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Capital budgeting is a financial viability estimation methodology on whether a capital investment is viable to take over a specified investment period (Hofstrand, 2013). This method focuses on cash flow rather than profits, considering cash flow inflow and outflow instead of revenues and profits (Hofstrand, 2013).
In essence, capital budgeting is making investments in real assets (Brealey, Myers, and Allen, 2012). The importance of capital budgeting in business are: (1) it ensures that decisions are made orderly; (2) it helps identify major uncertainties in project proposals (Brealey, Myers, and Allen, 2012); (3) it helps a company develop and formulate long-term strategic goals, look for new investment projects, forecast and estimate future cash flows, facilitate information transfer, monitor and control decisions, make decision rules (Gad).
Information in a capital budgeting process should be a systematic manner in such a way that the following are determined before comparing investment alternatives: rate of return expected, cash outlay budget, and projected future cash flows. In addition, information on marketing, science, regulations, engineering, production, ethics, and behavioral issues need to be systematically gathered and evaluated (My Investment 101, 2012).
Capital budgeting involves thorough projections of the future. If the projections are incorrect, then the whole capital budgeting process could go wrong. For example, if the future free cash flow projections are not based on some credible historical factors, or external market conditions are not deeply researched, then it would have an impact on the capital budgeting process. Capital budgeting decisions are crucial because it would be very difficult to recover once the initial cash outlay has been made. Therefore, it is important not to make mistakes in this crucial decision and this can be done if relevant, objective, and appropriate information is gathered.
An example of a capital budgeting process would be a business involved in a car rental business. The initial capital outlay is $300,000 where $100,000 is for the space, $170,000 for the cars to be rented by customers and related equipment, $30,000 as working capital, and projected cash revenue of $110,000 every year for 10 years (Hofstrand). Then after all variable and fixed costs are deducted, a net cash flow before tax is generated every year.
After further deducting depreciation expenses and taxes, the cash flow after tax is $42,000 every year for 9 years then on the 10th year, $37,500. The net present values of all the cash flow after tax and the cash value of the cars and equipment after 10 years is $140,000. After discounting all of these cash estimates, the net present value is $64,315 which makes the investment favorable to take (because the cash flow is positive)
References
Gad, S. Capital budgeting: the importance of capital budgeting. Investopedia.
Hofstrand, D. Capital Budgeting Basics. Iowa State University.
My Investment 101. Capital Budgeting Process.
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