Capital Budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known as capital expenditures.
Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Various methods of capital budgeting can include throughput analysis, net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.
There are three general methods for deciding which proposed projects should be ranked higher than other projects, which are (in declining order of preference):
- Throughput analysis. Determines the impact of an investment on the throughput of an entire system.
- Discounted cash flow analysis. Uses a discount rate to determine the present value of all cash flows related to a proposed project. Tends to create improvements on a localized basis, rather than for the entire system, and is subject to incorrect results if cash flow forecasts are incorrect.
- Payback analysis. Calculates how fast you can earn back your investment; is more of a measure of risk reduction than of return on investment.