Capital budgeting

What it means

Capital budgeting is the process of evaluating and selecting investment projects, such as buying machinery, building a warehouse, opening a new branch or introducing a new information system. Its aim is to allocate limited capital where it will create the most value.

Projects are compared on future cash flows, not accounting profit. The most widely used methods are net present value NPV, internal rate of return IRR and the payback period, with the profitability index added when the budget is constrained.

A key input is the discount rate, which reflects the cost of capital and the project's risk. Companies often use the weighted average cost of capital WACC and add a premium for riskier projects so that they are not judged on the same basis as safe investments.

How it works in practice

For each project, estimate the initial outlay or CAPEX, future revenue and savings, operating costs, the working capital required and the residual value at the end. Taxes are included in the cash flows too, including the effect of tax depreciation in reducing tax.

A project with a positive NPV at an appropriate discount rate increases the value of the company. If projects are mutually exclusive or there is not enough money for all of them, the highest NPV decides, not the highest IRR. Payback is a useful supplement when liquidity matters.

Estimates are uncertain, so results are tested through sensitivity analysis and scenarios. This shows how far sales could fall or costs rise before the project stops being worthwhile, and which assumptions need watching most closely.

What to watch out for

A common mistake is excessive optimism about sales and underestimating costs and implementation time. It helps to compare plans with the outcomes of past projects and, once an investment is complete, to run a post-audit of what was achieved and what was not, so that future estimates improve.

Sunk costs that have already been incurred and cannot be recovered do not belong in the calculation, nor do allocated overheads that would arise without the project. On the other hand, indirect effects must be included, such as lost sales of an existing product that the new project will replace.