Capital Budgeting is taught in every single finance course worth its title.
And it’s applied extensively in Business Intelligence, Finance, and Managerial Accounting divisions.
This particular concept is surprisingly easy, incredibly intuitive, and indeed powerful.
Fundamentally though, what is capital budgeting (aka ‘Investment Appraisal’)?
What is Capital Budgeting?
As the name kind of suggests, it’s the budgeting of capital.
More precisely, it’s the allocation of capital (aka funds, money, cash) in an optimal way.
Generally speaking, ‘capital’ refers to large amounts of money. So in the context of a business, this would include funds required to invest in a new building, for example. Or the funds required to set up operations in a new country.
This is also why such large expenditures are usually called Capital Expenditure (or “CAPEX”).
At an individual level, you can think of the decision to pay for college vs. getting a job right after school as a capital budgeting decision.
Or indeed, the decision to buy a house outright or get a mortgage (loan) – again, a (personal) capital budgeting decision.
Put simply, capital budgeting exists to help us spend our money wisely, in projects / firms / ventures / ideas that are likely to make the most amount of money.
It’s also called “Investment Appraisal” because it involves appraising (i.e. evaluating) investments and seeing whether they’re worth our while. In other words, capital budgeting is used to guide us in making a ‘good’ / the ‘right’ investment decision.
Related: Investment Appraisal Course
This Article features a concept that is covered extensively in our course on Investment Appraisal Mastery.
If you’re interested in mastering the NPV and other investment appraisal / capital budgeting techniques, then you should definitely check out the course.
What does capital budgeting entail?
Essentially, capital budgeting is a process. And the capital budgeting process involves using a variety of tools and techniques including:
- Net Present Value (NPV),
- Internal Rate of Return (IRR),
- Payback Period,
- Profitability Index (PI)
- Accounting Rate of Return
That’s to name a few of the most popular ones.
Each of these tools have the same objective, but vary in their methodologies and assumptions, thus sometimes vary in their results.
For instance, you might find the Payback Period telling you an investment opportunity is worthwhile, but the Net Present Value (NPV) telling you the exact opposite.
This would likely be because of the effects of the ‘time value of money’
RELATED: What does Time Value of Money Mean?
In other words, it’s likely because the NPV incorporates the fact that money loses value over time, while the Payback Period fails to do so.
The NPV is a discounted cash flow based capital budgeting method, relying on an initial investment, future cash flow and a discount rate to express future expectations in present terms.
Payback Period on the other hand, is largely based on a personal / preference based rule of thumb!
But that’s just a technical note, anyway.
The fundamental idea to conduct capital budgeting analysis to evaluate / appraise opportunities and see if they’re worth pursuing.
Why use Capital Budgeting?
Failure to use capital budgeting is essentially akin to making decisions like a headless chicken.
Investments are all about the future, which inevitably brings a high degree of risk and uncertainty.
Capital budgeting / investment appraisal helps alleviate some level of uncertainty by giving you an idea of the risks involved.
For instance, say you’re looking to set up a business.
This involves a variety of costs both monetarily as well as time.
The decision to go ahead and setup the company is essentially a “NPV question”, meaning it’s an investment decision that can be guided by capital budgeting techniques.
So if the NPV is positive – that is to say, setting up the business will make you money given a whole host of risks and the time value of money – then it’s worth your while.
If not, then you’re better off spending that time and money elsewhere.
The important thing you want to bear in mind is that no tool is “perfect”.
To get your capital budgeting / investment appraisal right, you want to use a combination of these tools.
Who uses Capital Budgeting?
Generally speaking, large companies are much more likely to use capital budgeting vis-a-vis small companies. That doesn’t mean small firms shouldn’t use it. Far from it!
Unfortunately, not a lot of people know what capital budgeting is let alone know how to apply it. This is one of many reasons why a lot of decisions in small companies tend to be made “on the fly”.
This notion is visible from research conducted by Arnold and Hatzopoulous (2000) who found that managers of large firms tend to use techniques like the NPV and IRR significantly more often than managers of smaller firms.
Source: Data from Arnold and Hatzopoulous (2000)
Notice that large firms tend to use the Payback method pretty much as often as the small firms, and this is intuitive given that the Payback method is more of a “quick filter” rather than a full fledged appraisal tool.
Apart from companies, capital budgeting techniques tend to be used quite widely by governments.
This is intuitive, especially since governments make many long-term investments, with timeframes for cash inflow and cash outflow ranging from a few years to several decades.
Governments, both national and local will often maintain a robust capital budgeting process as part of their planning and development of public investment projects.
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Capital Budgeting Global Interest
Google trends presents some fascinating insights. From the graph below, you can see how the Net Present Value and Internal Rate of Return are the most commonly searched techniques.
Payback Period and the Accounting Rate of Return – perhaps unsurprisingly – are nowhere near as popular as the NPV and IRR.
Tick ‘Include low search volume regions’ to see how Romania appears to be the only country interested in the Accounting Rate of Return!
Don’t see a chart here? It’s likely a browser issue. Explore Google Trends data here.
Source: Google Trends: google.com/trends
What’s interesting however is that the IRR appears to be a lot more ‘popular’ in terms of interest, vis-a-vis the NPV.
This is intriguing, particularly since the NPV – on average – is a better tool compared to the IRR.
Importantly, this is not to say that people aren’t interested in NPV. Far from it. In fact, you can see the global interest in the NPV here:
Don’t see a chart here? It’s likely a browser issue. Explore this Google Trends data here.
Source: Google Trends: google.com/trends
Which techniques should you use?
In a nutshell, you want to use all the techniques. Each technique is telling you a story. If they’re all telling you the same story more or less, then you’ve likely got the ‘correct’ answer.
As a general rule of thumb though, you should prefer:
- NPV to the IRR,
- IRR to the Payback Period, and
- Payback Period to the Accounting Rate of Return (ARR).
That’s because the ARR, unlike all other capital budgeting / investment appraisal techniques uses profit instead of cash flow.
When you invest in a project / venture / idea, you’re investing your money.
And profit is not the same as money!
So there you have it – you now know what is capital budgeting. You know what it entails, why it’s important, and who uses it.
If you’d like to learn more about investment appraisal and the associated techniques, feel free to check out our other articles and the course below.
Related Course: Investment Appraisal Mastery
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