How To Conduct Capital Budgeting

A growing business requires continuous reinvestment of capital, usually into projects that can bring in new cash flows. 

But how do you figure out which projects will help expand your business and are worth pursuing? 

That’s where capital budgeting comes in. It’s a decision-making process that business owners, corporate finance teams, and investors use to evaluate potential investments and whether to go after them.

What is Capital Budgeting? 

Capital budgeting, also known as “investment appraisal,” is an accounting process that businesses and investors use to evaluate a potential investment or proposed project before approving it.

Specifically, capital budgeting techniques use future cash flow instead of profit projections to evaluate projects. Future cash flow refers to the new income streams (cash flowing into the business) minus cash outflows, which include the initial investment and any ongoing costs connected to a proposed project.

Profit, on the other hand, is the amount of revenue that remains after all costs are taken into account (e.g., taxes). 

Examples of capital budgeting

Capital budgeting can be used to appraise almost any type of investment or proposed project, including:

• Upgrading equipment or facilities
• Purchasing new equipment
• Expanding into new markets
• Developing new products
• Renovating property
• Hiring new people

For instance, let’s say you have $100k and you want to see if pouring it into hiring two new sales reps is a good idea. 

You can use capital budgeting to estimate the value of the future cash inflows (additional revenue) you expect from two new reps and compare it to your initial cash outlay (the $100k investment and future salaries). 

These estimates provide insight on how long it will take to break even and what your long-term return on investment (ROI) may look like. When you have multiple projects to choose from, capital budgeting helps you decide which one is best based on estimates, such as the number of years to break even or the annual rate of return.

The Importance of Capital Budgeting

Capital budgeting allows businesses to evaluate the impact of potential investment decisions to avoid spending money blindly. Businesses can also use the practice to demonstrate financial and managerial responsibility to its shareholders.

Furthermore, capital budgeting helps business owners and investors use more objective (rather than subjective) information to drive decisions. Leaders can rely on set formulas and numbers, rather than just going with their gut.  

The Capital Budgeting Process

The general steps in the capital budgeting process are as follows:

1. Identify potential investment projects. 
2. Assess each project’s benefits and risks.
3. Choose a project based on your business’s goals and requirements.
4. Implement the chosen project. 
5. Analyze and report the project’s performance.

While step one is fairly straightforward, steps two and three (project assessment and selection) are more subjective. There are several ways to analyze a potential investment opportunity and different types of selection criteria. 

Within the broader process, four of the most common capital budgeting metrics are payback period, net present value, internal rate of return, and profitability index.

Capital Budgeting Metrics

Payback period

The payback period is an estimate of how long it will take for a project to recoup the initial capital expenditure (or break even). 

It uses the formula: 

Payback period = Initial investment / Annual projected cash flow

For example, let’s say that you want to calculate the payback period for an investment into a new piece of equipment, and you have the following information: 

• Total capital investment: $10k
• Lifespan of the equipment: 4 years
• Additional cash flow: $4k per year

To calculate the payback period, plug this information into the formula: 

Payback period = $10k / $4k = 2.5

This tells you that it will take 2.5 years to break even and recoup the initial $10k investment. 

When comparing several options, choose the one that breaks even in a shorter period of time (AKA the smallest payback period).

Net present value (NPV)

Net present value is an estimate of the projected earnings of your investment. The formula compares your estimated cash inflows and outflows. This method assumes that any project with a positive NPV is profitable. 

It uses discounted cash flow estimates to account for the time value of money, which states that one dollar today is worth more than a dollar in the future because you can grow your current money through investment.

The formula for NPV is: 

Image source: Investopedia.com

Where: 

• R = net cash flow (total new inflows - cash outflows)
• i = minimum required rate of return (AKA the discount rate)
• t = number of time periods (usually years)

To calculate the NPV of the new equipment:

• Total capital investment: $10k
• Lifespan of the equipment: 4 years
• Additional cash flow: $4k per year

Then, say you have a minimum required return rate of 12%. 

Your NPV = ($6k) / (1 + 0.12)⁴ = $3,813.11

In other words, the current value of your project’s estimated earnings is $3,813.11. Since the NPV is a positive number, the project is worth investing in. 

If you want to use this technique to compare two possible investments, simply choose the one with the higher NPV. 

Internal rate of return (IRR)

The internal rate of return estimates the annual rate of return a potential investment will generate. 

Since the formula is complex, IRR is often calculated using software. Excel and Google Sheets both have an IRR function that calculate return rate based on a table that includes the initial investment and all future cash flows. 

If you were to use the IRR function to evaluate the new equipment investment, it would look like this: 

=IRR({cash flow amounts}) 

=IRR({-10000,4000,4000,4000,4000}) 

=22%

The first value represents the initial investment as a negative value because it’s a cash outflow. After that, you include the annual cash inflow estimates for each year of the equipment’s lifespan. 

When plugged into the software, you get an annual rate of return of 22% for this project. If the IRR value is equal to or higher than your ideal rate of return, then you should invest in the project. 

In the previous example, the minimum annual rate of return is 12%. So, the IRR calculation here would signal a green light. 

When comparing several investment proposals, choose the one with the higher rate of return.

Profitability index (PI)

The profitability index is a ratio that compares the present value (PV) of your expected return to the initial investment amount. Like net present value, the profitability index uses a discount rate to adjust for the time value of money. So the further out the cash inflow, the higher the discount.

PI is calculated using the formula: 

Profitability index = PV of future cash flows / Initial investment 

To calculate the present value of future cash flows, use the following formula: 

Image source: Investopedia.com

Where: 

• FV = future value (of cash inflows)
• r = minimum rate of return (the discount rate)
• N = number of time periods

Using the equipment example, where the project had an annual cash inflow of $4k per year and a discount rate (minimum return rate) of 12%.

While your total cash inflows would be $16k, the present value would be $12,149.40.

If you plug the PV into the profitability index formula, you get: 

PI = PV / Initial investment

PI = $12,149.40 / $10k = 1.215

A profitability index of 1.0 means that the project breaks even. Anything higher indicates that it will generate a profit; anything lower suggests the project will not break even, and you shouldn’t invest in it.

When comparing two projects using this method, you should invest in the one with a higher PI value.

Keep in mind that all of these techniques use future cash flow estimates. The more accurate your projections, the better each capital budgeting method will work for you. 

You also don’t have to choose one technique — many business owners and investors use several estimates, which allows them to evaluate a project from different angles.  

Personal Capital Budgeting

Capital budgeting techniques can also apply to personal financial investments. In particular, you can use them to compare different ways to invest or use your money.

For instance, say you have two potential yearlong side hustles: selling handcrafted goods or becoming a rideshare driver. You want to choose the option that will become profitable faster, so you compare the two using the payback period method.

To sell handcrafted products, you’ll need an initial investment of $6k for supplies and expect to make $1k per month, for a total cash inflow of $12k in the year. 

The payback period is your initial investment divided by the total annual cash inflow, or: 

Payback period = $6k / $12k = 0.5 years (or 6 months)

Compare that with the rideshare side hustle: Say you already have a car, but you set aside an extra gas budget of $3k for the year. You predict you can make an extra $800 per month driving, which will total $9.6k for the year.

Your payback period = $3k / $9.6k = 0.31 years (or ~4 months)

Using this method, you see that you’ll break even and start earning a profit faster by choosing the rideshare option.

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