When businesses are considering massive undertakings—like building a new facility or investing in expensive new equipment—they generally can’t just dip into their working capital to cover the costs.
Whether they have money on hand or need to raise funds to cover the expenditure, most organizations go through a process called capital budgeting to determine whether the investment is worthwhile.
What is capital budgeting?
Capital budgeting is the process in which organizations evaluate several different high-cost opportunities to see which one will deliver the most value to shareholders.
For example, a company considering building a new manufacturing plant would conduct a capital budgeting exercise to weigh the costs that would go into the project, the timeline, the impact the project might have on cash flow, and what the return is projected to look like on the other side (i.e., how much cash it’s supposed to bring in).
Based on this information, the organization can prioritize projects accordingly and choose which ones to move forward with and which to kick to the back burner.
What are the five methods of capital budgeting?
Not every capital project is the same.
For example, you can’t make an apples-to-apples comparison between buying a new fleet of industrial equipment and investing in a best-in-class training program for your entire team.
To make it easier to figure out which projects are worth prioritizing, many organizations use a combination of these five capital budgeting methods.
1. Net present value (NPV)
NPV represents the difference between cash inflows and outflows over a specific period of time. When a project has a positive NPV, it signifies that the project will bring in more revenue than you’ll have to pay out to complete it. Generally speaking, projects with negative NPV should be avoided at all costs.
2. Internal rate of return (IRR)
The IRR refers to how much an investment is expected to grow over a one-year period. This figure is determined using the same equation as NPV, except the NPV value is zero. This method is helpful for comparing expected annual returns of different projects over 12 months.
3. Profitability index
The profitability index is a simple equation where you divide the present value of expected future cash flows by the associated capital expenditure. If, for example, future cash flows are $500,000 and your project costs $300,000, its profitability index rating would be 1.67. As a rule of thumb, when a project has a profitability index over 1, it will likely be a worthwhile investment.
4. Accounting rate of return (ARR)
ARR is another capital budgeting accounting method that compares a project’s expected average revenue to how much money the organization invested to make it all happen. Unlike other capital budgeting methods, ARR does not consider cash flow or the time value of money. Still, the metric can be helpful in determining how much revenue you can expect to generate across a number of projects.
5. Payback period
The payback period metric tells you how long it will take to break even on a capital project. Like the ARR, the payback period doesn’t consider the time value of money either. If, for example, a company is considering investing $6 million in a new project that is supposed to return $2 million a year, the payback period would be three years. At the same time, they’re also considering another $6 million project that is supposed to return $1 million a year. In this scenario, the company might decide to go with the first project because they can start making money faster.
The pros and cons of capital budgeting
Let’s face it: Capital projects are massive undertakings. Make the right decision, and great things can happen. Make the wrong one, and disaster might be lurking right around the corner.
With that in mind, let’s take a look at some of the pros and cons of capital budgeting to help you figure out whether it makes sense for your business.
Pros
- Helps you compare different kinds of projects along the same metrics to make the best decisions based on data
- Gives you a number of different techniques to use to make wise investments
- Enables you to deliver more value to stakeholders by increasing the chances you make the best decisions
Cons
- Can give you false security because you are dealing with hypotheticals; if a project gets delayed or runs over budget, what good are your calculations?
- When you make a decision, the implications can be significant; the wrong decision could seriously hurt your organization
- Finding skilled accountants with bandwidth to make these calculations can be a tall order—and a pricey endeavor
Is capital budgeting right for you?
At the end of the day, capital budgeting can be a particularly helpful mechanism for deciding which capital projects to pursue—and which to put on pause. That said, your capital budgeting calculations are theoretical and not set in stone.
While you should certainly use capital budgeting to help determine your next moves, you should also be wary to treat these numbers like gospel. If there’s one thing we’ve learned over the last year, the world can change rapidly overnight, and anything can happen at any time.
By doing your due diligence and crunching the numbers before moving forward with your next capital project, you can improve the chances your company makes the right moves. And when it boils down to it, that’s the best you and any stakeholders can hope for.
Here’s to prioritizing the most profitable capital projects!
