What Is Capital Budgeting?

Capital budgeting is the process organizations use to evaluate whether or not to fund major projects or investments intended to increase cash flow or advance strategic objectives. It involves the planning and analysis of investment in long-term assets such as new or replacement machinery, new plants, products or R&D.

The goal of capital budgeting is to determine whether an investment or project is worth pursuing, and to ensure the company's capital resources are efficiently allocated, as these assets require a considerable amount of funding and are not easily liquidated.

FP&A is generally involved in supporting the creation of a business case that includes the strategic rationale, detailed valuation, operational risks, opportunity costs and various other factors.

PART 1

What Is the Difference Between Capital Budgeting and Operational Budgeting?

The key difference between capital and operational budgeting lies in the timeframe and the nature of the expenses.

Capital budgets are for long-term, multi-year strategic investments. These are physical assets like property, buildings or equipment with long lives that are valued as assets on the balance sheet.

Operational budgets are for the day-to-day running of the business. They are classified as short-term expenses because they have a useful life of less than one year, like inventory to be turned into products, salaries and office supplies.

PART 2

What Is the Difference Between Capital Budgeting and Working Capital Management?

While capital budgeting involves evaluating and selecting successful long-term investments, working capital management focuses on managing the company's short-term assets and liabilities to ensure effective operations and adequate liquidity. By overseeing the organization’s current assets and liabilities, a balance is maintained that allows the company to meet its short-term financial obligations while optimizing operational efficiency. In short, successful working capital management ensures the company can continue its day-to-day activities without interruption — and without taking on unnecessary financial risk.

Charts on Tablet

PART 3

Why Is Capital Budgeting Important?

Because capital expenditures are large, irregular items, they receive a lot of scrutiny. The budgeting process needs to ensure efficient resource allocation to meet the long-term strategic plan within the defined risk tolerance. It is a crucial process for any organization. By evaluating potential investments, organizations are able to make informed decisions that maximize shareholder value and maintain financial control.

When a great capital budgeting decision is made, it sets the stage for competitive advantages, including revenue growth, product innovation and cost savings. Additionally, capital budgeting ensures that organizations are in compliance and maintaining ethical standards, both of which contribute to sustainable growth and overall financial health.

PART 4

Capital Budgeting Process

The capital budgeting process has five stages: strategic alignment, information gathering, forecasting value, decision-making, and implementation and evaluation.

  1. Strategic alignment. In this step, each capital investment is screened with respect to its ability to support and promote the organization’s strategy.
  2. Information gathering. This step involves collecting quantitative information necessary to estimate the present value of future expected cash flows. Assumptions required include anticipated revenues and costs, duration and timing of cash flows, salvage value of fixed assets purchased, and the implications of depreciation expense and taxes.
  3. Forecasting value. This step is achieved using preferred capital budgeting methods to analyze the change in value and/or effects on cash flows over the duration of the capital investment.
  4. Decision-making. By weighing the quantifiable results from step three with qualitative considerations, such as the long-range strategic importance of the capital investment, the board and senior management make a decision. Their decisions can be driven by individual considerations such as overall valuation, or they can be based on performance criteria stipulated for the entire organization or individual divisions.
  5. Implementation and evaluation. This step is focused on the results and involves tracking and comparing actual cash flows to projections. Additionally, any variances, favorable or unfavorable, must be analyzed.
Charts and Graphs

PART 5

Capital Budgeting Metrics

Five capital budgeting metrics are commonly used in the forecasting value step: net present value, internal rate of return, payback period, discounted payback period and profitability index. The values of these metrics help determine whether the project is a “go” or a “no-go” investment decision.

Net Present Value (NPV)

The net present value (NPV) method evaluates the value created or destroyed by a capital investment by accounting for all marginal benefits and costs. Marginal benefits are the future cash flows from the investment, while costs include upfront, future and opportunity costs. In this way, NPV distinguishes favorable investments from unfavorable ones.

In terms of the actual calculations, future cash flows are converted to present value using the discount rate, which is typically the weighted average cost of capital (WACC) adjusted for investment risk. The NPV is then calculated by identifying the annual cash flows, computing their present value at the WACC, and summing these (present) values. An NPV of less than $0 means that the capital investment is unfavorable, while an NPV equal to or greater than $0 is favorable.

Internal Rate of Return (IRR)

The internal rate of return (IRR) is the annualized return from a capital investment’s cash flows, defined as the discount rate that makes their net present value zero. Investments are evaluated by comparing the IRR to the appropriate discount rate. If the IRR exceeds this rate, the investment is favorable; if it is less than, the investment is unfavorable. For investments similar to those in the existing portfolio, compare the IRR to the organization’s WACC; if the IRR is less than the WACC, the investment is considered a no-go.

Payback Period

The payback period measures the time it takes for a capital investment’s cash flows to equal the initial outlay, without discounting. A shorter payback period indicates less risk, so it is, of course, preferred. Investments with payback periods shorter than a management-set cutoff are accepted, while those longer are rejected.

The payback period is calculated by subtracting annual cash flows from the initial investment until it is recovered. Any remaining amount is divided by the cash flow of the final year to determine the exact payback time.

Discounted Payback Period

The discounted payback period measures the time it takes for a capital investment’s discounted cash flows to equal the initial outlay, thereby accounting for the time value of money. This method tells you if an investment is acceptable by comparing the discounted payback period to a subjective cutoff period — if it’s shorter, it’s acceptable.

The discounted payback period is an improvement over the standard payback period because it considers the time value of money. However, it shares the same weaknesses: It ignores cash flows after the payback period and relies on a subjective cutoff. Therefore, it is not recommended that the discounted payback period be used alone, as it may result in suboptimal investment decisions.

Profitability Index (PI)

The profitability index (PI) measures the expected present value of cash flows per dollar invested. This is calculated as the ratio of the present value of future cash flows to the initial investment, ignoring the negative sign of the initial outlay. A PI greater than 1.0 indicates that the investment is expected to create value, while a PI of less than 1.0 suggests it will destroy value.

PART 6

The Role of FP&A in Capital Budgeting

The analytical, modeling and forecasting skills of FP&A professionals play a critical role in capital budgeting. When capital projects are under consideration, FP&A prepares detailed financial models and forecasts that estimate the future cash flows, costs and returns associated with the proposed projects.

FP&A professionals analyze these projections using various techniques (e.g., NPV, IRR) to assess the feasibility and profitability of the investments, and ensure the assumptions used in the models are both realistic and aligned with the company's strategic goals. Additionally, it is the responsibility of FP&A to collaborate with other departments to gather necessary data, initiate the decision-making process by presenting their findings to senior management, and monitor the performance of approved projects to ensure expectations are met.