Capital Budgeting is the process of deciding whether a company should spend money on new capital items. Companies will generally make these investments when they believe that the returns from them will be greater than their costs, although this is not always the case. There are many methods to determine the Return on Investment (ROI) from a project, but it can generally be seen as one of three types: cost-benefit analysis, payback period, or net present value.
Types of Capital Budgeting
Cost-Benefit Analysis
The Cost-Benefit Analysis calculates the "net" benefits received from a project, meaning what benefit would remain after some costs have been deducted. Examples of some costs that may be deducted include government subsidies and certain opportunity costs such as interest foregone once initial capital has been borrowed. This analysis is useful in determining whether or not a project would lead to an overall profit for the company.
Payback Period
The Payback Period calculates how long it will take for the money invested in a project to be paid back through its revenue streams, assuming that all costs are already known, and no more capital will be reinvested into the project. It can also tell you how much revenue must be generated during that time period to pay back the initial investment, which may help you determine what sales levels must be reached while factoring in the associated costs of achieving them (including labor). A drawback of this analysis is that it doesn't account for any further benefits after the payback period has expired; it only looks at recouping the original investment.
Net Present Value
The Present Net Value is a calculation of all cash flows (both positive and negative) that will take place during the life of a project and then discounts those cash flows back to the present using a chosen discount rate. This analysis takes into account not only the initial investment and payback period but also any future benefits that are expected to arise from the project. It can be used to compare different projects as well as weigh up risks and rewards. A major advantage of this method is that it allows for comparisons between projects which have different payment schedules or cash flow profiles.
Internal rate of return (IRR)
The IRR is a measure of the profitability of a project and can be used to compare projects that have different initial costs. IRRs are the discount rate at which the NPV of future cash flows is 0.
No one capital budgeting method is perfect, and each has its own advantages and disadvantages; it is up to you to decide which method is most appropriate for the circumstances of your business. For this reason, it's especially important to understand what each type of analysis can and cannot do before deciding how to proceed with a new capital budgeting project.