Capital budgeting for investing

Capital budgeting is a key part in marketing. Decisions on investment are based on the returns which that investment will make. If the investment will be unprofitable in the long run, it is not wise for a company to make an investment now. So what is capital budgeting?

Capital budgeting is the planning process used to determine whether a firm's long term investments (machinery, replacement machinery, new products, and developmental projects) are worth pursuing. It is good to know what the present value of future investments are, and how long it will take for the investment to provide a return.

Some typical investment decisions are decisions on building grain silos, cotton gins, or investment in a new distribution depot. For lower levels of capital budgeting, the investment could be an evaluation on advertising or increasing the sales force.

The formal methods used in capital budgeting include the following techniques:


• Net present value - Each project's value is estimated using a discounted cash flow to find its net present value. This includes sizing and timing all of the incremental cash flows from the project. Future cash flows are often discounted to determine their present value. The values are all summed together to determine the net present value.


•  Internal rate of return - The IRR is the discount rate that gives a net present value of zero. This is commonly used to measure investment efficiency. The IRR equation typically cannot be solved analytically, only with iterations.


•  Modified Internal Rate of Return - This is used to measure the attractiveness of an investment. It is used in capital budgeting to determine the ranks of alternative choices.


•  Equivalent annuity method - This method is used to express the net present value as an annualized cash flow by dividing it by the present value of the annuity factor. It is used when you are assembling the costs of specific projects that have the same cash inflows. It is also used if you are comparing investment projects of unequal life-spans.

Capital budgeting is also called "investment appraisal." It basically means that there is a certain level of value you should put toward an investment. If you succeed at proper capital budgeting, your business will profit from proper investment decisions.

Capital planning involves a certain level of budgeting. This includes the development of benefits, losses, and costs associated with certain risks your company will take. The point of capital budgeting is that it will create a simple process of explaining the most important variables in a business investment decision over the short and long term.

Capital budgeting is more than just number crunching. You need to plan a strategy to support your numerical analysis and planning options. In order to do well in investing your business dollars, you need to have the ability to evaluate both the hard numbers and the soft numbers in order to produce a realistic capital budget.

Capital budgeting is a significant investment of time, experience, and number crunching. Having the insight to foresee investment risks and weigh them against potential investment benefits can be taught through time and experience. Before you sign on for a capital budgeting project, be sure you know what you are doing. This is one area in business that you do not want to be out of the loop with.

Of course, the business decision making process can be difficult, especially when your reputation, business experience, and job are on the line. Many companies don't have time to wait for you to show them results in the future, they want results now. With some training and a good understanding of the importance of capital budgeting, business investments can be rewarding and fun.