Capital budgeting is the process where a business decides if a long-term investment is worth pursuing based on its long-term benefits. These types of capital investments could be in vehicles, buildings, tools, or technological improvements.
Usually, businesses will look at the lifetime cash flows (both in and out) that will be associated with the investments to determine if the returns make sense. For instance, when purchasing a new truck for your business, you may also have to hire a technician to drive it and to go to job sites in it.
The cost of many larger capital investments can be spread out over time through financing. However, for some investments there will be a larger investment up front, but then benefits that continue indefinitely.
Capital budgeting decisions can become a key factor in the long-term profitability of a company. Therefore, owners and managers need to compare the benefits and costs of the various capital investments they can make in their companies. There are many techniques companies can use to determine the long-term value of an investment.
I won’t go into them in too much detail here, but I will list and link to places to learn more:
- Accounting rate of return
- Net present value
- Profitability index
- Internal rate of return
- Modified internal rate of return
- Equivalent annuity
Most of the methods take into account the incremental cash flows or cash savings from the potential investment or project. Using these methods can help you determine if investing in new vehicles, new equipment, new warehouses, or new technology will be a wise investment.
Factors to Consider
The most important factors to consider are the total costs that will be present, including purchase price, maintenance costs, operational costs, etc. Vehicles for your service company, for instance, are good investments, but there is also the cost of running another vehicle (including maintenance, fuel, and manpower) to consider.
The process you use to budget for your equipment or technology improvements will vary based on what you are thinking of purchasing or accomplishing. However, one of the most important parts of budgeting is determining what you need and how it will help you.
Determine what the capital improvement project will accomplish or what time-consuming task it will replace. Look at the opportunity costs that not having the equipment or technology is costing both in the short and long-term. Then look at the cost of doing nothing both in the short and long-term compared to the total cost of the investment.
Finally, remind yourself why you were considering this capital investment in the first place. What are you trying to accomplish? What pain do you expect it to ease? With the costs and benefits in mind, estimate what kind of return on investment you can expect. Are you assumptions realistic? Will the benefits outweigh the costs by enough?
Thinking through all the costs and benefits of any capital improvement project will let you make the smartest decision for your company. Sometimes inaction is more expensive in the long-term than the investment in the new equipment you’re considering. Keep that cost in mind too when doing capital budgeting.
How do you go about deciding what investments are right for your company?