What is capital budgeting, and what does it have to do with your business investment?

When a business is considering an investment or project, one of the first things it should do is capital budgeting. Capital budgeting uses a number of methods and formulas to determine whether or not a project or investment will be profitable for the company in the long run.

Capital budgeting can mean the difference between a profitable investment and one that actually ends up costing the company money in the long run. As a general rule, there are two main types of investment decisions you will need to capital budget for:

1. Selecting new facilities or expanding your existing facilities. This could be on a very large scale, including investing in more long-term assets such as a new building or new equipment, or it could be smaller and include market research or purchasing a new computer.
2. Replacing existing facilities with new facilities. This could include replacing manual systems with computerized ones, or replacing worn equipment with newer, fully-functional equipment.

What does capital budgeting have to do with my business investment?
Say you decided to invest $50,000 on a new computer system for your office designed to save money by reducing the time it takes to process orders. You invest in the necessary equipment, only to find that the revenue you make from the orders isn't enough to justify the expense for the new system. Capital budgeting could have helped you to see that before you made the costly mistake.

Capital budgeting involves a number of methods and formulas for determining long-term profitability. Some of the more common include:

- Internal rate of return. Sometimes referred to as the economic rate of return, the internal rate of return essentially makes the net present value of all cash flows from a project or investment equal to zero. It helps to determine the rate of growth a certain project or investment is expected to generate. Most often, the higher the project or investment's internal rate of return, the better the chances of a project or investment being profitable. Many companies will use the internal rate of return to rank a number of potential investments or projects they are considering to determine which will be the most profitable in the long run.
- Net present value. The net present value is another way of analyzing the profitability of an investment by comparing the value of a dollar today to the value of the dollar in the future. It also takes inflation and returns into account as well. This is done using a certain formula. If the net present value of the potential project is positive, the project or investment is usually accepted. However, if the net present value is negative, the investment should not be undertaken because cash flows, as a result, will also be negative.
- Equivalent annual cost. The equivalent annual cost is the cost per year that is required to own and operate a particular asset over its given lifetime. This can include machinery, vehicles, and other types of assets. The equivalent annual cost is calculated by dividing the net present value (see above) of a project by the present value of an annuity factor.

As you can see, capital budgeting is a valuable way of determining whether or not an investment will be profitable in the long run.