Capital budgeting

Capital investments are long-term investments in which the assets involved have useful lives of multiple years. For example, constructing a new production facility and investing in machinery and equipment are capital investments. Capital budgeting is a method of estimating the financial viability of a capital investment over the life of the investment.

Unlike some other types of investment analysis, capital budgeting focuses on cash flows rather than profits. Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment. For example, non-expense items like debt principal payments are included in capital budgeting because they are cash flow transactions. Conversely, non-cash expenses like depreciation are not included in capital budgeting (except to the extent they impact tax calculations for "after tax" cash flows) because they are not cash transactions. Instead, the cash flow expenditures associated with the actual purchase and/or financing of a capital asset are included in the analysis.

Over the long run, capital budgeting and conventional profit-and-loss analysis will lend to similar net values. However, capital budgeting methods include adjustments for the time value of money (discussed in AgDM File C5-96, Understanding the Time Value of Money). Capital investments create cash flows that are often spread over several years into the future. To accurately assess the value of a capital investment, the timing of the future cash flows are taken into account and converted to the current time period (present value).

Below are the steps involved in capital budgeting.

Identify long-term goals of the individual or business.
Identify potential investment proposals for meeting the long-term goals identified in Step 1.
Estimate and analyze the relevant cash flows of the investment proposal identified in Step 2.
Determine financial feasibility of each of the investment proposals in Step 3 by using the capital budgeting methods outlined below.
Choose the projects to implement from among the investment proposals outlined in Step 4.
Implement the projects chosen in Step 5.
Monitor the projects implemented in Step 6 as to how they meet the capital budgeting projections and make adjustments where needed.
There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the Payback Period, Discounted Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.