capital-budgeting

What Is Capital Budgeting? Capital Budgeting In A Nutshell

Business / By / August 20, 2021

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

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

Some of the more common capital budgeting methods include:

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.

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.

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.

Connected Business Frameworks

pirate-metrics
Venture capitalist, Dave McClure, coined the acronym AARRR which is a simplified model that enables us to understand what metrics and channels to look at, at each stage for the users’ path toward becoming customers and referrers of a brand.
north-star-metric
A north star metric (NSM) is any metric a company focuses on to achieve growth. A north star metric is usually a key component of an effective growth hacking strategy, as it simplifies the whole strategy, making it simpler to execute at high speed. Usually, when picking up a North Start Metric, it’s critical to avoid vanity metrics (those who do not really impact the business) and instead find a metric that really matters for the business growth.
marketplace-business-models
A marketplace is a platform where buyers and sellers interact and transact. The platform acts as a marketplace that will generate revenues in fees from one or all the parties involved in the transaction. Usually, marketplaces can be classified in several ways, like those selling services vs. products or those connecting buyers and sellers at B2B, B2C, or C2C level. And those marketplaces connecting two core players, or more.
network-effects
A network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.
platform-business-models
A platform business model generates value by enabling interactions between people, groups, and users by leveraging network effects. Platform business models usually comprise two sides: supply and demand. Kicking off the interactions between those two sides is one of the crucial elements for a platform business model success.
negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 
virtuous-cycle
The virtuous cycle is a positive loop or a set of positive loops that trigger a non-linear growth. Indeed, in the context of digital platforms, virtuous cycles – also defined as flywheel models – help companies capture more market shares by accelerating growth. The classic example is Amazon’s lower prices driving more consumers, driving more sellers, thus improving variety and convenience, thus accelerating growth.
amazon-flywheel
The Amazon Flywheel or Amazon Virtuous Cycle is a strategy that leverages customer experience to drive traffic to the platform and third-party sellers. That improves the selections of goods, and Amazon further improves its cost structure so it can decrease prices which spins the flywheel.

Connected Financial Concepts

Financial Modeling

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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.

Double-Entry Accounting

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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.

Accounting Equation

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The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down into assets, and how they get sources (either through equity/capital or liability/debt).

Financial Accounting

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Financial accounting is a subdiscipline within accounting that helps organizations provide reporting related to three critical areas of a business: its assets and liabilities (balance sheet), its revenues and expenses (income statement), and its cash flows (cash flow statement). Together those areas can be used for internal and external purposes.

Balance Sheet

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).

Capital Structure

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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 endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

CAPM Model

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In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to building a diversified portfolio able to give satisfactory returns. 

Capital Expenditure

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Capital expenditure or capital expense represents the money spent toward things that can be classified as a 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.

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with the 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.

Income Statement

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).

Profitability Framework

profitability
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

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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.

Profit Margin

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The profit margin is a profitability financial ratio, given by the net income divided by the net sales, and multiplied by a hundred. That is expressed as a percentage. That is a key profitability measure as combined with other financial metrics, it helps assess the overall viability of a business model.

Gross Margin

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The gross margin is a financial ratio metric, which helps assess the profitability of a business and also its operational efficiency. Indeed, as gross margins take into account cost of goods sold (the cost incurred to deliver the software to the customer) it’s a measure to assess the value of a business.

Financial Option

financial-options
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.

Financial Ratio

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Buffet Indicator

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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.

Behavioral Finance

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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.

Market Moat

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Economic or market moats represent 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.

Decentralized Finance

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Decentralized finance (DeFi) refers to an ecosystem of financial products that do not rely on traditional financial intermediaries such as banks and exchanges. Central to the success of decentralized finance is smart contracts, which are deployed on Ethereum (contracts that two parties can deploy without an intermediary). DeFi also gave rise to dApps (decentralized apps), giving developers the ability to build applications on top of the Ethereum blockchain.

Blockchain

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Establishing a robust infrastructure is the cornerstone of cloud computing. It often accounts for a third of the total amount spent on IT in a majority of businesses. Instead of taking computer workloads through the internal IT team, this traditional approach seemed to be long gone. Modern industries that embrace digital transformation with open arms gradually transfer systems into the cloud. Whether the information is on a private or public cloud, it offers increased security and safety against cyber threats. The result of increased cloud usage opens doors for cloud computing services provided by vendors and enterprises.

Bitcoin

bitcoin
Bitcoin was the first digitalized and decentralized cryptocurrency, released as open-source software in 2009. It uses an underlying technology called Blockchain, which works as digital, distributed ledger, that can be used as a mechanism for disintermediating trust in transactions.  

Revenue Modeling

revenue-modeling
Revenue modeling is a process of incorporating a sustainable financial model for revenue generation within a business model design. Revenue modeling can help to understand what options make more sense in creating a digital business from scratch; alternatively, it can help in analyzing existing digital businesses and reverse engineer them.

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