Capital budgeting is the process that businesses follow in deciding where to invest. Businesses are there to make money for their owners, among other things, which is possible only when all investment decisions are made after considering whether they result in an increase in the business’ owner’s equity. Capital budgeting employs different tools, such as net present value (NPV), internal rate of return (IRR), profitability index, payback period and accounting rate of return.
Capital budgeting process involves:
- Identifying potential investment opportunities, gatheting the necessary information about their future cash flows and initial investment requirement
- Evaluating the proposals in the context of the company's overall strategic position and outlook using different capital budgeting techniques such as net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, profitability index. Such analysis may include scenario analysis and sensitivity analysis of the projects.
- Creating a capital budget through the capital rationing process which involves selecting the profitabile projects that can be financed from the available resources.
- Performing a post-audit by comparing actual results with initial estimation and make necessary adjustments.
Net present value is the most theoretically sound approach to evaluate investment opporunities. Other important techniques are internal rate of return and payback period.
Net Present Value (NPV) measures the net increase in a company’s value resulting from an investment. It equals the difference between the (a) present value of future cash flows of the investment estimated based on a discount rate that reflects the equity and debt mix used to finance the investment and the risk inherent in the investment and (b) the amount of total initial investment required. Only those investment opportunities that generate a positive NPV are considered and those that maximizes NPV are ultimately selected for investment.
Internal Rate of Return (IRR) works out the rate at which the present value of a project’s net cash flows equals its initial investment outlay. Only projects whose internal rate of return is greater than the risk-adjusted required rate of return, should be considered for investment.
Payback Period finds the number of years in which a project or investment will recoup its initial investment.
Written by Obaidullah Jan, ACA, CFA and last revised on