What is capital budgeting and what is its purpose?

By Indeed Editorial Team

Published 22 November 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Capital budgeting, also known as investment appraisal, is a process organisations use to determine whether or not to invest in a new project. The concept suggests that if the value of the project's future cash flows is greater than the initial investment required to complete it, it's a wise investment. If you work in finance or business, it helps to know more about this process and how it works. In this article, we look at capital budgeting and its purpose, alongside some tips to help you use it.

What is capital budgeting?

Capital budgeting is the process of choosing whether or not to undertake a proposed capital expenditure. This refers to any investment that has the potential to produce future benefits beyond the current period, such as the purchase of new equipment or the construction of a building. It requires businesspeople to decide how much they may spend on each project and how much they expect those projects to make in return. The goal of investment appraisal is to maximise shareholder value by ensuring that investments are profitable and well-suited for an organisation's specific needs.

Related: What is cost budgeting? (Definition, tips and steps)

What is the purpose of investment appraisal?

The following are common reasons for using investment appraisal:

Determining how much money to spend on a new project or investment

Organisations use investment appraisal to determine how much money to spend on a new project or investment by calculating the project's net present value (NPV). The NPV is the total value of all future cash flows from a project, discounted back to today at an appropriate discount rate. To determine the NPV of an investment, it's necessary to estimate all the cash inflows and outflows associated with it. For example, if you're considering purchasing a piece of equipment, you estimate the cost of equipment, the equipment's overall maintenance costs and the timeframe in which you expect to recoup costs.

Related: What is investment? Definition, types and how it works

Deciding whether to expand existing operations

Organisations use investment appraisal to decide whether or not to expand existing operations by weighing the benefits of expansion against the costs. For example, an organisation might compare the revenues and costs of the new project against its existing operations. They may also consider whether any external factors might impact the results of the project. For example, if an expansion requires hiring more employees or purchasing more equipment, this may increase overhead expenses for several years after the completion of the project. Organisations also determine whether there are any more suitable projects.

Related: Understanding business expansion advantages and disadvantages

Evaluating whether to acquire another organisation

Organisations may also use investment appraisal to evaluate whether or not to acquire another company by looking at the NPV associated with the transaction. The NPV is typically calculated by taking all of the expected costs and revenues and subtracting them from each other. Divide the number of that result by one plus the discount rate. The discount rate is usually used because it represents how much more valuable money is in the future than it is now. The higher the number, the less preferable present expenses are. If the NPV is positive, the acquisition makes sense for an organisation.

Related: What is net present value and how do you calculate it?

Determining what projects are worth pursuing to increase profits

Investment appraisal may also determine which projects are worth pursuing to increase profits. This is because it evaluates a project's expected return on investment (ROI). Organisations use this method by comparing the project's cost and its expected future cash flows. They then discount those cash flows back to the present using a weighted average cost of capital (WACC) or an internal rate of return (IRR). By comparing these two values, organisations determine whether the project is worth pursuing. The higher the IRR or WACC, the better the investment opportunity is.

Related: What is IRR and why is it useful in financial analysis?

Deciding whether to retain earnings or pay dividends to investors

Organisations use investment appraisal to decide whether to retain earnings or pay dividends to investors by calculating the cost of capital. The cost of capital is the rate at which an organisation is typically required to pay investors so that they're indifferent between investing in a project and taking their money out of the business. If the cost of capital is greater than the return on investment that a project is expecting to generate, then it's better for an organisation to retain earnings rather than pay dividends. This is because it results in more money for the organisation.

Related: How to calculate dividend yield (and why it matters)

Determining whether to finance projects with debt or equity

Organisations use investment appraisal to determine whether to finance projects with debt or equity. The process involves a comparison of the expected rate of return on the project with the cost of debt, which includes the interest rate and any associated fees. If the expected rate of return is higher than the cost of debt, it makes sense to finance a project with debt. Shareholders may receive dividends and have an opportunity to reinvest those dividends into other projects that aren't financed by debt.

If the expected rate of return is lower than the cost of debt, then it makes sense to finance a project with equity. This is because shareholders don't receive any dividends and have no opportunity to reinvest those dividends into other projects.

Related: What is the cost of equity: definitions and examples

Tracking progress towards goals by setting targets for profitability and growth

Organisations also use investment appraisal to track progress towards goals by setting targets for profitability and growth. They do this by estimating the monetary value of each goal, examining how much it may cost to reach that goal and how much extra revenue it may generate. With this information, organisations then set targets for profitability or growth based on the amount of money necessary for reaching this goal. They also use this information to review their capital budgets regularly to determine if they're on track to achieving their goals. If not, they may start making the necessary adjustments.

Tips for using investment appraisal

Here are some tips to help you use investment appraisal more easily and accurately:

Ensure that you understand the basics of investment appraisal

The investment appraisal process is specially designed to help you make decisions about the allocation of resources. The process, therefore, helps you evaluate the costs and benefits of each option, which helps you make increasingly informed decisions about which option is most effective for an organisation. Without a complete understanding of investment appraisal and how to use it, you may end up making decisions that aren't in the organisation's best interests.

Target a specific return on investment for your project

Targetting a specific ROI helps you determine whether or not a project is fully worth pursuing. If you're able to get a high ROI, you know that your project is likely to be profitable and successful. If you don't get as much of an ROI as you might prefer, this may indicate that your project isn't worth pursuing. This helps you make better investment decisions as it presents you with the necessary data to make educated decisions.

Consider the time value of money (TVM) when making your cash flow estimates

The TVM is a concept that helps accountants and other financial professionals determine the present value of future cash flows. It's a useful tool for investment appraisal because it allows you to compare the benefits of taking action now versus waiting and taking action later. For example, you might decide to use this tool alongside investment appraisal when an organisation considers investing in new equipment. This is because you might want to consider how much it might cost to purchase that equipment today versus waiting until next year to see which is the best option.

Be sure to include all relevant costs, including opportunity costs and sunk costs

Including all relevant costs when using investment appraisal provides a more accurate picture of the profitability of an investment. If you only consider the price tag associated with investing, you may miss out on other costs that impact your bottom line. For example, if you take out a loan to purchase something that doesn't generate revenue and it goes bankrupt, you may end up owing money on top of the cost of buying it in the first place. This is typically called an opportunity cost.

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