Capital budgeting refers to the process a business follows to determine which long-term capital investments are worth investing in in relation to their potential returns.
If a business is considering whether to undertake a large investment project, capital budgeting is the most efficient approach for making an informed decision.
Yet what is it exactly? Let’s explore this topic in this article, and see what capital budgeting is and why it is important.
What is capital budgeting?
Capital budgeting, also known as investment appraisal, involves the evaluation of the costs and benefits of a business’s potential large-scale projects.
Here are some examples: adding a new product to the range, building or purchasing a second warehouse, or a major software change.
Before deciding whether and which option to pursue, it would be necessary to first complete a financial analysis, referred to as capital budgeting.
Capital budgeting involves choosing projects that bring value to a business.
Businesses are, in fact, expected to choose and pursue only those projects that will increase their profitability and, by extension, improve shareholder wealth.
Companies, apart from nonprofit organizations, do exist to make a profit.
Hence, the capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project.
Why capital budgeting is important
Capital budgeting is a precious tool since it provides a means of estimating and measuring project value throughout their life cycle.
These investment projects may include:
- Investing in new equipment, technology and buildings;
- Upgrades and maintenance of current equipment and technology;
- Renovation interventions on existing buildings;
- Increasing workforce;
- New product development;
- Expansion into new markets.
Before a business approves a given project, capital budgeting allows for the company to establish a cost budget, estimate a timeline for return on investment, and decide whether the potential value of the project is worth the capital investment required.
Below are 7 reasons that detail why capital budgeting is important:
- Future cash flow calculation: the capital budgeting process takes into account estimated future cash flows by using various techniques such as calculating net present value, profitability ratio, and accounting rate of return.
- Business long-term goals: capital budgeting assists organizations in taking decisions and achieving long-term goals as it provides insight regarding future costs and growth. Setting long-term goals is one of the most important and sensitive areas for any organization. Any wrong decision made in this area can impact negatively on a company’s long-term profitability.
- Spending control: the capital budgeting approach takes into account the investment cost for the project by factoring in related expenses such as research and development costs, operating costs, etc. Therefore, with this information, the organization can have full control of its future costs. The proper management and control of total costs is a very important factor in ensuring a company’s perspective of growth and efficiency.
- Wealth maximization: interest and investment decisions of the company’s shareholders depend on its long-term investment decisions. If investments are made by the company in a sound and planned manner, shareholder confidence increases and they thus become more interested in investing in the company resulting in wealth maximization.
- Collaboration across departments: throughout the capital budgeting process, many steps and ideas are involved, and a number of decisions are taken by different departments and levels within the company. This allows the flow and exchange of information within different departments increasing collaboration.
- Large fund protection: through the capital budgeting process, funds invested in the company are protected to some extent from any future uncertainty.
- Risk awareness: through the capital budgeting process, company management can have a sense of the different types of risks and complications that may be encountered during the life cycle of a project. Therefore, management can have ready and advanced strategies for dealing with such future complexities.
Bottom line, budgeting is a key component of any successful financial investment and is one of the cornerstones in any decision-making process.
When no adequate planning process is executed for the development of a project, there is always a risk of a sudden increase in costs, delays in output development, regulatory complications, etc.
Therefore, every business should put in place a sound capital budgeting process before launching any large investment project.
This process can also help in comparing profitability of different projects and in prioritizing one project over the other.
Without an efficient capital budgeting process, a business will face more risk, less trust from investors and customers, and, as a result, less available funds.
Capital budgeting is thus an efficient way to know what is the best direction for a company to take.
Also, a project management software can help ensure an efficient and flawless capital budgeting process.
In this article, we have covered how the economic-financial part plays a key role in a company’s success, and using project management software such as TWproject can ensure that the capital budgeting process takes place in the most efficient way possible. Try it for free by clicking on the banner below.