Capital budgeting for business investments

What is capital budgeting?
Capital budgeting for business investments is something every business owner needs to take into consideration as the business grows or expands. Capital budgeting is, essentially, the process of making long-term planning decisions for capital investments.

As a general rule, there are two main types of investment decisions you will need to capital budget for:
1. Selecting new facilities or expanding your existing facilities. This could be on a very large scale, including investing in more long-term assets such as a new building or new equipment, or it could be smaller and include market research or purchasing a new computer.

2. Replacing existing facilities with new facilities. This could include replacing manual systems with computerized ones, or replacing worn equipment with newer, fully-functional equipment.

Capital budgeting, in turn, has a large impact on the overall long-term profitability of a business.

Capital budgeting for business investments
If you are making capital budgeting decisions for your business, there are a number of methods you can use to do so. Some of the more well-known ones include:

Net present value
Net present value is one way of analyzing the profitability of an investment by comparing the value of a dollar today to the value of the dollar in the future. It also takes inflation and returns into account as well. This is done using a certain formula. If the net present value of the potential project is positive, the project or investment is usually accepted. However, if the net present value is negative, the investment should not be undertaken because cash flows, as a result, will also be negative.

Internal rate of return
Also referred to as the economic rate of return, the internal rate of return essentially makes the net present value of all cash flows from a project or investment equal to zero. It helps to determine the rate of growth a certain project or investment is expected to generate. Most often, the higher the project or investment's internal rate of return, the better the chances of a project or investment being profitable. Many companies will use the internal rate of return to rank a number of potential investments or projects they are considering to determine which will be the most profitable in the long run.

Payback Period
The payback period is another important factor when capital budgeting for business investments. Quite simply, the payback period is defined as the length of time required to recover the cost of an investment. It is calculated by dividing the cost of the project by the annual cash inflows. For example, if a project cost $50,000 and was expected to return $10,000 annually, the payback period would be calculated as $50,000/$10,000, or five years.Naturally, the best business investment with regards to payback period would be the one with the shorter payback period, meaning you can begin grossing money from your investment at a much faster rate.

Generally speaking, however, the payback period method is not the most accurate, as it does not take into account the time value of money or inflation. In addition, it does not measure profitability. For that reason, other methods are more accurate.

Capital budgeting is a necessary task before undertaking a large business investment or project. It will help to see whether the investment will actually help the company by generating more revenue, or it could determine if the investment wasn't financially sound.