What is capital budgeting?
In an ideal world, businesses would be able to pursue any type of project that has the potential to increase shareholder value. In reality, however, all businesses have a limited amount of capital, which means that they need to choose which projects to invest in wisely. Capital budgeting can help businesses determine which investments are likely to yield the best return, making it an important process for any business owner to have a handle on. Find out everything you need to know about the significance of capital budgeting, right here. Capital budgeting, sometimes referred to as investment appraisal, is the process by which businesses determine which investments or purchases should be pursued. Essentially, the capital budgeting process helps companies produce a quantitative view of each potential investment, giving them a more rational basis from which to make a decision about its viability. Capital budgeting can involve virtually any sort of investment, from purchasing fixed assets like machinery to mergers and acquisitions. There are three main approaches taken by businesses to a capital budgeting decision. While you might expect each method to produce a similar result, the results of these approaches are often wildly contradictory, which means youll need to decide where to put your emphasis for yourself. Heres a little more information about each method:  Net present value (NPV)  Net present value identifies the net change in cash flows (i.e. the difference between your cash inflows and outflows) over the course of the project. When used in capital budgeting, youll simply select the project with the highest NPV. As its a direct measure of profitability, NPV is very easy to use and allows you to compare mutually exclusive projects. Payback period  With the capital budgeting payback period method, youll need to calculate how long it will take to recoup the costs of your initial investment. This is a good method to use if liquidity is a major concern, and its especially easy to calculate once youve established your cash flow forecast. However, the capital budgeting payback period approach does have drawbacks. Most notably, payback period doesnt account for the time value of money (TVM). Furthermore, payback period may ignore cash flows at the end of a projects life, such as salvage value. Internal rate of return (IRR)  The internal rate of return refers to the discount rate on a project/investment that results in a net present value of zero. IRR provides a benchmark figure you can use to assess the viability of projects with reference to your firms capital structure, although its important to note that it doesnt convey the actual profitability of a project. So, now that you know a little more about the capital budgeting process, lets explore the significance of capital budgeting, and why its almost always a good idea. The significance of capital budgeting  Investments are a major (not to mention irreversible) decision for all businesses, regardless of size or industry. If you make a bad call, you could end up facing enormous financial ramifications, including bankruptcy. If youre considering making a large investment in a fixed asset, capital budgeting isnt a nice-to-have, it should be a central part of your decision-making process. That way, you can move forward with the best possible information at your disposal. However, its important to note that the significance of capital budgeting may not extend to smaller investments. In many cases, investments that take place on a smaller scale are more impactful if theyre made quickly, so its best to streamline your capital budgeting process in these instances. Thats not to say that you shouldnt analyse these sorts of fixed asset proposals, but that the process should be expedited to ensure that your analysis isnt standing in the way of a profitable return. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.