August 23, 2022
Explainer

A guide to capital budgeting in financial management

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When business owners think of budgeting, they may immediately think about their operating budget and how they can improve it. With so many moving parts of a business, crafting a budget that accurately tracks spending and maintains cash flow can be difficult.

Capital budgeting, however, differs from traditional budgets used by companies. It can help businesses improve their cash flow while making rational decisions about investments. 

But what is capital budgeting, and how can you use this form of budgeting to decide on long-term investments for your company? Here’s what you’ll learn in this article:

What is capital budgeting?

Capital budgeting is the process of deciding which fixed assets or investment projects are right for the growth of your company. Capital asset management is both time-consuming and requires large amounts of funding. The capital budgeting process allows businesses to ensure that their investment will result in profits for their company. 

Capital budgeting is unique because it focuses on cash flows instead of profits like other types of investment. 

Capital budgeting is characterized by these key features:

  • The investment is long-term 
  • It establishes whether or not an investment will yield results
  • Investments directly impact the profitability of the company 
  • Takes time to see expected returns from initial investment 

Types of capital budgeting

Expansion 

As the name suggests, expansion projects are designed to help your business grow. A company might seek to expand production with new products or move into a new target market. Expansion projects are only accepted if the projected results of the growth are profitable. 

Diversification

Diversification occurs when the business chooses to expand activities or engage in new production activities. For example, your company may decide to invest in the development of new products outside your current market to reach a new customer base.  

Investments 

Capital budgeting is most often used to compare the profitability of investments. These investments may be independent of each other, dependent, or compete with each other. 

In some cases, the pursuit of one project may require the undertaking of another. For example, a toy company may build a new factory in a remote town with poor infrastructure. The company will need to invest in housing, employee facilities, roads, or schools for the town to attract employees. 

Research and development 

Research and development (R&D) is crucial to discovering solutions to existing problems or updating products. Many companies choose to invest in R&D to make future strategic investments. A company may choose to research the pain points of customers to create a product that fills a need or invest in a company that can tackle that area of the market. 

Capital budgeting methods

Capital budgeting methods are used to evaluate investment proposals to help businesses decide if they’re worth the investment. We’ll discuss four methods:

Payback period

The payback period is one of the most straightforward capital budgeting methods. This refers to the amount of time it takes to recover the initial cost of an investment. 

Let’s say that an investment of $900 will generate an annual cash flow of $150 a year. You can calculate the payback period by dividing the initial investment by annual cash flows. 

Payback method: Initial cash investment/annual cash flow  = 900/150 = 6 years 

The time to recover the cost of the initial investment is six years. Generally, companies tend to choose capital budgeting projects that have the quickest payback terms. 

The payback method is most useful for companies that specialize in smaller investments, as these usually don’t require complex calculations. Larger companies should use this method in conjunction with other capital budgeting methods when analyzing the value of potential investments. 

One of the biggest downsides to using the payback period method is that it ignores the time value of money, leading many companies to use the net present value method instead. 

Net present value

The net present value (NPV) method of capital budgeting explores the difference between the present value of incoming cash flow and the initial cost of the project. This method recognizes that money does not keep the same value over time. It uses the term “present value” because it expects future cash flows to drop in value. 

In this method, only projects with a net present value of greater than 0 are selected. Typically businesses will use either the company's cost of capital or a rate based on the risk of the investment to discount forecasted cash flow.

If the project has a single cash flow, you can use this equation to calculate its net present value:

PV = Cash flow / (1 + i)^t – initial investment

Here, i is the discount rate, and t is the number of years.

Let’s look at an example. Let us assume that the discount rate is 10%. Let’s say you plan to invest $2,000, and the cash flow is $500 per year with a payment of $1,500 in the third year. 

  • Now: PV = $2,000 
  • Year 1: PV = $500/1.10 = $454.55
  • Year 2 : PV = $500/1.10^2 = $413.22
  • Year 3: PV = $500/1.10^3 = $375.65
  • Year 3: (final payment): PV = $1,500/1.10^3 = $1126.97

Add those up and you get -2,000 +(454.55 +413.22 +375.65 +1126.97) = -2,000 + 2370.39 = NPV 370.39.

Since the number is greater than 0, this would be considered a good investment. 

One of the downsides to this method is that it’s largely based on assumptions. This leads businesses to use the internal rate of return for profitability projections. 

Internal rate of return 

Internal rate of return (IRR) compares the return on the investment to the cost of financing the project. It determines the estimated profitability of an investment or projected annual rate of return.  If the IRR is more than the cost of financing the project, then the investment is profitable. 

If a company needs to choose between multiple projects, the project with the highest IRR is chosen. This makes the IRR a great capital budgeting technique for companies needing to decide between two seemingly project's initial costs. 

The formula for IRR considers fluctuations in the value of money in an investment. As a discounted cash flow analysis, this is the discount rate at which a project or investment's net present value (NPV) is zero.

This is the IRR equation: 

$0 = Σ CFt ÷ (1 + IRR)t 

OR 

$0 = (initial outlay * −1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ... + CFX ÷ (1 + IRR)X

CF = net cash flow

IRR = internal rate of return

t = period (from 0 to last period)

To understand the IRR further, imagine your company must choose between two projects. The cost of capital is 8%. The cash flow patterns for each are listed below:

Project A 

  • Initial outlay: $6,000
  • Year 1: $1,600
  • Year 2: $1,800
  • Year 3: $1,700
  • Year 4: $1,500
  • Year 5: $1,200

Project B 

  • Initial outlay: $3,000
  • Year 1: $600
  • Year 2: $700
  • Year 3: $500
  • Year 4: $600
  • Year 5: $250

Solving the IRR equation by hand is tricky and time-consuming, but Excel allows you to calculate your rates of return on an annual basis easily.

Using the above projects as examples, the IRR for each project is: 

Project A: $0 = (−$6,000) + $1,600 ÷ (1 + IRR)1 + $1,800 ÷ (1 + IRR)2 + $1,700 ÷ (1 + IRR)3 + $1,500 ÷ (1 + IRR)4 + $1200 ÷ (1 + IRR)5 = 9.925%

IRR Project A = 9.925%

Project B:(−$3,000) + $600 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 + $600 ÷ (1 + IRR)4 + $250 ÷ (1 + IRR)5 = -4.432%

IRR Project B = -4.432%

Given that your company’s cost of capital is 8%, you should accept the first project and reject the second. 

Profitability index 

The profitability index (PI) is the ratio between the present value of cash inflows over the initial investment or cash outflows. If this ratio is above 1, the investment is favorable, and the chances of acceptance are high. A ratio below 1 reveals that the project’s present value is less than the initial investment, resulting in rejection. 

The PI formula is:

PI = present value of cash inflows/initial investment

For our example, we’ll calculate the PI of a potential five-year project with a discount rate of 10%. 

Years
Cash flow
10% discount
0
-$12,000
-$12,000
1
$2500
$2,273
2
$3,000
$2479
3
$3,500
$2630
4
$2,500
$1708
5
$3,400
$2111
Total
-
$11201

The profitability index with a 10% = $11,201/$10,000 = 1.1201

Since the ratio is positive, this project would likely be selected. This formula is generally used for ranking projects and can assist your business in deciding on the most promising investments. 

The capital budgeting process 

We can break down the process of capital budgeting into five steps.

1. Explore potential investment opportunities 

Every capital budgeting process begins with evaluating potential investment opportunities.

Companies will have many options to choose from. For instance, If a company is looking to expand its manufacturing facilities, it’ll need to decide between purchasing a new location or building onto its existing facilities. 

2. Collect and analyze investment proposals

After identifying promising investment proposals, these are collected and further analyzed by authorized people in the company. In the decision-making stage, business management or executives determine which investments seem the most promising. They check to see how much it will cost to bring the project to completion. 

3. Estimate cash flow and investment benefit 

Cash inflow is a key part of capital budgeting, and this step determines how much cash flow the project is expected to produce. Companies may choose to review similar capital investments that were successful in the past.

4. Determine investment risk 

This stage involves determining risks correlated to the project. Businesses will estimate the amount of money they stand to lose if the project doesn’t hit milestones or if it fails. First, businesses calculate the degree of risk. Then they weigh it against the expected return to see if it’s worth the investment.

5. Implement investment proposal

Final capital budgeting decisions are made in this step of the process. The implementation plan will cement decisions and outline how the project is funded, track expenses, and record cash flows that the project generates. It will also include a timeline that outlines the major project milestones and has a proposed end date. 

Potential pitfalls of capital budgeting 

Here are a few limitations of capital budgeting to consider: 

  • Doesn’t account for economic reactions: Capital budgeting only accounts for the potential profitability of a project, but not economic reactions. For instance, if a highly profitable product is introduced to the market by your company, competitors may release products soon after, lowering the future profitability of your product. 
  • Companies can be overly cautious with investments: Businesses are sometimes overly cautious during their capital budgeting analysis. This causes them to miss out on capital projects because they require several levels of management approval. 
  • Errors in cash flow: Capital budgeting techniques focus on estimates to forecast cash flows, which don’t always line up with actual amounts for profitability. 

Common capital budgeting mistakes

When performed correctly, capital budgeting can contribute to the success of your business. But poor financial management can trip up your business and stunt growth. Here are three common capital budgeting mistakes to avoid. 

  • Taking out multiple business loans: Steer clear of accepting multiple business loans from different lenders simultaneously. Taking out multiple working capital loans within a short period will make it difficult for you to qualify for traditional bank loans or other financings in the future. 
  • Buying vs. leasing equipment: Many businesses struggle to decide between buying or leasing equipment at the start of their company. Purchasing equipment with a low cash reserve could lead to your company taking out large loans to pay it off. Leasing with a low monthly payment can help you stretch limited funds, but not if you have the cash upfront to buy equipment outright. Weigh your options and make the best choice for your business. 
  • Rushing expansion: Expanding your business might seem like a sure path to success, but don’t be so quick. Scaling up too quickly can cause you to run through your cash flow and increase the cost of running your business. 

How to analyze and forecast cash flow to help your capital budgeting

While companies may think the first step to improving cash flow is building a better budget, it doesn’t stop there. Start by looking at financial statements to track the amount of cash going in and out daily. 

To improve your cash flow, streamline client billing by encouraging them to pay upfront or send out invoices as soon as the billing cycle closes. This gives clients more time to send payments and gives you a steady cash inflow. 

Reduce operational costs and consider leasing equipment instead of purchasing it to offer more cash flow flexibility. Choose an expense management software that monitors cash flow in real-time and uses automation to support invoicing and budgeting. 

Cash inflows and outflows are a critical part of capital budgeting, and Ramp can help companies track, manage, and forecast cash flow. You can create and manage a cash flow strategy by staying updated on your cash balance and projected cash amounts daily. 

Gain greater control and visibility over spending with Ramp 

When it comes to properly managing finances, there are several aspects of your business that you need to consider. Wouldn’t it be nice to have an expense management platform to help you identify areas you can fix now to improve future cash flows?

Ramp is your answer. Ramp provides companies with unlimited physical and virtual cards, 1.5% cash back on all purchases, and high credit limits. On top of these features, all companies can utilize the built-in expense management software to assist with investment decisions. 

Learn how Ramp can help your business gain greater control and visibility over spending. 

Learn how Ramp strengthens your finances

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FAQs
What is the difference between capital budgeting and traditional budgeting?

Capital budgeting determines the risk of an investment and if it will provide profits for the company over a set period. Traditional budgeting only looks at the cash flow for the current year while using the previous year's spending as a model.

What is the difference between net present value and internal rate of return?

Net present value reveals the difference between the current value of cash inflows and the current value of cash outflow over a set time. The internal rate of return is used to estimate the profitability of potential investments. The NPV will provide a dollar amount a project will produce, while the IRR is a projected percentage. 

How can Ramp help with capital budgeting?

Ramp helps companies get the most out of capital budgeting by helping businesses track, manage, and forecast cash flow accurately. 

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