As a business owner, budgeting is something that is vital to the success if your business. How much should be allocated for payroll, special projects and even unexpected expenses. Limitations such as time, money and logistics frequently prevent a company from moving forward with too many major expenditure projects at the same time. Instead, a company will often rank its projects by priority and profitability. By using a process called capital budgeting, the company decides which capital expenditure projects will be undertaken and when.
At the top of the list of capital expenditure projects are those for which no real choice exists (e.g., installing an updated sewer line within the plant to replace one that is leaking, correcting a safety hazard, correcting a code violation, etc). The remaining capital expenditures are usually ranked according to their profitability using a capital budgeting model.
Capital Budgeting Models
There are a number of capital budgeting models available that assess and rank capital expenditure proposals. Let’s take a look at four of the most common models for evaluating business investments:
- Accounting rate of return
- Payback
- Net present value
- Internal rate of return
While each of these models has its benefits and drawbacks, sophisticated financial managers prefer the net present value and the internal rate of return methods. There are two reasons why these models are favored: (a) all of the cash flows over the entire length of the project are considered, and (b) the future cash flows are discounted to reflect the time value of money.
(Table below)
The following table highlights the differences among the four models:
