Capital Budgeting

Big investments tie up large sums of money for many years and are often hard to reverse. Capital budgeting provides a structured way to decide which projects are worth pursuing.

The process usually involves estimating all the cash a project will cost and generate over its life, then evaluating those cash flows with financial methods. The most widely used method is net present value, which compares the value today of future cash flows with the initial cost. Other common methods include internal rate of return, payback period and profitability index.

For example, a company considering a new production line costing 2 million would forecast the extra sales, operating costs and maintenance it brings over, say, ten years. It would then discount those cash flows at its cost of capital to see whether the project adds value.

Capital budgeting also involves judging risk, testing how results change if assumptions are wrong and ranking projects when money is limited. Good capital budgeting decisions are among the most important a company makes, because they shape its future for years.