What Is Capital Budgeting? Capital Budgeting In A Nutshell

Capital budgeting is the process used by a company to determine whether a long-term investment is worth pursuing. Unlike similar methods that focus on profit, capital budgeting focuses on cash flow. Capital budgeting is used to determine which fixed asset purchases should be accepted, and which should be declined. The process itself provides a quantitative evaluation of each asset, allowing the company to make a rational and informed decision.

Understanding capital budgeting

When a company goes through the capital budgeting process, it will be drawn to assess the anticipated lifetime inflows and outflows of cash for a potential investment or project.

This will help them determine whether or not it is a wise venture for the company, financially speaking.

In an ideal world, a business would be able to participate in any project or investment that they anticipate would enhance profits and the valuation of public shares.

However, this is not a realistic option for most businesses, which have limited resources to allocate to new projects.

Instead, they have to carefully plan and predetermine which business ventures are most likely worth the investment. 

In theory, the decision should favor an asset that delivers the best return for both the company and its shareholders.

For this reason, capital budgeting is sometimes referred to as investment appraisal.

Capital budgeting is useful for almost any asset, including new or replacement machinery, plants, products, or in research and development. It can also be used to value assets during mergers or acquisitions.

Capital budgeting methods

When a company goes through the capital budgeting process, it will be drawn to assess the anticipated lifetime inflows and outflows of cash for a potential investment or project.

This will help them determine whether or not it is a wise venture for the company, financially speaking.

Some of the more common capital budgeting methods include:

Discounted Cash Flow (DCF)

Discounted cash flow is one of the most common valuation methods for capital budgeting.

Here, a company looks at current revenue to estimate a particular venture’s expected future cash flows.

This helps them to determine the long-term value of an investment. 

There are a few main components to DCF:

  1. Net Present Value (NPV) – the calculated difference between cash inflows and cash outflows at present.
  2. Cost of Capital – the calculated minimum return required to justify moving forward with the capital budgeting project.

Net present value (NPV) analysis

Where the net change in cash flow is estimated over the course of the project.

Cash flow is analyzed using the discounted cash flow analysis (DCF), which looks at the cash needed to fund and maintain a project while also considering future revenue.

NPV is a direct measure of profitability and can be used to compare mutually exclusive projects.

Payback period

Using this method, the business calculates how long it will take to recoup the costs of the investment.

The payback period method is particularly useful where concerns exist around liquidity.

This is the simplest form of capital budgeting analysis. However, because of its simplicity, it can also be the least accurate.

Managers use payback analysis to achieve quick estimates for capital budgeting projects. 

As we saw the primary use of payback analysis is to determine how long it will take to recoup the initial investment amount.

The amount of time it takes to break even after the investment is placed is known as the payback period. 

Internal rate of return (IRR)

Or the expected return on a particular project. IRR is characterized by a discount rate that reduces NPV to zero.

Higher discount rates are noteworthy because they denote higher uncertainty in future cash flow rates.

Profitability index (PI)

Also known as profit investment ratio, profitability index is the ratio of payoff to investment in a potential project.

The method can be used to rank different projects according to their per-unit generated value.

Equivalent annuity

This is the annual cost of owning and operating an asset over its entire lifespan.

It may be calculated by dividing the project NPV by the annual interest rate and the number of years the annuity will occur.

This method is useful when comparing projects of varying lifespans.

Throughput Analysis

Throughput analysis is known as the most complex form of capital budgeting analysis.

With that said, it is also the most accurate tool for helping managers determine whether or not a project is worth pursuing.

This method provides a comprehensive rundown of the potential profit that the company can achieve as a result of the capital budgeting project.

In other words, managers should prioritize projects that will increase throughput or the flow that can pass through the system, thus increasing profitability. 

What are the main goals of capital budgeting?

There are several goals and associated benefits of capital budgeting:

They include:

  • Project ranking – many organizations are spoilt for choice when it comes to financially lucrative projects. Capital budgeting allows the organization to compare a list of viable options and select the highest-ranking project to invest in.
  • Fundraising – capital budgeting also allows the business to strike the correct balance between the cost of borrowing and the return on investment. Each project has a different level of risk and should be matched to the appropriate capital raising method. For publicly listed companies, corporate bonds are lower risk while preferred and common stock issuance is higher risk.
  • Revenue and expenditure forecasts – the process of capital budgeting encourages the formation of detailed revenue and expenditure forecasts. In other words, what are the financial implications of certain strategies, events, or plans if they were to be carried out? Capital budgeting also forces management to consider potential problems before they arise, and plan accordingly.
  • Collaboration – an organization implementing capital budgeting is also forced to examine the operational relationships between its various departments. The process encourages leaders to communicate their plans to colleagues and motivates them to achieve budgetary goals. More broadly speaking, capital budgeting increases visibility into the financial performance of the company.

Key takeaways

  • Capital budgeting involves estimating the financial viability of a capital investment with a focus on cash flow instead of profit.
  • Capital budgeting methods include net present value analysis, payback period, internal rate of return, profitability index, and equivalent annuity.
  • Capital budgeting allows a company to rank and invest in the project with the highest potential return on investment. The method also clarifies risk level, which can then be matched with a suitable funding method.
  • For businesses, capital budgeting is essential to taking on any significant investment or project.
  • This helps them accurately assess how profitable a particular project will be in the long run and whether or not it is worth the resources.
  • Capital budgeting provides businesses with vital knowledge and is a mandatory step for all new business endeavors.

Connected Financial Concepts

Circle of Competence

The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 


Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.


Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio



The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

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