What Is Capital Budgeting and Why Is It Important?

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At some point or another, most businesses have to decide whether spending serious money now on capital investment projects will generate a payoff in future. An excellent aid in the decision-making process is capital budgeting. Capital budgeting helps a business to see into the future and figure out the profitability of a long-term investment.

TL;DR (Too Long; Didn't Read)

Capital budgeting is a financial planning process that businesses use to determine the worth of long-term investments of an organization.

What is Capital Budgeting?

Capital budgeting is a series of steps that businesses follow to weigh the merits of a proposed capital investment. "Capital" in this context means the company's long-term fixed assets such as real estate or technology. Therefore, the company is deciding which capital investment projects, such as buying a new building, replacing machinery or launching a new product, are a sound investment and should be given the go ahead. The capital budgeting process is highly structured. By following the framework, companies can be sure they have thoroughly evaluated every possible risk and return associated with the project with minimal margin for error.

Uses of Capital Budgeting

Businesses use the concept of capital budgeting whenever they want to appraise the long-term value of an asset purchase or compare one investment option with another. It can also help to narrow down the possibilities when it comes to choosing which investment in a sea of opportunities may be fruitful for the company. In this respect, capital budgeting can help you develop long-term strategic goals for the business. Perhaps more crucially, it provides budgeting and expenditure control for the projects you've green-lighted. As you push forward with a project, capital budgeting will notify you if expenditures threaten to derail stability or growth.

How Capital Budgeting Works

Capital budgeting takes multiple factors into account when evaluating the profitability of a project. The rate of return is the key influencing factor but other factors, such as a project's value to society, can justify adding a project to the company's portfolio. The starting point is to compare the internal rate of return that an investment should generate against the cost of the financing the company will need to pay for the project, known as the weighted average cost of capital. If the internal rate of return exceeds the WACC, then you should consider accepting the project.

The internal rate of return is itself a complex financial analysis that involves estimating the future cash flows produced by the investment. Many small businesses seek professional assistance from a financial consulting firm before starting a capital budgeting exercise.

Importance of Capital Budgeting

Capital budgeting is important because it gives the business some hard numbers which it can use to measure the risks and potential returns of a project. A business that allocates resources to a speculative investment without measuring its likely effectiveness may be seen as irresponsible and lose the support of shareholders. Besides keeping shareholders at peace, capital budgeting ensures that the dollars you spend are making money for the company. Capital investment often involves substantial amounts of money and debt financing. Consequently, making poor investment decisions can have a disastrous effect on the company.