Capital Budgeting

Capital budgeting is the process in which a business determines and evaluates potential large expenses or investments. These expenditures and investments include projects such as building a new plant or investing in a long-term venture. Often, a company assesses a prospective project's lifetime cash inflows and outflows to determine whether the potential returns generated meet a sufficient target benchmark, also known as "investment appraisal."

Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period. Various methods of capital budgeting can include throughput analysis, net present value, internal rate of return, discounted cash flow and payback period.

There are three popular methods for deciding which projects should receive investment funds over other projects. These methods are throughput analysis, DCF analysis and payback period analysis.

One measures throughput as the amount of material passing through a system. Throughput analysis is the most complicated form of capital budgeting analysis, but is also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is a single, profit-generating system.

The analysis assumes that nearly all costs in the system are operating expenses, that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place higher consideration on capital budgeting projects that impact and increase throughput passing though the bottleneck.

DCF analysis is similar or the same to NPV analysis in that it looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs. These costs, save for the initial outflow, are discounted back to the present date. The resulting number of the DCF analysis is the NPV. Projects with the highest NPV should rank over others unless one or more are mutually exclusive.

Payback analysis is the simplest form of capital budgeting analysis and is therefore the least accurate. However, managers still use this method because it's quick and can give managers a "back of the napkin" understanding of the efficacy of a project or group of projects. This analysis calculates how long it will take to recoup the investment of a project. One can identify the payback period by dividing the initial investment by the average yearly cash inflow.