Capital budgeting is an important function of the finance department within a business. It is the process of allocating funds for the purchase of property, factories and equipment. While the importance of capital budgeting is not disputed, the methods of capital budgeting enjoy support from a wide array of finance professionals.
Payback period is perhaps the most simple method of capital budgeting. The basic premise of this method is to determine the amount of time that is required to recoup the funds spent on the capital project or equipment expenditure. The payback period is calculated by dividing the total expenditure amount by a desired time frame for investment recovery. This method is not a recommended means of capital budgeting due to its simplistic concept.
Net Present Value
Net present value is a widely used method of capital budgeting that determines if a capital project should proceed based upon analysis of the benefits versus the costs. Firms should always ensure that their rate of return of their investment is always higher than their cost of capital and the premium that they place on the risk of the investment. This concept is known as the hurdle rate. Net present value is calculated by subtracting the present value of the costs from the present value of the benefits of the capital project.
Internal Rate of Return
Internal rate of return is a complex capital budgeting method. The internal rate of return is the discount or interest rate that makes the income stream of an investment sum to zero. The income stream of an investment is calculated by adding the total cash flows of the project. The initial cash outflow begins as a negative, with the interest, or benefits, received each year listed as a positive. When the project is completed, the value of the investment is also added to the negative initial investment figure and the yearly interest amount. Internal rate of return is the discount percent that makes these figures total to zero, and it is helpful when comparing alternative investments or capital projects.
Spreadsheets in Capital Budgeting
The mathematical equations that arise when attempting to calculate net present value and internal rate of return can be formidable to the untrained analyst. Spreadsheet programs have made the task of capital budgeting much easier and user friendly. Analysts can find spreadsheet-based capital budgeting templates online. This decreases the amount of time spent during the capital budgeting process, while producing a more consistent, accurate result. Analysts and accountants can take courses to better equip them to use spreadsheet applications to produce capital budgeting documents from groups such as a state Certified Public Accountant trade group.
A southeastern Ohio native, Justin Johnson is a finance professional with accounting and financial planning experience in various manufacturing industries. He discovered a love for writing as student at Pensacola Christian College and after learning many lessons in the workplace, he enjoys writing business and finance pieces.