Capital Budgeting
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Capital Budgeting


Evaluating which projects offer the best financial rewards




Capital budgeting is a technique used to get the best possible return on the money you invest in your business. The goal of any business should be to maximize the amount of money made.



Normally a NPV model(net present value model)is used for the analysis. Other models, such as an IRR model could also be used.




How It Works


You have a fixed amount of money to invest in your business. You also have a number of projects that you could invest in. This analysis helps you answer the question of which of the projects to chose.


Key Steps For Performing Capital Budgeting


  1. First you need to perform the NPV of the cashflows of each project. The cashflows consist of the initial investment and the net profit or cost for each year of the life of the project. Of course each of the net annual cashflows needs to be discounted back to present value. The comparison number therefore becomes the sum of all the discounted cashflows.

  2. Next you need to rank the projects according to highest NPV to the lowest.

  3. Begin chosing the highest ranked projects until your budgeted money has been expended.




Summary


Capital budgeting allows you to get the best possible return on the money you invest in your business. When you use the NPV model you know if the project has met a minimum return set by your choice of a hurdle rate or discount rate. If the NPV is positive the minimum return has been exceeded.


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