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What is Capital Budgeting?

It’s common to have many projects on your to-do list when running a business, and many of those projects will likely require an investment to get them off the ground. But accepting every proposed project or purchase without a second thought can drastically damage the health of your business. This is where capital budgeting comes in to save the day. 

The Importance of Capital Budgeting 

Capital budgeting is the process of determining what purchases and projects are worth investing in. By partaking in capital budgeting, you will be able to sift through the hundreds of proposed ideas and narrow it down to the ones that will bring profit to your business. Don’t worry; capital budgeting isn’t expected for every little purchase needed to run your daily operations. That being said, it is crucial to capital budget for any significant investment under consideration as its success or failure will have a drastic impact on your business.

Methods Used to Capital Budget

The process of capital budgeting involves analyzing a project’s expected cash inflows and outflows to determine if the returns will be profitable. There are multiple ways to do this, and the method your company decides to use will vary based on your company’s size, policies, and the project in question. The three most common approaches used are:

  • Payback period
  • Internal rate of return
  • Net present value. 

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Payback Period

The payback period is the number of years it would take for the company to see enough positive cash flow to pay back the initial investment. This method is popular thanks to its simplicity. An acceptable payback period will depend on your business and your goals, but it’s generally recommended that you select the project with the shortest payback period. 

Payback Period = Project Cost /  Annual Cash Inflows

For example, a farm is deciding whether to invest $50,000 in 6 more acres to grow potatoes. The profit that would result from the increase in potatoes is expected to be $10,000 per year. For the farm to find its payback period, it would divide $50,000 by $10,000 to conclude it would take five years to pay back the investment. 

$50,000 / $10,000 per year = 5 years

One drawback to the payback period method is that it does not consider the time value of money; it only takes into account the time it would take to pay back the initial investment. 

The time value of money is a concept that says the money you have now is worth more than the money you will collect later on. This is because you have options like investing it or earning interest now and not in the future. The money you have now is also not affected by inflation as while the money you collect later on is.

This leaves an unknown about which project would be more profitable in the future after the project is paid off. 

Internal Rate of Return (IRR) 

The internal rate of return, or IRR, is a way to predict the profitability of an investment using a percentage value rather than a dollar amount. Simply put, IRR is a way to show what you earn back from an investment over each period. 

Companies that use this method set their standards by creating a baseline rate of return (the gain that they expect to get back from an investment). If the IRR of an investment is more than a company’s baseline, that project should be accepted. If IRR falls below the company’s baseline, it should be rejected. Pretty straightforward, right? 

A higher IRR is generally considered better, as you would pay back the investment faster while a lower IRR would take longer. This provides the ability to compare alternative investments based on the earnings that would be generated over the period the investment is in action.

In a case where the IRR is 20%, and the company’s required rate of return is 13%, you would accept the investment as it will generate an average annual rate of return that is higher than the company baseline. 

Like the payback period, IRR has its downfalls. It should never be done by itself because it doesn’t take the total value into account, which means the possibility that something that takes longer to pay off might make more money for your company in the long run. 

Net Present Value (NPV) 

Net present value, or NPV, is a way to calculate what you expect to earn from a project into its total value, or what it would be worth in today’s dollars. NPV uses the IRR method, while also incorporating the time value of money into its calculation, making it perhaps the most successful and transparent method of capital budgeting. NPV needs three things to be calculated:

  • The upfront cost of investment 
  • Projected revenues from it each year
  • Your company-specific discount rate 

From there, a series of complex equations can give you your NVP. Because of its complexity, getting help from an accountant (or even some calculators) is encouraged. A positive NPV means that the investment’s projected earnings exceed the anticipated cost, while negative NVP expects less profit than the expected cost. Therefore, a company should never accept a negative NVP.

Your ultimate guide to SMB accounting

Let’s get those books in order.

Capital Budgeting and Your Business.

Capital budgeting is both a financial commitment and an investment, so it’s essential to make sure each high-capital project you are considering has the ability to be measured. This measurability will make it possible to put these methods to use and limit your overall risk. 

That said, It’s important to understand that no method of capital budgeting is perfect, and they can get pretty complex. With the help of a professional, each technique listed above can be a tool to help your business make the most profitable decisions with the least amount of risk. 

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