What Is Capital Budgeting?

Capital budgeting is the process a business undertakes to evaluate

potential major projects or investments. Construction of a new
plant or a big investment in an outside venture are examples of
projects that would require capital budgeting before they are
approved or rejected.

As part of capital budgeting, a company might assess a prospective

project's lifetime cash inflows and outflows to determine whether
the potential returns that would be generated meet a sufficient
target benchmark. The capital budgeting process is also known as
investment appraisal.

Capital budgeting in corporate finance is the planning process used

to determine whether an organization's long term
capital investments such as new machinery, replacement of
machinery, new plants, new products, and research development
projects are worth the funding of cash through the
firm's capitalization structures (debt, equity or retained earnings).
It is the process of allocating resources for major capital, or
investment, expenditures. An underlying goal, consistent with the
overall approach in corporate finance, is to increase the value of
the firm to the shareholders.
Capital budgeting is typically considered a non-core business
activity as it is not part of the revenue model or models of most
types of firms, or even a part of daily operations. It holds a strategic
financial function within a business. One example of a firm type
where capital budgeting is plausibly a part of the core business
activities is with investment banks, as their revenue model or
models rely on financial strategy to a considerable degree.
Many formal methods are used in capital budgeting, including the
techniques such as

 Accounting rate of return

 Average accounting return
 Payback period
 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annual cost
 Real options valuation
These methods use the incremental cash flows from each potential
investment, or project. Techniques based on accounting earnings
and accounting rules are sometimes used - though economists
consider this to be improper - such as the accounting rate of
return, and "return on investment." Simplified and hybrid methods
are used as well, such as payback period and discounted payback
period.
Net present value
Main article: Corporate finance § Investment and project valuation
Cash flows are discounted at the cost of capital to give the net
present value (NPV) added to the firm. Unless capital is
constrained, or there are dependencies between projects, in order
to maximize the value added to the firm, the firm would accept all
projects with positive NPV. This method accounts for the time value
of money. For the mechanics of the valuation here, see Valuation
using discounted cash flows.
Mutually exclusive projects are a set of projects from which at most
one will be accepted, for example, a set of projects which
accomplish the same task. Thus when choosing between mutually
exclusive projects, more than one of the projects may satisfy the
capital budgeting criterion, but only one project can be accepted;
see below Ranked projects.
Internal rate of return
Main article: Internal rate of return
The internal rate of return (IRR) is the discount rate that gives a net
present value (NPV) of zero. It is a widely used measure of
investment efficiency. To maximize return, sort projects in order of
IRR.
Many projects have a simple cash flow structure, with a negative
cash flow at the start, and subsequent cash flows are positive. In
such a case, if the IRR is greater than the cost of capital, the NPV is
positive, so for non-mutually exclusive projects in an unconstrained
environment, applying this criterion will result in the same decision
as the NPV method.
An example of a project with cash flows which do not conform to
this pattern is a loan, consisting of a positive cash flow at the
beginning, followed by negative cash flows later. The greater the
IRR of the loan, the higher the rate the borrower must pay, so
clearly, a lower IRR is preferable in this case. Any such loan with IRR
less than the cost of capital has a positive NPV.
Excluding such cases, for investment projects, where the pattern of
cash flows is such that the higher the IRR, the higher the NPV, for
mutually exclusive projects, the decision rule of taking the project
with the highest IRR will maximize the return, but it may select a
project with a lower NPV.
In some cases, several solutions to the equation NPV = 0 may exist,
meaning there is more than one possible IRR. The IRR exists and is
unique if one or more years of net investment (negative cash flow)
are followed by years of net revenues. But if the signs of the cash
flows change more than once, there may be several IRRs. The IRR
equation generally cannot be solved analytically but only via
iterations.
IRR is the return on capital invested, over the sub-period it is
invested. It may be impossible to reinvest intermediate cash flows
at the same rate as the IRR. Accordingly, a measure called Modified
Internal Rate of Return (MIRR) is designed to overcome this issue,
by simulating reinvestment of cash flows at a second rate of return.
Despite a strong academic preference for maximizing the value of
the firm according to NPV, surveys indicate that executives prefer
to maximize returns

Risk Premium
Investors try to avoid risk. To encourage investors to invest their
funds into risky projects, the returns from such projects should be
higher than returns from less risky investments such as treasury
bonds. A risk premium is a discount rate that is added to the risk-
free rate of borrowing. The risk-free rate is the rate of return of
low-risk investments such as government-backed securities. The
investments are then appraised using the resulting discount rate.
Investments that offer better returns are chosen. The increasing
volatility of the global economy has caused investors to search out
safer investment alternatives. Investors use a capital budget when
selecting their investments. A capital budget is a plan for investing
in long-term assets such as buildings and machinery. Risk is
inevitable to these investments. The various risks include cash
flows not being paid in time as agreed, the risk of the investee
company collapsing and also the management sinking the invested
funds in risky projects. By incorporating risk in capital budgeting,
investors can minimize losses.
What is depreciation and how does
fixed asset depreciation work?
Depreciation is the term we use for the loss of value of a fixed asset during its

lifetime. Generally speaking, depreciation only occurs in fixed assets, such as

property, vehicles, or machinery as they are tangible, physical assets that

your business owns. Although both fixed assets and other intangible assets,

such as trademarks or branding, show on your company’s balance sheet for

accounting purposes, only fixed assets are able to be depreciated for tax

purposes.

What’s more, not all fixed assets are eligible to be depreciated over time. For

example, they should have a value higher than $500, and they should also

have a useful operating life of over one year. This discounts stock and

inventory, as this type of asset generally moves through a business at a

faster rate and is not usually retained for longer than a year.

The 4 main types of fixed asset

depreciation methods
You may be surprised to hear that there are actually a number of ways to

calculate the depreciation rate of an asset and make a fixed asset

depreciation entry. Though at face value, this seems overly complicated, it is

actually very useful as it gives an organization a standard way to depreciate

an asset, depending on a number of factors. Let’s take a closer look at how

to calculate the monthly depreciation of a fixed asset:

1. Straight-line method
Arguably, the most common and popular depreciation method is the straight-

line method. Praised for its simplicity, it works by reducing the value of the

asset by the same amount every year for the length of its usable life.

It is calculated as follows:

Depreciation expense = (cost – salvage value) / useful life.

2. Units of production depreciation

method
The units of production depreciation method aim to reduce the value of an

asset using the total number of hours it is used (or the total number of units

that it produces) during the course of its useful life.

This method uses the following formula:

Depreciation expense = (number of units produced. life in number of units) x

(cost – salvage value).

3. Declining balance depreciation

method
The declining balance depreciation method is different from the straight-line

method in that it distributes the asset depreciation unevenly throughout its

life. It has higher expenses in the early years based on the assumption that

assets have higher productivity at this time as opposed to the later years of

its lifespan.

The formula used for this method is as follows:

Periodic depreciation expense = (beginning book value x rate of

depreciation) x (cost – salvage value)

4. Sum of the years’ digits method

The sum of the years’ digits method is similar to the units of production

depreciation method in that it recognizes the higher expense that is incurred

in the early years of the asset’s life.

However, it uses a different calculation, as follows:

Depreciation expense = (remaining life/sum of the years’ digits)