Capital Budgeting: Meaning And Techniques

“Capital budgeting: Where strategy meets numbers, and investments shape the future.”

When we spend money on stuff, we want it to either make us more money back or at least cover what we spent. Small things like phone accessories don’t need much thought, but big businesses with lots of fixed costs (like equipment and factories) need to be smart about what they invest in. They need to figure out which products will make enough money to pay for the investment, and how long it will take for that to happen. This process is called investment evaluation or capital budgeting.

“Capital budgeting is like making a smart plan for spending big money. It’s about deciding which long-term investments will give you the best returns for your money. You figure out where to put your money to get the most return over time.”

Read here about Budgeting for teens

Meaning

Capital budgeting is the strategic evaluation and selection of long-term investments involving substantial financial commitments, such as acquiring assets or expanding operations. It entails assessing potential returns and risks to determine feasibility and alignment with the company’s goals.

How capital budgeting works and Importance

Suppose you’re aiming for the best smartphone, it might seem logical to go for the most expensive one. Similarly, when considering projects within a company, the temptation might be to opt for the most expensive or ambitious ones. However, just like we have a budget for buying a smartphone, companies have budget constraints too. To ensure they make the most of their available funds and get the best returns, they utilize capital budgeting techniques. Among these techniques are three commonly used ones: payback period, internal rate of return (IRR), and net present value (NPV) method. Before we move ahead we should know about Time Value of Money.

Time value of money

We’ve often heard our parents say that when they were young, they could buy things for much less money than what those same things cost today. This shows that over time, the value of money decreases. That’s why money we have now is more valuable than money we might have in the future. This is called Time value of money.

Capital Budgeting

Techniques

Net Present Value

Imagine you’re thinking about throwing $1,000 into a project that’s supposed to bring in $300 every year for the next five years. Now, because money you get in the future isn’t as awesome as money you have now thanks to things like inflation and opportunity cost.

So, you crunch some numbers with a discount rate (let’s say it’s 10%) to see what those future cash flows are worth in today’s dollars. Then you subtract the initial $1,000 investment. If you end up with a positive number, congrats! That means the investment might be a winner. But if it’s negative, well, it’s like your wallet’s saying “Nah, not worth it, dude.

“In simple terms it is a method used to compare worth of your future money with today’s investment“

Payback Period

Payback period is like a quick and simple way to figure out when you’ll make back the money you initially put into an investment. You just divide the initial investment by the cash flow you get each period. So, if you invested $1,000 and you’re getting $200 each year, it would take you 5 years to get your initial investment back ($1,000 / $200 = 5 years). The limitation for this method is that it doesn’t consider Time Value of Money.

Internal Rate Of Return

IRR (Internal Rate of Return) represents the rate of return that a project is expected to generate over its lifespan. It’s like the actual return the project is predicted to earn.

In capital budgeting it is used to calculate break even point (point at which revenue is equal to cost) of your investment for the project means the rate at which the Net Present Value(NPV) becomes zero. In simpler terms, it’s the interest rate at which the present value of all future cash flows from an investment equals the initial investment cost. If IRR is more than Required Rate of Return (the return that you, as the investor, want to achieve from the project), then you accept the project otherwise reject.

Example! Let’s say you’re considering investing $1,000 in a project, like buying a vending machine. Over the next three years, you expect to receive cash flows of $400, $500, and $600 respectively from the machine. To find the IRR, you want to figure out the interest rate at which the present value of these cash flows equals your initial investment of $1,000. Suppose you find that the IRR for this investment is approximately 20%. If your Required rate of return is less than 20% then you can accept the project.

For More examples refer here

Conclusion

Capital budgeting helps businesses decide where to invest their money for long-term growth, using techniques like NPV, payback period, and IRR. These methods consider the time value of money except payback period and aim to maximize returns while managing risks. For example, IRR calculates the rate of return an investment is expected to generate, helping businesses determine whether a project is financially viable.