What is Capital Budgeting? Process, Methods, Formula, Examples

Dec 17, 2020

Capital budgeting is a useful tool that companies can use to decide whether to devote capital to a particular new project or investment. There are several capital budgeting methods that managers can use, ranging from the crude but quick to the more complex and sophisticated. Payback analysis is usually used when companies have only a limited amount of funds (or liquidity) to invest in a project, and therefore need to know how quickly they can get back their investment.

But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects – not simply accept or reject them. Real options analysis tries to value the choices – the option value – that the managers will have in the future and adds these values to the NPV. These methods use the incremental cash flows from each potential investment, or project.

Which Method Should Your Business Use?

An organization implementing capital budgeting is also forced to examine the operational relationships between its various departments. Also known as profit investment ratio, capital budgeting involves profitability index is the ratio of payoff to investment in a potential project. The payback period method is particularly useful where concerns exist around liquidity.

To strike a balance, organizations must identify and prioritize projects that maximally align with their CSR objectives while maintaining a reasonable profit margin. The practice ensures a win-win situation, where both the firm and the society it operates in reap the benefits. Capital budgeting process used by managers depends upon size and complexity of the project to be evaluated, size of the organization and the position of the manager in the organization. If IRR is greater than the required rate of return for the project, then accept the project. And if IRR is less than the required rate of return, then reject the project. Thus, the manager has to choose a project that gives a rate of return more than the cost financing such a project.

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