Decision-making is very important for every business. The future of the business is determined by these decisions. Financial decisions are equally important, especially when it comes to spending big money on projects. One such decision-making process is called capital budgeting.
In this blog, we will understand what capital budgeting means and how it works and see an example of project investment.
What is capital budgeting?
Businesses use capital budgeting to decide whether it is worth making long-term investments, such as buying new machinery, opening a new branch, replacing old equipment, and launching a new product line.
These are not everyday expenses. These are major spending decisions that affect the business for years. That is why it is important to plan them carefully.
Why is Capital Budgeting Important?
Why is the process of capital budgeting so important? Because it involves money. It helps businesses in some other ways, which are as follows:
1. Helps in making smart investment decisions, like where to invest, how much to invest and what return to expect
2. Wrong investments can lead to losses for many years. It prevents costly mistakes.
3. Ensures long-term business growth Capital budgeting is not about today or tomorrow; it is about the future.
4. Improves cash flow planning.
5. Increases shareholder confidence.
6. Helps in comparing multiple projects.
Steps in Capital Budgeting Process
Capital budgeting is process of the organizations employ to determine if they should invest in long-term endeavors like new equipment, structures, or vehicles. It aids in determining if the initiative will produce sufficient returns in the future.
1. Identify the Project
Finding possible investment prospects is the first step.
For example: Is it preferable for the business to construct a new warehouse or acquire a new delivery vehicle?
Managers now list all potential projects and decide which ones to research in greater detail.
2. Determine Cash Flows
Estimate all future cash inflows and outflows once you have chosen the project.
For instance:
The van price is ₹12,00,000.With an estimated annual savings of ₹100,000 on fuel and maintenance.Fast delivery generates an additional revenue of up to ₹2,00,000 per order.
The objective is to determine the ratio of the project's revenue to its expenses.
3. Evaluate the Project
To determine if the project is lucrative, use financial instruments:
Net Present Value (NPV): Determines the current worth of future cash flows. A project is considered to be excellent if its NPV is greater than zero.
Internal Rate of Return (IRR): The anticipated rate of return from the initiative. should exceed the rate that the business needs.
Retribution Duration: The amount of time it takes to get back the money you put in at the start. The shorter, the better.
4. Decide
According to the study, management decides:
If the project is financially viable, then accept.
If not, then reject or change.
5. Examine the Findings
Compare the real performance to the predicted outcomes after implementation.
For instance, did the new delivery vehicle really boost sales and reduce gasoline expenses?
This will help you make better capital budgeting decisions in the future.
Capital Budgeting Example
Suppose a company is planning to improve its operations by purchasing a new packaging machine.
Cost of the machine: ₹10 lakhs
This is the amount the company will have to spend upfront to buy the machine.
Expected savings in labour costs: ₹3 lakhs per year
Because the machine will handle packaging work, the company can reduce the number of workers or overtime needed. The cost of labour is saved by 3 lakhs every year as a result of that.
The useful life of the machine is 5 years.
The expectation is that this machine will work efficiently for 5 years.
Calculating the total benefit is what we need to do:
The amount saved over 5 years
₹3 lakhs × 5 years = ₹15 lakhs
Using the machine instead of manual labour will result in the company saving this amount.
Initial investment
The amount of money that was spent on the machine is 10 lakhs.
Final Result:
Total Savings (₹15 lakhs) – Investment (₹10 lakhs) = Profit of ₹5 lakhs
The company will not only recover the entire cost of the machine in 5 years, but they will also earn an additional 5 lakhs on top of that.
Common Methods Used in Capital Budgeting
Businesses use the following methods to evaluate projects:
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Method What It Tells You
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Payback Period : How fast you'll recover your investment
NPV (Net Present Value) : Whether the project adds valuein today’s money
IRR (Internal Rate of Return): The rate of return expected from the project
Profitability Index (PI): How much value is created for every ₹1 invested
There are different viewpoints to consider when looking at an investment through each method.
Final Summary
Businesses can make wise, long-term spending decisions with the aid of capital budgeting. Making sure the money spent benefits the business is the aim, regardless of whether it's a new machine or a new location. Even small businesses can use capital budgeting to expand safely and profitably with a few easy steps and some basic maths.
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