Capital budgeting involves deciding what new projects a company should invest in. Business owners strive to determine which projects would yield the most return over a given period of time. For example, a business might weigh the benefits of starting a new product line, building a new plant or partnering with an overseas firm in a joint venture. Capital budgeting projects typically continue to earn money for the firm after one year.
The five steps of capital budgeting are often described as exploring opportunities, estimating costs, determining the benefits, assessing any potential risk involved, and making the final decision.
Discuss potential projects with your firm's major departments, Mark Hirschey advises in "Managerial Economics." Ask the accounting department how much money the firm can spend on new projects during the current year. Discuss market forecasts with the marketing department to learn which types of investments are currently strongest. Also, discuss ideas for development with other departments such as engineering and research. Consider routine cost-reduction projects such as replacing old equipment, as well as expansion projects such as offering new services.
Ask departmental staff to estimate the operating costs for the projects that seem most promising in light of the market forecast. For instance, find out from the engineering department what new equipment, supplies and other expenses are necessary for a research project. Next, have the accounting or purchasing department to confirm these operating expenses.
You will need to estimate the cash flows – how much the firm expects to earn – from each proposed project. Determine the value of each project at a specific date, such as one year from its start. Subtract the project's cost from this amount to determine how much profit the company would earn, then compare the expected earnings from each project.
Assess Potential Risk
Estimate the risk involved with each project – how much the firm stands to lose if the project fails. Along with marketing staff and head staff from any departments involved with the project, estimate the likelihood of failure and success. Assign each project a percentage expressing likelihood of failure and a percentage expressing likelihood of success.
The Final Decision
Weigh the likelihood of failure against the estimated return for each investment. Pursue projects for which the likelihood of success outweighs the likelihood of failure, as long as their expected return makes them worthwhile investments. You and your accounting department must determine how much of a return makes an investment worthwhile for your firm. Ultimately you must also decide how much risk you're prepared to accept for a potentially profitable investment. This will depend on how diverse your investment portfolio is – if you have numerous low-risk investments, a high-risk investment might be worthwhile. Just make sure your firm could weather the loss of an investment.