What are Capital Budgeting and Capital Structure?

Capital structure refers to the composition of the "Shareholder Equity and Liabilities" section of a corporation's balance sheet. Capital budgeting, on the other hand, refers to the process of evaluating investment prospects. Capital structure and capital budgeting must be aligned to ensure that the business has sufficient cash to undertake the investments necessary. A failure to match cash needs to cash sources spells disaster for any business and, in extreme cases, can result even in bankruptcy.

Capital budgeting is the process of evaluating a prospective investment from a financial perspective. During the capital budgeting process, the CFO, or in a smaller company the business owner, maps out the cash outlays and cash inflows associated with an investment. In the case of building a new factory, for example, the cash outlays may be monthly expenses for the construction, lasting two years. The cash inflows may then last for 10 years, resulting from the sales proceeds of products to be manufactured in the facility, until a renovation is needed. Companies use various tools when comparing cash inflows and outflows, including internal rate of return, discounted cashflow analysis and payback period.

Capital structure refers to how a business is financing its operations. It's quantified as the ratio of net shareholder equity to total debt on the balance sheet. Regardless of the size and scope of a business, all companies have access to the same two basic sources of funds: shareholders or lenders. In other words, the source of funds on the balance sheet is either shareholder equity or liabilities. Retained earnings from a past period's profits also qualify as shareholder equity, since these profits belong to shareholders. Liabilities encompass a wide variety of loans, including bank loans, funds provided by bond investors and money owed to suppliers far past purchases.

Most businesses can't afford to invest in all profitable projects. Instead, investments are dictated by the availability of funding. Lenders and shareholders will look at the capital structure before deciding to give the OK to a project. Their analysis will project how the successful implementation or failure of the project will change the capital structure. In some cases, a project must either be shelved or scaled back until the funds that investors are willing to contribute can be matched to the cash that must be invested.

The risks involved in a project will determine whether financing through shareholders or lenders makes more sense. The riskier the project, the more heavily a business should rely on shareholder funds to finance it as opposed to loans. This is because a failure to earn as much cash as previously expected has far worse consequences if the money has been secured through loans. Unpaid creditors can sue the business and even confiscate assets. In extreme cases, this can result in bankruptcy. If, however, shareholders fail to realize the gains they had hoped for, they can, at worst, vote the board of directors out of office in the annual shareholders meeting.