Definition of Capital Budgeting
Capital budgeting is the process that a business uses to determine which proposed fixed asset purchases it should accept, and which should be declined. This process is used to create a quantitative view of each proposed fixed asset investment, thereby giving a rational basis for making a judgment.
Capital Budgeting Methods
There are a number of methods commonly used to evaluate fixed assets under a formal capital budgeting system. The more important ones are:
- Net present value analysis. Identify the net change in cash flows associated with a fixed asset purchase, and discount them to their present value. Then compare all proposed projects with positive net present values, and accept those with the highest net present values until funds run out.
- Constraint analysis. Identify the bottleneck machine or work center in a production environment and invest in those fixed assets that maximize the utilization of the bottleneck operation. Under this approach, you are less likely to invest in areas downstream from the bottleneck operation (since they are constrained by the bottleneck operation) and more likely to invest upstream from the bottleneck (since additional capacity there makes it easier to keep the bottleneck fully supplied with inventory).
- Payback period. Determine the period required to generate sufficient cash flow from a project to pay for the initial investment in it. This is essentially a risk measure, for the focus is on the period of time that the investment is at risk of not being returned to the company.
- Avoidance analysis. Determine whether increased maintenance can be used to prolong the life of existing assets, rather than investing in replacement assets. This analysis can substantially reduce a company's total investment in fixed assets.
The Importance of Capital Budgeting
The amount of cash involved in a fixed asset investment may be so large that it could lead to the bankruptcy of a firm if the investment fails. Consequently, capital budgeting is a mandatory activity for larger fixed asset proposals. This is less of an issue for smaller investments; in these latter cases, it is better to streamline the capital budgeting process substantially, so that the focus is more on getting the investments made as expeditiously as possible; by doing so, the operations of profit centers are not hindered by the analysis of their fixed asset proposals.