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Enterprise Project Performance

Capital Budgeting: Definition and Methods

Sustainable growth requires companies to choose the projects and investments that will yield the greatest return — but determining this is rarely straightforward. Capital budgeting is used to carefully evaluate potential projects by organizations across industries, from oil and gas enterprises to chemical companies to construction firms. There are many ways to handle capital budgeting analysis, of course, and which suits your enterprise best depends on which functional areas and projects you’re dealing with. 

Here you’ll learn how to build a robust, adaptable capital budgeting process to identify the opportunities that will add the most value to your company.

What is capital budgeting?

Capital budgeting is the process of allocating resources to capital projects and investments. It’s a key part of weighing potential projects to choose the most financially sound option. Capital budgeting is applicable to everything from purchasing a new piece of machinery to building a new facility. In general, capital budgeting focuses on cash flows rather than profits. It’s intended to reveal which project’s net cash flow has more value after expenses have been subtracted. Essentially, whichever project yields the most money is the front-runner to  get the green light. Of course, there are always other considerations — like potential risks — to take into account, and capital budgeting is only one part of a comprehensive portfolio planning process.

Why capital budgeting matters to your business

Capital budgeting helps your enterprise prioritize projects more intelligently, making a big contribution to its success and delivering an array of benefits.

Better return on investment

The most basic function of capital budgeting is determining which project has the best potential to bring in money. Companies that use capital budgeting have a better idea of a project’s earning potential and, by extension, which offers the best return on investment.

Align assets and budgets with business strategy

The process of capital budgeting ensures that decision-making at your enterprise is thoughtful and data-centered. It relies on teams coming together to compare top project ideas before analyzing which best align with the company’s needs. This attention to detail ensures that capital spending decisions align with the organization’s overall business strategy.

Improved accountability and financial transparency

Capital budgeting relies on accurate data and the ability to leverage technology, like project portfolio management (PPM) platforms, to get a full picture of the cash flows, expenses, and risks associated with a project or investment. Relying on established processes and a wide range of information to make these important decisions leads to enhanced accountability when it comes to a project’s success or failure. It also leads to a clear view of where an enterprise’s financial resources are allocated at any time, so it can quickly pivot and transfer those resources to other areas as needed and understand the impact of any changes.

Challenges of capital budgeting

There are a few potential pitfalls that your organization should take into account when practicing capital budgeting.

Using an unsuitable method

There’s more than one way to go about capital budgeting, and choosing the right method isn’t always easy. But failing to select the most appropriate method for the project at hand can lead to misalignment between cash flow expectations and reality. Do your research and use several methods if needed to get a full picture of a project’s potential return. 

Not adopting an integrated capital budgeting platform

Effective capital budgeting is almost impossible without a capital budgeting platform that integrates with other key project management and PPM areas. Look for a solution that can adapt to your organization’s unique processes and goals while bringing in information from forecasts and risk analyses. With the capability to produce multi-year capital plans that align with your enterprise’s overall business strategy, the right software can make capital budgeting more impactful than ever.

Failing to resolve process and personnel issues

Capital budgeting won’t deliver accurate results if consistent process and personnel issues drag project performance down. Establish project baselines and create snapshots of historical project data so you can identify and resolve problems to help capital budgeting estimates better match reality.

Four capital budgeting methods

Capital budgeting methods look at cash flows to give an indicator of economic performance and feasibility. Capital budgeting is different from actual budgeting, which involves allocation of funding to projects an organization decides to move ahead with based in part on the analysis of capital budgeting.

There are several capital budgeting methods. We will look at six of the most popular methods below.

1. Payback period

The payback period is the most straightforward capital budgeting method available. It calculates the amount of time it takes to make back the original investment. The rationale is simple: as companies lose money when they invest upfront, the best outcome is the shortest possible payback period once the investment begins generating revenue. What qualifies as an attractive payback period varies based on industry, the current state of the economy, and the projects or investment options currently available to an organization.

The equation for this method is as follows:

PP = investment amount/projected annual cash flow of project

For example, if a company invests $20,000 into a project, and the project is expected to earn $4,000 each year, it would take five years to make back the full investment amount. This project would likely move forward in the absence of other factors, as the payback period is relatively short.

The simplicity of payback period analysis also has its drawbacks, however. It doesn’t account for revenue after the payback period. In the example above, this might include another anticipated five years where the project earns $4,000, with an additional $2,500 from selling assets at the end of the project’s life. The payback period method also fails to discount the return on investment, whether in terms of opportunity cost or simply the time value of money.

2. Discounted payback period

That’s where the discounted payback period analysis comes in. It’s a more sophisticated version of the payback period method that discounts future cash flows to achieve a more accurate estimate of a project’s value. This involves establishing a discount rate, which should include up-front and ongoing costs, including those involved in acquiring the necessary capital, as well as the opportunity cost of selecting this project instead of others available. If the project’s discounted cash flow isn’t greater than the initial investment, it’s not worth pursuing.

Take a three year project with an initial investment of $10,000. The equation to calculate the discounted cash flow would be as follows, where “CF” is the cash flow period and “r” is the discount rate:

DCF = CF/(1+r) + CF/(1+r)/(1+r) + CF/(1+r)/(1+r)/(1+r)

As shown above, the discount rate is applied on a yearly basis, with the second and third years then being discounted at a higher compounded rate. With a cash flow of $5000 per year and a 10% discount rate, the discounted cash flow over three years comes to about $12,430.

2a. Net present value

After calculating the discounted cash flow, you can use the result to determine net present value (NPV). NPV compares the adjusted value of future cash flows to the present value of the investment. The equation below is a simplified net present value equation:

NPV=present value of expected cash flows−present value of investment

All other things being equal, organizations should go with the project that has the highest positive NPV. In our example above, the NPV comes out to $2,430. Note that, as with all calculations that rely on a discount rate, the NPV is based on predicted future values and may end up being incorrect.

2b. Profitability index

Alternatively, you can use the discounted cash flow figure to calculate the profitability index. Divide your result by the initial investment, instead of subtracting the two, to calculate the project’s profitability index:

PI=present value of future cash inflows/initial investment

If the profitability index is greater than one, the project stands to make a profit. For the example project, the profitability index is 1.243. If this was greater than the result for any other available projects, the organization should move forward in the absence of additional risks or other relevant factors.

3. Internal rate of return

The internal rate of return (IRR) is simply whatever discount rate results in an NPV of zero. It provides a relatively straightforward benchmark when compared to the cost of capital: if greater, then the project can proceed. If not, then it should be shelved. However, if cash outflows continue beyond the initial investment, there will be multiple internal rates of return, and it only serves as a benchmark, not an indicator of the full revenue a project will generate.

In addition, the IRR method assumes that cash flows during the project are reinvested at the internal rate of return. This is often not the case in reality, so organizations should instead consider employing the modified internal rate of return method, which allows for more control over the reinvestment rate.

4. Throughput

Unlike the other methods, which focus on individual projects, throughput measures revenue and expenses across an entire organization:

Throughput=revenue – variable costs

It revolves around a  bottleneck operation: whatever process serves as a limitation on the enterprise’s ability to generate revenue. Instead of taking on projects that look profitable but fail to realize that potential due to the limitations of the bottleneck operation, this analysis determines whether the project will improve the overall throughput of the company. This is typically through improving the capacity or efficiency of the bottleneck operation, or by reducing expenses.

This method is only appropriate for organizations that have a bottleneck operation, of course. And there are some instances where a project should still move forward even when it does not improve throughput. For example, hosting a charity event will not increase throughput, but an enterprise may choose to pursue the project due to positive impact on the community and its brand. Similarly, complying with relevant regulations or responding to risks may reduce throughput but still be required.

An example of the capital budgeting process

Now that you know the various capital budgeting methods you can choose from, let’s look at an example of the capital budgeting process in action. Consider an enterprise operating in the oil and gas industry. With project investments below pre-COVID levels, selecting the right projects and assets to invest in is critical. 

1. Identify available opportunities

This step will involves organizing all available contract offers and taking them one-by-one through the capital budgeting process. Our oil and gas company is first considering a refining project, with gasoline margins increasing five-fold over the past two years.  It anticipates that this project will bring in $400 million annually in profit once it is fully operational.

2. Estimate the cost of the investment and its return

This company knows that the initial investment, including labor, is $1 billion. They decide to start by calculating the discounted cash flow over fifty years. With a cash flow of $400 million per year after the estimated five-year construction period and a 10% discount rate, the discounted cash flow over fifty years comes to north of $4 billion. This leads to a profitability index of greater than 4. As the profitability index considers projects with ratios over 1.0 as candidates to move forward, so far, this opportunity looks promising. 

3. Evaluate potential risks

One major risk for this enterprise is not completing the project within the five year window. The longer it takes to get the refinery online, the longer it takes to start bringing in revenue. Another risk is a reduction in gas prices, as this will significantly affect their bottom line.

If the organization decides to move forward with the project, they will use their capital budgeting platform to closely manage these and other risks. It may be able to mitigate risks associated with constructing the refinery by drawing on historical data to make informed calculations regarding the resources needed to get the job done, so the organization can confidently procure them well in advance. The enterprise may also want to perform the calculations above again with an extended timeline for construction to see if the project still makes financial sense. 

4. Move forward — or don’t

The organization should go through the steps above for all other projects that are on the table and compare them all. Which have the highest potential to bring in the most revenue? What are the relative levels of risk? Are any mutually exclusive? Once all the information has been collected and analyzed using the appropriate capital budgeting methods, the enterprise can confidently choose the project or projects that stand to benefit it the most. 

Deliver accurate capital budgets with EcoSys™

EcoSys is an enterprise project performance platform that helps your organization produce accurate capital budgets tailored to its specific processes. It’s a flexible, integrated platform that connects capital budgeting with project portfolio management (PPM) and project management processes, so you always have a full picture of where your enterprise stands when making key capital spending decisions. 
Make capital budgeting a driver of organizational success at your company by contacting Hexagon today.