposed to an operational budget that tracks revenue and expenses, a capital budget must be prepared to analyze whether or not the long-term endeavor will be profitable. Capital budgets are often scrutinized using NPV, IRR, and payback periods to make sure the return meets management's expectations.